Inflation Expectations or What?

There is much talk today about what appears to be rising inflation expectations in the U.S. There are several market indicators that are capturing people's attention today.

First the yield curve, measured by the difference between the 2 year yield and the 10-year yields stands near 262 bp, having risen now 21 bp over the past month. Second, the five-year/five year forward, which some Fed officials have cited in the past, is at 288 bp today, the highest in over a year. This is also reflected in the 10-year breakevens (10-year TIPS vs the conventional note yield). Third, some observers are also emphasizing the new record high price of gold. Fourth, the dollar remains offered with the much watched dollar index making a new low for the year.

Just last week, the FOMC statement identified that "subdued inflation trends, and stable inflation expectations". Could it be wrong so soon ?

Perhaps there is something else going on. Like what? Like a record quarterly refunding this week. Each leg, $40 bln of the 3 year note, $25 bln of the 10-year note, and $16 bln of the 30-year bond, is a record.

In addition, over the weekend, Obama signed on to a further extension of unemployment benefits, an extension of the home buyers tax break and an extension of businesses ability to deduct 2008 (and now 2009) losses from profits over the past five years (not just two).

The US does not report it Oct inflation readings until next week. Both the PPI and CPI will remain in negative territory. In Sept, PPI stood 4.8% below year ago levels. The consensus is for the Oct reading to be around -2%. But this likely reflects energy prices and core PPI is likely to ease toward 1.4-1.5% from 1.8% in Sept. Headline consumer prices are expected to have risen by 0.3%, but this too is likely a reflection of food and energy prices. core prices are expected to have risen by 0.1%. The year-over-year headline rate may moderate to -0.2% from -1.3% owing largely to base effects. Core CPI is expected to be little changed at 1.5%.

It seems too early to conclude that inflation expectations have broken out to the upside. It would be significant development if they did and therefore it requires convincing evidence to draw that conclusion. A clearer picture should emerge on the other side of this week's refunding and next week's inflation report.

That said, over time, inflation expectations likely will rise as the US economy continues what we expect to be a moderate recovery with the next several quarters averaging above trend growth. The high levels of unemployment, which still appears to be rising, even though the pace of initial jobless claim filing and non-farm payroll cuts seem to be moderating, relatively low level of industrial capacity utilization, and low unit labor costs, suggest some observers may be exaggerating the near-term inflation outlook.