Inflation Expectations Revisited

In this How To Calculate Expected Inflation post from April 2011, I described the process of finding the rate of inflation expected by investors.  At that time, the rate for the 10-year period examined was 2.65%.  This was based on a yield on the 10-year Treasury note of 3.52% and a rate on the 10-year TIP of  0.87%.

Well, yields have changed since then.  Today, going to Bloomberg, etc. as described in the previous post shows that the yield on the 10-year Treasury note is 1.83% and the yield on the 10-year TIP is -.74%. S ubtracting, gives us an inflation expectation of 2.57%.

I have to say that I am surprised that the expectation has dropped slightly, in light of the ongoing printing of money and monetizing the Debt; but I understand there are factors influencing inflation other than money and that a lot of what we have seen is a build-up of excess reserves which still, this late in the recovery, have yet to be lent. 

This inflation expectations number is important to follow because it impacts views on what the Fed can and cannot do, the budget, and yield premiums on longer-term fixed income instruments.

It is, however, in my view, a very narrow reflection of inflation.  In fact, I will go out on a limb and argue that most economists don't really understand inflation.  To many, inflation is measured by the cost of a basket of goods and services over a period of time.  Others take a somewhat broader view and take a measure based on GDP--called the GDP deflator--or focus on Bernanke's favorite--the PCE deflator--reported with Personal Income.

All of these measures, I believe, miss the totality of inflation.  To me, inflation has to itself be put in real terms - specifically into labor units.  If the average labor force participant has to work more hours today than a year ago for a basket of goods, then we have inflation.

Think about this in light of what was reported above from the perspective of the tidal wave of retiring baby boomers.  In April 2011, a retiree who put $1,000 worth of stored up labor (40 hours, say) into a 10-year U.S. Treasury note got to buy $35.20 worth of goods and services.  Today the same $1,000, i.e. 40 hours, based on the 1.83% yield on the Treasury note, can buy $18.30 worth of the basket!  He or she would have to give up approximately twice the number of stored-up labor hours to get the same goods and services!  This is an inflation that is missed and is part of what is killing the economy IMHO. In fact, from a retiree's perspective, looking at money market and CD rates, it borders on hyperinflation!

So, Helicopter Ben continues to write checks out of thin air and baby boomers continue to take on riskier and riskier assets and Helicopter Ben puffs up and proclaims that one mandate - stable inflation - is being met.  What he doesn't get is that when you control prices, i.e. the price of money via the fed funds rate you are going to get inflation in some form.  Right now, it is a form that beats up on retirees and those trying to save for retirement.

I believe his price control policies are wrong and, like 2001 and 2008, in the end we may end up once again walking around like zombies wondering why the economy isn't working -  muttering about bubbles.How to Calculate Expected Inflation