The economy contracted at a 6.1% annual pace in the first quarter, more than expected. The contraction was driven mainly by a huge inventory drawdown, which in turn was a reaction by business to the big slump in spending in the prior quarter. That will almost certainly turn around for the better in the current quarter, because spending is now growing again—real consumer spending rose at a 2.2% rate in the first quarter, and all the green shoots out there confirm that activity is bouncing in many areas of the economy.
The big news for me, however, was the 2.8% annualized rise in the GDP deflator, which is the broadest gauge of inflation. The chart above shows the year over year change in the deflator, and as you can see, there's not a lot going on, with inflation today about where it has been on average since the early 1990s. This is one of those "dogs that didn't bark," because conventional wisdom says that the huge (6.2% annualized) contraction in GDP over the past six months should have produced at least a little bit of deflation. That inflation is instead still alive and well is big news, because it says the conventional view of inflation is wrong. Inflation is not, as most people think, a function of the strength of the economy, but rather, as Milton Friedman says, a monetary phenomenon. Money has not been tight enough in recent years to bring inflation down. Since monetary policy is now quite accommodative, we should expect to see inflation drifting higher over the course of the year. This runs counter to what the market and the Fed are expecting, and that could easily overshadow the economy's likely recovery.
TIPS still offer good protection against higher-than-expected inflation, since they are priced to the assumption that inflation will be much lower than average over the next several years. Treasury bond yields, on the other hand, are going to be under tremendous pressure to rise.
Full disclosure: I am long TIP and TIPS, and long TBT at the time of this writing.