Inflation Continues to Decline

Balance Sheets Solutions, LLC
May 10, 2010 | COMMENTS

We have been in a disinflationary environment now for nearly 30 years. The disinflationary trend started with ex-Fed Chairman Paul Volcker's monetary restraint. Then came the productivity revolution via the Internet, followed by China 's export of its deflationary labor market around the world.

And the trend continues. Last week, it was reported that consumer prices rose 0.1% in March, on a seasonally adjusted basis. The core CPI (excludes food and energy prices) was unchanged in March while analysts had expected a 0.1% gain. In the past year, the headline CPI has risen 2.3%. The core rate has been up 1.1% in the same period, the smallest gain since early 2004. The last time the year-over-year core increase was smaller was in January 1966.

Studies suggest that subdued core inflation may continue to decline post-recession, for up to two years following the economic nadir. So “if” the economy bottomed in the third quarter of 2009, inflation by this measure might remain quiescent into 2011. For example, over the past 50 years, U.S. core inflation was lower in the year after a recession ended 87% of the time. Not only that, 75% of the time core inflation was down two years after the recession ended. As mentioned, the current level of 1.1% year over year matches the low last seen in January of 2004. Interestingly, this low came 26 months after the official end of the last recession (November 2001). If history repeats itself, core inflation could end up in negative territory.

30 Years of Disinflation

U.S. Treasury 10-year “real” yields, as deflated by core CPI, have become more attractive in recent months. As can be gleaned from the following graph, 10-year nominal yields have been rising since the end of November. Real yields, or what investors get on 10-year Treasuries after accounting for inflation, increased to 2.67% this month. This is versus 2.03% in January and 1.67% in October of 2009.

Many if not most pundits are forecasting higher rates over the balance of the year, due to ever burgeoning supply pressures and an economic recovery. It is also important to remember that inflation is likely to remain subdued for some time to come. This, in turn, should serve as an anchor for bond valuations amidst the ongoing tsunami of supply.

10-Year Treasury Yields

Subdued inflation will mark the months ahead and provide one reason the Federal Reserve policy makers are keeping the benchmark interest rate near zero for an “extended period of time.” Given that the Fed will likely be on hold for the balance of the year, credit unions with excess cash reserves, and within a well-defined risk control process, should continue to move out the curve to enhance yield and total return.

This article originally appeared in Balance Sheet Solutions, LLC's "Weely Relative Value" and is reprinted with permission.