Color us stunned. While the world and their pet cat Roger are not worrying about inflation because Bernanke says CPI/PPI are still well-anchored and everything else is "transitory"; it turns out the market has a 'different' opinion. We have discussed inflation expectations before (whether 5Y5Y forward views or 10Y inflation swap breakevens) as a trigger for Fed action (or inaction) but this time, the market front-ran Bernanke's Bazooka and in the last two days of QEternity has exploded higher with 5Y forward expectations now near 6 year highs. CPI remains below 2% but there is a clear lag between the rise in market-implied inflation and it showing up in the unicorn-laden CPI prints - what this means is that given the hubris of the Fed yesterday, market expectations of inflation are inferring CPI could rise to over 5% within the next 3 to 6 months. It will surely be difficult for Ben to keep-on-buying ('Finding Nemo'-like) in the face of that kind of 'transitory' rise in real data - though for now, real money remains bid as risk comes off a little (even as the long-bond yield blows 26bps higher this week) - oh and CPI and PPI jump their most in 3 years.And from the IMF (2009):
CPI vs inflation break-evens and forward expectations...
and longer-term - this has not ended well as once it runs, it is hard to stop...
Working Paper 09/90
Long-term investors face a common problem—how to maintain the purchasing power of their assets over time and achieve a level of real returns consistent with their investment objectives. While inflation-linked bonds and derivatives have been developed to hedge the effects of inflation, their limited supply and liquidity lead many investors to continue to rely on the indirect hedging properties of traditional asset classes. In this paper, we assess these properties over different time horizons, in the context of a diversified portfolio. Using a vector error correction model, we find that effective short-run hedges, such as commodities, may not work over longer horizons and that tactical asset allocation could enhance investment returns following inflation surprises.
Long-term investors face a common problem: how to maintain the purchasing power of their assets over time and achieve a level of real returns consistent with their investment objectives. Both dimensions of this problem are often considered together, but there remains an active debate regarding the first, namely which type of assets provide the most effective hedge against inflation. The focus on inflation-hedging properties, naturally, sharpens and fades along with the fluctuations in inflation itself. The most intense burst of activity in this area followed the persistent rise in inflation through the 1970s. So why focus on inflation hedging now?
Up until the emergence of the financial crisis in 2007, inflation had been rising on a global scale. Since then, the economic implications of this crisis, including wider output gaps, have led to an abrupt decline in inflation. If policymakers are successful in their attempt to stabilize output and stave off deflation, then inflation could resume its upward path. Given the policy tools employed through the crisis so far, particularly massive injections of liquidity and quantitative easing, the risks of this outcome remain significant. This implies that inflation hedging should remain an important component of long-run investment policy....MUCH MORE (28 page PDF)