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Inflation: Back to the Future

Fiscal policy and monetary policy in the U.S. are both expansionary. They're also potentially the most inflationary of our lifetimes. But the market does not see inflation yet.

For years analysts used the interest rate on the 30-year Treasury bond as a barometer of future inflation.

In the late 1970s, the market expected inflation would keep accelerating. The 30-year treasury interest rate climbed sharply.

By the early 1980s, the market began to believe that the Federal Reserve's tight money policy would wring inflation out of the economy. The 30-year rate fell well below the inflation rate as measured by the Consumer Price Index.

Recent 30-year rates have run 2.5% to 3%, the lowest in 30 years.

In normal times, the 30-year interest rate is a barometer of future inflation. The logic--if people in the market expected inflation to accelerate, they would not be willing to lend money at 3% for 30 years.

But current times are anything but normal.

Safety crucial

"The reason today's Treasury bond rates are so low has little to do with current expectations of future inflation," explains Dennis Starleaf, Iowa State University economist. "People and institutions want a safe place to store value and hopefully receive some sort of return on their investment."

Many people and institutions are suspicious about the safety of other assets like corporate bonds, stocks and even the debts of many other governments. Uncle Sam can ill afford a reputation of stiffing creditors. So investors view U.S. government securities as safe.

"When people are desperate for safety, any positive return on investment is good, but of secondary importance," explains Starleaf. "Return of principal is more important than return on principal. So big demand for safe assets to store wealth has driven the interest rate on U.S. government bonds to very low levels. Most people are simply not much concerned about future inflation."

Debt service cost could climb

Off hand figures, the national debt is about $11.3 trillion. U.S. population is about 305 million. Uncle Sam's debt load works out to about $37,050 per American.

Suppose improving U.S. and world economies combined with concerns about accelerating inflation boost the interest cost to service the debt by 5%, from say 3% to 8%. Each American's share of the annual interest tab would rise to about $1,852.

Inflation... or recovery?

Inflation, as producers learned in the 1970s and early 1980s, is a double-edged sword. The grain export boom and inflation drove commodity prices and land prices to then all-time highs.

The Fed initiated tight monetary policy to choke off spending to wring inflation out of the economy. Interest rates skyrocketed. Inability to service variable interest rate debt as commodity prices tumbled sparked the farm crisis of the mid 1980s.

Expansionary monetary policy will likely keep treasury interest rates low for some time. The lagging economy will likely restrain inflation well into 2009.

However, yields on 30-year Treasury bonds appeared to bottom near 2.5% in mid December. They appear to be creeping higher, with recent yields around 4.25%. The uptick could signal inflation coming. It could also mean investors are gaining confidence in other investments, which would mean Uncle Sam has to pay more to borrow money to spend.

Meanwhile watch changes in the Federal Funds and the U.S. Labor Department's reports on consumer and producer price indexes for clues.