Inflation Expectations

There has been a lot of discussion over the past two days about Ben Bernanke’s inflation-fighting credentials, as PGL so aptly summarized in the previous post. Interestingly, the past two days have also seen some significant activity in bond markets. For example, as of 3pm today (EDT) Marketwatch reports that short-term interest rates have leapt to their highest levels in four years.

But this is the result of steady upward march in interest rates that has been ongoing for some time, as the chart below illustrates.

There are a couple of reasons behind this recent trend in interest rates. First, short term rates are continuing upward because of expected continuing Fed tightening; i.e. the market fully expects the pattern of increases in the Federal Funds rate to continue.

The Federal Funds rate has little influence over long-term interest rates, however. The recent rise in long-term rates could be because that the market expects higher inflation over the coming years, because the market expects higher real interest rates, or a combination of the two. But it turns out that the recent run-up in long-term bond yields is due to higher real interest rates, not higher inflation expectations.

As the chart below illustrates, inflation expectations (which can be measured as the difference between the nominal bond yield and the inflation-adjusted bond yield) increased somewhat during August and September (almost certainly tied to the rise in oil prices during that time), but have not risen since then. (Note that the chart includes data for Monday, Tuesday, and Wednesday of this week.)

Reassuringly, the market’s inflation expectations in the wake of the Bernanke nomination have not shown any significant change from last week or last month. If there are people who worry that Bernanke will be an inflation dove, then apparently there are equal numbers who worry that he will be an inflation hawk, leaving the average inflationary expectation pretty much right where it was.