Bond market on the horns of a dilemma

Inflation and expected inflation are arguably the major determinants of interest rates. If the bond market appears to react to signs of growth, as it often does, then that is because the bond market—and the Fed—continue to think that growth and inflation are linked: i.e., more growth increases inflation risk, while less growth reduces it. We are now living in interesting times, however, because growth has been unusually weak and the so-called "output gap" (the amount of excess capacity, or the amount by which the economy is operating below its potential) has been huge—currently about 10% according to my calculations. Yet inflation by all measures has been rising. The bond market wants to rally, given how weak the economy is, but it is bumping up against the reality of higher inflation, as the chart above suggests.

Core inflation over the past six months is running at a 2.5% annualized rate. That doesn't sound like much, but as the top chart suggests, when core CPI is 2.5%, 10-yr Treasury yields tend to be in the neighborhood of 4.5%, and a 2% spread between inflation and bond yields is close to the long-term average. If long-term trends reassert themselves, Treasury yields could rise significantly. So the bond market is essentially caught on the horns of a dilemma: the lure of weak growth (perhaps made weaker by sovereign defaults) vs. the reality of rising inflation. We haven't seen a test of the Phillips Curve theory of inflation like this for a long time. The last time I remember such a test was in the late 1990s, when the economy was booming, and the Fed was fearful that the economy was "overheating" and inflation would rise. By the time the dust had settled, around 2002-2003, we realized that inflation had almost fallen enough to produce deflation. I think that when the dust finally settles on the current environment, we will see inflation rising some more, and Treasury yields rising by a lot more. 

In the meantime, there are two clear facts about inflation: 1) it has been extraordinarily volatile over the past 10 years, and 2) by all measures inflation has moved higher in the past year. At the very least, the volatility of inflation is a problem since it leaves the world uncertain as to what is really going on. The fact that inflation has risen, despite the very sluggish recovery and the existence of tons of excess capacity, is also problematic, because it directly challenges the theory that says inflation should be very low because the economy is so weak. Both of these realities weigh heavily on Treasury note and bond prices.