So, what does the market use to sniff out inflation? The market actually uses market factors like commodity prices and interest rates. Recent movements in these markets all indicate investors feel the inflation threat is real. Let's first look at Treasury bonds. At December 31, 2010, the 10-yr Treasury closed at 3.31%. On February 15, the 10-yr Treasury closed at 3.62%. On December 31, 2010, the 30-yr Treasury closed at 4.36%. On February 15, the 30-yr Treasury closed 4.66%. These movements indicate traders are realizing the inflation risk and moving out of Treasuries, and into commodities.
In my opinion, a recent CNBC article summed up the movement in the bond market:
While inflation today looks pretty benign, what bond investors don't like right now is the uncertainty factor around the future inflation picture.
These factors will not inhibit the Fed to continue to pursue the policies it has been pursuing. First, the Fed has to maintain stable prices. As long as core CPI is under two percent, the Federal Reserve is going to maintain the current interest rate policy. Second, the Fed has the mandate to maintain prices. As long as unemployment is high, the Fed will continue to puruse quantitative easing and zero interest rates to increase growth and lower unemployment. The end game for the Federal Reserve is to create a wealth effect. The idea is that asset prices will go up, which will encourage investors to spend and firms to be more ambitious about expansion plans.
Good questions to ask right now include: 1) are commodities and equities going up because an underlying bubble is being formed?; 2) how should policymakers respond?; and 3) how is an investor able to protect themself in either high inflation or asset bubble?
Pedro de Noronha, Noster Capital, believes the market is currently in a bubble. According to him, the valuations do not support 2012 and 2013 earnings. So, as a value investor, it is important to let the market indicate the firm's intrinsic value. Until it does, it is important to get paid through dividends. Also, it is important to note Mr. de Noronha's point:
If we are indeed witnessing the third liquidity-induced bubble in a little over ten years (this time fuelled by public, not private sector debt), we are fearful that there could be severe consequences for the market over the medium term...We won't hesitate forsaking some upside for the fund in order to ensure that we will be in good standing to take advantage of very compelling opportunities that will arise should such a financial event occur
So, if there is an asset bubble being created, what are the mechanics of one? In my senior year of college, I wrote a paper about inflation targeting. I wrote how Mr. Bernanke does not believe central banks can prevent one from forming, in addition to the behavior of their creation and aftermath:
A debate exists among central bankers who believe asset prices should play a role in creating an inflation forecast. Ben Bernanke, Federal Reserve Chairman and a leading proponent of inflation targeting, has argued against a central bank’s focusing on asset prices, “…only to the extent they affect a central bank’s forecast for inflation.” Bernanke argues a central bank does not know the level of price increases in volatile assets that constitute an asset bubble or when the bubble will burst. Claudio Borio and Philip Lowe argue that a central bank should not “target” asset prices such as stocks or real estate, but instead focus on their changes.
A central bank should take asset prices into consideration for specific reasons. First, asset price bubbles have occurred when credit increased at a greater rate than inflation. Since the central bank can control inflationary expectations, firms and households feel optimistic when high GDP growth can be accompanied by low inflation; this causes firms to increase investment. Due to the influx of credit, lenders, firms and households begin to make poor decisions by overvaluing assets and not assessing risk.
Second, the supply side of the economy improves because of low inflation. One impact is workers and firms are more willing to enter into contracts when current inflation is low. Because the nominal price inputs like labor are held constant or grow at a specific rate, corporate profitability increases. Increased profitability makes investment in stocks more attractive to the public. Capital gains from the stock and bond markets become “self-reinforcing” and feed into each other. Also, it is more attractive for firms to increase their investment in assets such as land and equipment. Because of their increased profitability, firms predict overall demand will continue to increase and may borrow funds to purchase these investments.
Third, when an asset bubble bursts, deflation usually occurs, which creates various problems. To fund expansion, many firms may finance part of the expansion with debt. Because inflation improved their outlook for the future, it may have caused a misallocation of assets. Furthermore, lenders make the decision to lend to firms and households based on increases in nominal income. The end result is more debt than before the bubble and deflation causes the real value of the debt to increase. As the value of debt increased, firms and households cannot afford to make regular interest payments. The end result is deflation, an increase in defaults and tightened lending standards.
These three arguments make a case that asset prices should play a role in creating inflation forecasts and determining monetary policy. Since asset prices play a major role in daily decisions that affect firms and households, an asset bubble created by inflation is not good for the economy in the long run. As the prospect of deflation increases, the central bank will have to reverse the trend it created. As Cecchetti and others argued, the central bank should not target asset prices, but only take them into consideration when determining monetary policy. If equities, real estate or any other volatile assets are increasing at a rate higher than historical levels, the central bank should raise interest rates. If any of these assets are increasing at a rate lower than historical levels, the central bank should lower interest rates.
Inflation Threat: Investors Starting to Show Inflation Threat Is Real (click here)
Liquidity Induced Bubble Could Burst: Fund Manager (click here)
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