Flat Inflation? Don’t Bet on It, says Bond Market

Friday, March 14, 2008 10:08 a.m. EDT

Consumers seemed to catch a break this month, if you buy the government’s official inflation report.
One widely followed market measure of inflation, however, paints a more disturbing picture.

Headline inflation -– which includes volatile energy and food costs -– in February remained at a comfortable 2.3 percent over the past 12 months.

Yet traders of Treasury inflation-protected securities, known as TIPS, appear to expect inflation to average 3.5 percent in coming years.

TIPS are regarded as an inflation hedge. The U.S. government makes regular interest payments to investors but at maturity returns an inflation-adjusted principal payment to the bond holder.
With the full backing of the US government and built-in inflation protection, the prices of TIPS are often used by economists to model inflation expectations. Lately, their models have been warning of much higher inflation ahead.

In recent weeks, TIPS market participants have been signaling increasing concerns about inflation. On some bond issues, the actual yields have even turned negative, meaning investors assume that after inflation, they will lose money by owning the bond.

Federal Reserve Governor Frederic Mishkin, in a recent speech, dismissed the significance of market prices. "My best guess is that much of the rise in inflation compensation reflects other factors,â€