Can We Trust the TIPS Spread?

Add Wolfgang Münchau to the list of inflation hawks. If the Fed ignores inflation while putting out more urgent fires in the financial markets, he says, "the US bond market would implode, the current account deficit would become impossible to finance, the dollar would collapse, inflation would rise even more and the Federal Reserve would have to raise interest rates to high single digits or higher".

Central banks have to be worried about inflation, he says, and they have to be worried about overall inflation, not just core inflation.

I expect that the biggest danger to global economic stability will be not the credit crisis, but the way we are overreacting to it. Both in the US, and increasingly in Europe as well, monetary policies are no longer consistent with price stability.

This is a debate that just won't go away. But Münchau adds an interesting twist, saying that even the TIPS spread, which is my favored inflation indicator, has serious weaknesses as a measure of inflation expectations:

Financial market indicators do not show any strong evidence of a rise in long-term inflationary expectations. These indicators include the yield difference between Treasury inflation-protected securities and ordinary Treasuries and their respective European equivalents. In fact, some of these indicators have actually gone up a little. But more importantly, they are not really forward-looking. The yield difference tells us more about liquidity conditions in those markets than about future inflation.

I'm not sure I understand this. Unless liquidity conditions in TIPS are significantly different from liquidity conditions in Treasuries, how could "liquidity conditions" keep down the spread between the two? I'm always a bit suspicious when economic commentators have to resort to the slippery notion of "liquidity" to explain away something which doesn't fit their thesis. If you know exactly what you're talking about, there's nearly always a clearer and more precise way of doing so.

(Via Knobel)

Update: SamiK, in the comment, points to a Cleveland Fed chart which actually attempts to quantify changing liquidity conditions in TIPS.