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Inflation and bond yields

Consumer price inflation came in a little higher than expected in September, and both the core and headline measures registered some acceleration. Inflation is alive and well, but not terribly high.

Subtracting energy, the CPI is up at a 2.9% annualized rate in the past six months, and that is almost the fastest pace in the past decade. As I've argued repeatedly, the fact that non-energy inflation is up despite the huge amount of economic slack prevailing in the economy is prima facie evidence that monetary policy has been and continues to be quite accommodative. There is no shortage of money out there, and that negates the deflationary concerns that have contributed to the market's malaise. Things could be a lot worse if we had not only a weak economy but also a general decline in the price level.

If you believe that core measures of inflation (ex-food and energy) are the appropriate ones by which to judge monetary policy (I don't necessarily agree, but the Fed pays more attention to core inflation than to headline inflation), then the chart above suggests that the bond market in the past three months has zigged when it should have zagged. Long bond yields are now only about 1% above the year-over-year rate of core inflation, when they typically exceed core inflation by at least 2% (note how the y-axes in the chart above offsets yields and inflation by 2%). The last time this happened (at the end of 2008), the decline in yields proved very fleeting, and already we have seen 30-yr bond yields jump by almost 50 bps from their lows earlier this month.

This last chart compares 10-yr Treasury yields to the core CPI over a shorter time frame, and it too shows that yields have fallen to very low levels relative to inflation. Bond market vigilantes have been lulled into complacency by the events in Europe—the threat of sovereign defaults seems to have created mass panic over the prospects of another recession and a return of deflation. But the longer we go without these fears being confirmed by terrible events in Europe—not just a Greek default, but also a wave of bank failures and a collapse of economic activity—the more upward pressure there will be on bond yields. More and more, I'm coming around to the idea that a Eurozone collapse has been so widely feared for so long that when Greece finally does default, the aftermath won't be nearly as ugly as the expectations.

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