Wednesday, December 16, 2009

Inflationary Expectations Rising

The yields on Treasuries have again started to increase. But that reflects a big increase in inflationary expectations, not rising real yields.

Though real yields both for 5- and 10-year notes temporarily dipped to even lower levels in late November, they have generally been a lot higher than they are now.

For example, the yield on 5-year inflation protected securities was 1.5% in early March while the yield was still more than 1% as early as in the beginning of Septemer. For 10-year securities, the real yield was more than 2% in early March and 1.7% in early September.

Now, however, the real 5-year yield has plummeted to as low as 0.28%, while the real 10-year yield has dropped to 1.28% (as of this writing, when you read this the numbers may have changed up or down by a few basis points).

Yet, nominal yields have generally not changed in the same direction. The 5-year yield rose from slightly less than 2% in early March to about 2.3% to 2.4%, a level at which it remains now. The 10-year yield rose from less than 3% in early March to nearly 3.5% in early September. Since then, the 10-year yield has risen slightly to about 3.6%.

The upshot of these differentials is that implicit inflationary expectations have risen from less than 1% in early March to 1.3% to 1.4% in early September to more than 2% now for 5-year securities, while implicit inflationary expectations have risen from less than 1% in early March to about 1.7% in early September to about 2.3% now.

It is possible and even likely that part of these changes in yield differentials have been driven by changes in liquidity preferences. Inflation-protected securities are not as liquid as nominal securities, so these movements likely reflect in part changes in liquidity preferences. But while liquidity preference probably was a factor, it was likely not the only one or even the most important one. Clearly, investor’s inflationary expectations are rising right now.

Since investors aren't infallible that of course doesn't mean that inflation will necessarily rise. The recent stagnant money supply developments makes a significant increase in inflation beyond what we've already seen (and are likely to see in the December numbers) unlikely. But increasing inflationary expectations is something which will increase demands of higher prices, interest rates and wages and so have a stagflationary effect on the economy.