Chart of the Day: Inflation Expectations

Greg Ip passes along this chart of long-term inflation expectations, which are now hitting new highs. The chart shows something called the "5yr-5yr forward breakeven" - what the market expects inflation to average over the five years from 2013 to 2018, which is as good a proxy for long-term inflation expectations as anything.

Clearly this is great for anybody with a curve steepener on, and it's bad for the long-term credibility of the Federal Reserve. But Ip implies that there might be technical reasons for the spike:

The short-term behavior of the TIPS market is heavily influenced by trading dynamics. Although they are a risk-free credit, TIPS often trade from day to day like non-Treasury bonds. That means when Treasurys are rallying on flight-to-safety, TIPS lag, and the same things happen when that rally reverses. Nominal bonds have been falling and yields rising lately as flight to safety reverses, and as TIPS yields have lagged, breakevens have widened.

It's true that TIPS (from which the breakeven rate is calculated) are not as liquid as Treasury bonds, and that they therefore suffer in a generalized flight to liquidity. But although credit markets are hardly what you'd call healthy right now, I don't get the feeling that there's an enormous flight to liquidity. These inflation expectations are real - and quite reasonable, too, given the fact that high food and commodity prices, as well as the weak dollar, have yet to really feed through to consumer-price inflation. Besides, as short-term interest rates continue to fall, long-term inflation pressures are sure to build up.

Right now, Ben Bernanke has bigger things to worry about than what the market thinks inflation is going to be in ten years' time. But it's not something he can forget about, either.

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