Saturday, October 4, 2008

Deflation fears or not

Greg Mankiw is perplexed by the return offered by the 5 year inflation adjusted bonds:
One might have thought that widespread fear in financial markets would cause a flight to quality, driving the price of safe assets up and their yields down.... If one wants to flee risky assets and invest safely, for many investors [5-year inflation-adjusted government bonds] are a pretty good place to be. But their yields, rather than falling, have been rising sharply of late. It's a puzzle.

This is a little bit beyond my technical capabilities, but it is not all that perplexing to me. In fact, it is one more data point that the current financial crisis is potentially very threatening to the American economy. These bonds are indexed to inflation, and would quickly lose value in a deflationary period. Investors are avoiding these bonds because they are expecting a deflationary period in the very near future. The fear is based upon an expectation that the credit crunch will cause a contraction in the money supply leading to deflation.

Update: I looked at the 5 Year Treasury note versus the 5 Year Treasury Inflation Indexed note. The 5 Year Treasury note is falling and trading at 2.87. The 5 Year Treasury Inflation Indexed note is rising and trading at 1.92. Based upon this information, it is clear that investors are still willing to pay a premium for protection from inflation (i.e., they still expect inflation). However, the amount of the premium that they are willing to pay for protection from inflation is decreasing.

So, it is clear that I was wrong (or overstated the case) to say they expect deflation. Instead, it would be more accurate to say that the rise in the yield of the 5 Year Treasury Inflation Index note is a result in a decrease of the expected inflation rate.

If at any point the 5 Year Treasury Inflation Index note rises higher than the 5 Year Treasury note, then at that point it could be said that the investors are demanding a premium for the deflation that they expect.