Wednesday, October 22, 2008

September Inflation

The chart below shows headline and core CPI have climbed sharply since mid-2006. Headline CPI is currently near 5% year-over-year, while all measures of core CPI are at 3%.

Why, even though inflation is high and has been increasing, does the Fed consider inflation expectations to be contained? The Fed noted the fall in commodity prices, which will dampen inflation in coming months, in their October 8th statement. They also noted inflation expectations have diminished.

The following chart shows inflation expectations via the spread between the 10-year constant maturity Treasury rate and the corresponding TIPS rate. Expectations currently stand at an average of 1% per year for the next 10 years. I seriously doubt this will be realized; it's more likely a function of the current market pessimism.

Two important caveats: (1) the spread has two components - expected inflation and inflation risk premium, and (2) TIPS yields have a liquidity premium. Given the short-term nature of our comparison, neither of these caveats should be too problematic.

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