Inflation is just around the corner.
The Federal Reserve policymakers continue to fight deflation and the massive drop in aggregate demand, but the markets are beginning to signal the costs of these monetary actions and the massive economic stimulus packages.
The U.S. Treasury market yield curve continues to show little indication of increased inflation expectations. This week the 10-year note is yielding just 2.7 percent, 1.8 percent higher than the 2-year note. But other markets are showing greater fear over rising prices.
The strongest current indicator of rising inflation expectations is the market for Treasury Inflation-Protected Securities, or TIPS. TIPS are marketable U.S. government bonds whose principal is adjusted by changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of 5, 10, and 20 years.
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TIPS, provide protection against inflation. The principal of a TIPS bond increases with inflation and decreases with deflation, as measured by the CPI. Thus, the current yield on TIPS is a real, or inflation-adjusted, return.
Subtracting the real yield on TIPS from the current nominal yield of Treasury notes of the same maturity gives a market-based measure of expected inflation.
Two months ago, five-year TIPS were priced for a annualized 0.5 percent drop in consumer prices. This week, five-year tips are priced for a 1.35 percent increase. That may seem small, but the magnitude of the change of direction is significant.
Commodity markets are also changing dramatically. The Wall Street Journal reported this week that while crude-oil prices are well off their high hit last summer, they are up 54 percent since early February.
Other commodities are showing strong reversals from the declines of last year. Prices for copper, a key construction and infrastructure commodity, are up 44 percent from December, and zinc is up 24 percent. In aggregate, commodity prices are about 10 percent higher than their recent lows.
The overall economy continues to struggle with higher unemployment, low housing price, and low interest rates. However, investors must be forward-looking. When the dust from the massive government spending packages and quantitative easing of monetary policy clears, prices will rise rapidly again.
Historically, the best hedges against inflation have not been commodities or real estate. Your best bets in periods of inflation are stocks, with a nearly 6 percent real return in the U.S. this past century. TIPS may provide a positive real return, but this will undoubtedly be smaller than the long-run real return on equity investments.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.