Recently Barry Ritholtz almost changed his opinion about bond traders being adult supervisors over the markets to the one that bonds do not predict inflation expectations well enough. He’s referencing the article of Peter Schiff where it’s claimed that bond traders:

  • they no longer focus very intently on CPI reports
  • they “admit” current signs of rising inflation are backward looking
  • Yields are below Fed funds rate, despite inflation running at its fastest pace since the 1980’s

Let look closer into details. What is inflation, anyway? Getting away from scientific definition I will better say that inflation is the willingness and ability of consumers to purchase things rather sooner than later on perception that things are getting more expensive.

Looking at the negative savings rate I rather rephrase this into inflation is a consumer perception that it is more practical to borrow and purchase things now rather then save and purchase things later.

And here we have the whole spectrum of people consciousness from, on one end, the habit to borrow as much as possible and declare bankruptcy when the credit is denied to, on the other hand, a cold blood decision to borrow below expected inflation rate and buy mostly items with very low deprecation rate, like real estate and furniture. But in essence, it’s all based on borrowed money, from Uncle Sam to uncle Joe. The good economist will easily show than the abrupt reduction in borrowing rate will immediately kill any consumer inflation.

So the current inflation is based on:

  • Reckless lending practices. That allows flocks of people who never owned the house before and have no idea how to manage finances or even read fine print to borrow horrible amount of money and purchase a house no matter what the price is as long as their negative-amortisation ARM is paying for it
  • Real estate and commodity bubbles. The wealth effect is filling the confidence to borrow and spend
  • Very low unemployment. People just have money to spend

Let see how those sources of inflation will be gone soon.

  • Lending practices are based solely on the bond markets accepting the Mortgage-backed securities (MBS) with quite low interest. Any increase in delinquency rate combined with Bank of Japan tightening will deteriorate MBS market. We are probably another 6 months from that
  • Real estate bubble already popped. It just takes time until consumers will realise that home prices are appreciating well below inflation and mortgage rates
  • Commodity bubble is fueled by the monetary inflation, i.e. the dollar losing its confidence on the world markets. That’s a function of Bush’ reckless borrow-and-spend budget. This bubble is not going anywhere, but I don’t see the producers to be able to pass the cost of materials along the pipeline. We rather see declining profits, i.e. job losses and less consumer spending, not more
  • Very low unemployment. Indeed, with 504,000 of real estate brokers in California alone the employment is quite low. Just in few months we will see a lot of new jobless people coming from the ranks of former real estate agents, mortgage brokers, construction workers, plumbers and painters, factory workers making anything related to construction, piping and wiring, anything that is put in or outside new homes

So the current inflation is based solely on inflation expectations but has no fundamentals. I expect February to be a turnaround, when Holiday shopping will not materialize, the unemployment will jump, real estate slump and any price pressure evaporate. Will it be a recession? Maybe not yet, but definitely not inflation.