Expectations of Deflation

A narrowing in the so-called yield spread is an indication that investors expect inflation to slow. The rate of inflation as measured by the consumer price index will likely slow to 2.75 percent next month from 5.6 percent in July, economist at Goldman Sachs Group Inc. said in a report to clients this week.

Yields on some Treasury Inflation-Protected Securities were higher than yields on conventional Treasuries of similar maturity in another sign investors are shedding assets and betting on a deepening U.S. recession.

The difference between yields on five-year Treasuries and five-year TIPS was a negative 0.46 percentage point at one point this week, a record. TIPS typically yield less than Treasuries because their principal payments rise at the rate of inflation. A shrinking yield gap indicates investors expect inflation to slow.

The market "is pricing in deep deflation,'' said Micheal Pond, an interest-rate strategist in New York at Barclays Capital Inc. one of the 17 primary dealers that trade directly with the Fed. He recommends investors bet on a widening yield gap between TIPS and conventional Treasuries of shorter maturities.

Find the story at Bloomberg online.

This has ramifications for the nature of the current crisis beyond merely deflation. As the price of oil has fallen 60% from the record high price in July of $147 a barrel to today's price of $61, we can infer that the market expects the broader monetary aggregates--like credit--to also fall decline during the coming weeks. A rising monetary base (as we have seen recently) will not lead to much inflation; the base has risen so much because the Fed has been trying to avert...a credit crisis. Imagine the boom in credit the recent monetary base increases would have fostered had we not been in...a credit crisis.