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It's become newly fashionable on the political left to downplay the risk of inflation by pointing to the bond market's apparent lack of concern. The yields on Treasuries are still quite low, which conventional financial economics tells us means that investors aren't demanding increased compensation to offset inflation. The five-year breakeven inflation rate, which is calculated by comparing the yield on inflation-protected securities to ordinary Treasuries, is at the highest level ever but nothing indicating that investors fear inflation will run very high over the next five years or so.
It's easy to see why the left likes the bond market. It makes their arguments seem indisputable and "market-based." And they hope that James Carville's famous view that the bond market can intimidate anyone still holds. How can the American right argue with the signals coming from financial markets?
The left would like to convince politicians, particularly a few reluctant Democratic senators, that the bond market's lack of concern about inflation means that they do not have to fret about passing the massive cradle-to-grave spending program that the Biden administration has dubbed Build Back Better. Inflation talk is just a Republican psy-op, they claim. Just look at bond yields.
Market prices are signals, but they are encrypted. Low long-term bond yields may not be telling us that inflation is not a risk or that profligate spending does not raise inflation. Instead, the market may be reflecting the likelihood that the Federal Reserve will successfully tamp down inflationary forces by tightening monetary policy. Alternatively, it may be reflecting the view that high inflation is likely to help the GOP win a majority in one or both houses of Congress next year with a mandate to bring down spending and ramp up domestic production to fight inflation. Either seems much more likely than the naive idea that investors just think inflation will wither away even in the presence of loose monetary policy, huge expansions of government spending, and growing deficits.
We saw an example of the need to decrypt bond prices in the market's reaction to Fed Chairman Jerome Powell's pivot to inflation hawkishness this week. All other things being equal, the announcement of an acceleration of the Fed's taper should raise yields at the long end. After all, one of the effects of the Fed's bond purchases is supposed to be lowering yields. But all things are not equal. If investors think the Fed tightening quicker will push inflation lower than it would have been, bond yields would fall. And that's exactly what happened on Tuesday and again on Wednesday after Powell reiterated his remarks.
– Alex Marlow & John Carney
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