Friday, October 26, 2012

Can Bond Markets Predict Inflation?

One of the key pieces of evidence marshalled by inflation doves is that the bond market expected extremely low inflation for foreseeable future. We know this because the spread between non-indexed and indexed Treasury yields has collapsed since the financial crisis of 2009, as nominal income growth has slowed to a crawl and excess capacity is plentiful. But just because bond investors in the aggregate expect low inflation, does that mean inflation won't happen anyway?
First off, lets take a look at the relationship between nominal interest rates and inflation:
So far so good. It appears the old monetarist notion that inflation expectations drive nominal interest rates holds. In addition, heres the relationship between inflation expectations and actual inflation:
So it appears that the bond market is not a perfect predictor of inflation, but not in the direction inflation hawks might think. The bond market consistently OVERESTIMATES the rate of future inflation. Nominal bond investors are peevish when it comes to the value of their investments. And if they're not afraid of inflation, neither should you be.

No comments:

Post a Comment