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Inflation expectations are heating up (cont.)




This chart compares my calculation of the 5-yr, 5-yr forward inflation expectations embedded in the pricing of Treasuries and TIPS (i.e., the market's expectation of what the 5-yr forward average rate of CPI inflation will be five years in the future) with the actual, year-over-year rate of inflation according to the CPI. By this measure, inflation expectations were only briefly higher than they are today in August 1997. (Note that forward inflation expectations have naturally been much less volatile than actual inflation, since the forward measure is based on what the market expects inflation to average over a 5-yr period.)

While it's clear that inflation expectations have been heating up considerably in the past few years (from almost zero at the end of 2008 to now almost 3%), it's also true that inflation expectations might still be considered to be "anchored" in the sense that they are not outside the range of what actual inflation has been over the past few decades.

So far, the market data support both those who worry that inflation is heating up, and those who believe that inflation is still firmly under control. Thus, reasonable men can continue to disagree on this subject.

As one of those who worries that inflation is likely to continue to heat up, and potentially sustain a higher level than what we have seen in recent decades, I cite the evidence of a very weak dollar, very strong gold and commodity prices, a very steep yield curve, and a super-abundance of bank reserves which have the potential to create a significant expansion in the money supply. Those who are not worried about inflation cite the economy's weak growth and large output gap (which according to Phillips Curve theory creates significant deflationary pressures), the relatively subdued 6% growth in the M2 money supply, and the significant decline in real estate prices.

I would add that on the margin, the evidence lends more support to those who worry than to those who don't. Both actual and expected inflation have been rising this year, much as the market-based evidence (e.g., the dollar, gold, commodities, yield curve) has been predicting, and contrary to what the Phillips Curve theory of inflation has been predicting.

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