The key fixed income story for 2009 is the inflation deflation debate. Of course, when is fixed income not a inflation story? There is a big gulf in reality and market expectations, but getting this question right will determine gains for the year in both fixed income and currencies.
US CPI came out this week with the usual mixed news message. CPI YOY was down -1.4 while the core CPI ex food and energy was stable at 1.7%. So what do we believe? If you look at headline CPI, the real rate of interest is significantly positive. 5-year Treasuries are at 4% so there could be an easy argument that we should see a rally. If you focus on the core we are slightly positive at .75%. Now we could argue that real rates should be negative in general at this point in the business and credit cycle if we want to see a recovery, but under the core inflation story we are approximately fair value.
The Fed scorecard could be considered mixed. If the objective of policy is to move rates to zero and get inflationary expectations positive to force real rates to be negative, they have failed. With the inflation rate negative, we still have positive short-term real rates.
The big difference in the two inflation indices was caused by the commodity price shock last year. Note that we have now reversed the big increase in CPI from last year, bu we over-all core inflation is not negative. (We are assuming that the inflation rate is measured properly.)
The graph of the difference in inflation indics shows that we can go for long periods of the the core CPI and headline being different. Headline as expected is more volatile. The correlation between the two rates has actually fallen over the last ten years. We are now seeing an increase but this c0movement is still low. Looking at these number suggests that deflation may not be a problem.
Reviewing the macro information suggests that inflation is not a problem in the short-run. There is a large output gap and a significant decline in capacity utilization. There is little change that we will have a tightness in the real economy. Money has increased as measured by the Fed balance sheet but most of this is in the form of excess reserves so the money multiplier and velocity have been falling. There is excess of money in the system. Hence there is no reason to believe that inflation will go up in the next two to three years.
There may be an inflation problem but it will not be present anytime soon. There may be a deflation problem but it is not present in the data once we account for the commodity price shock of last year.
US CPI came out this week with the usual mixed news message. CPI YOY was down -1.4 while the core CPI ex food and energy was stable at 1.7%. So what do we believe? If you look at headline CPI, the real rate of interest is significantly positive. 5-year Treasuries are at 4% so there could be an easy argument that we should see a rally. If you focus on the core we are slightly positive at .75%. Now we could argue that real rates should be negative in general at this point in the business and credit cycle if we want to see a recovery, but under the core inflation story we are approximately fair value.
The Fed scorecard could be considered mixed. If the objective of policy is to move rates to zero and get inflationary expectations positive to force real rates to be negative, they have failed. With the inflation rate negative, we still have positive short-term real rates.
The big difference in the two inflation indices was caused by the commodity price shock last year. Note that we have now reversed the big increase in CPI from last year, bu we over-all core inflation is not negative. (We are assuming that the inflation rate is measured properly.)
The graph of the difference in inflation indics shows that we can go for long periods of the the core CPI and headline being different. Headline as expected is more volatile. The correlation between the two rates has actually fallen over the last ten years. We are now seeing an increase but this c0movement is still low. Looking at these number suggests that deflation may not be a problem.
Reviewing the macro information suggests that inflation is not a problem in the short-run. There is a large output gap and a significant decline in capacity utilization. There is little change that we will have a tightness in the real economy. Money has increased as measured by the Fed balance sheet but most of this is in the form of excess reserves so the money multiplier and velocity have been falling. There is excess of money in the system. Hence there is no reason to believe that inflation will go up in the next two to three years.
There may be an inflation problem but it will not be present anytime soon. There may be a deflation problem but it is not present in the data once we account for the commodity price shock of last year.
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