Friday, December 05, 2008

Deflation Alert

In a previous post, I suggested a reason why older, rather than newer on-the-run, TIPS were closer to true measures of real interest rates. Here (in blue) is the yield on such a bond issue, compared with the yield on a nominal bond (in red). As of the most recent data, the yield on a TIPS bond that was issued about five years ago and will mature in about 5 years is 173 basis points (1.73 percentage points) above the yield on a five-year nominal bond.
Perhaps this difference in yield has to do with a particularly large liquidity premia for TIPS. And perhaps it is due to the changing risk premia associated with the two bonds. (See this post.) But to the extent the yield spread reflects inflation expectations, it suggests deflation is an increasingly likely possibility.
I think it is time for the Fed to consider in earnest taking up some form of inflation targeting. (Or, better yet, price level targeting.) Initially, inflation targeting was discussed as a policy aimed at reassuring markets that we won't have too much inflation. Right now, we need it to reassure markets that we'll have enough.