Aug. 21 (Bloomberg) -- Talk about anchored.

Inflation expectations are so weighted down that investors are buying 10-year Treasuries yielding 3.8 percent with inflation running at 5.6 percent.

Federal Reserve policy makers couldn't ask for a stronger mooring in the face of disappointing inflation news. A pair of reports on consumer and producer prices for July showing year- over-year increases of 5.6 percent and 9.8 percent, respectively, the fastest pace in 17 and 27 years, failed to rattle the U.S. Treasury market.

There are two schools of thought on why Treasuries are expensive relative to inflation and an expected onslaught of supply to finance the growing federal deficit. The Bush administration projected a record $482 billion deficit in the fiscal year that begins Oct. 1.

The first holds that bonds are mispriced. Buyers are either complacent or smoking something stronger than tobacco. Even if they are in full command of their faculties, they are choosing liquidity over yield.

``Investors are willing to take a lower yield on risk-free investments'' in light of questions about the solvency of Fannie Mae and Freddie Mac and systemic risks the Fed is working to mitigate, says Greg Ehlers, a managing partner at Navigate Advisors, a Stamford, Connecticut, brokerage firm.

The other school sees the market as forward-looking. Inflation may be elevated now, but bonds are telegraphing better (inflation) or worse (economic) news, depending on one's reference point, ahead.

Great De-leveraging

Investors may be willing to accept a lower yield in exchange for assurances of timely payment of principal and interest. But why would they knowingly tie up money for 10 years in anticipation of a negative return when they have the option of investing for a shorter term or buying inflation-indexed bonds (TIPS), which offer a real yield plus compensation for actual inflation?

Answer: Because enough folks expect the great de-leveraging under way, with its contractionary effect on money and credit, to pare inflation so that the return on a nominal 10-year note will exceed that on 10-year TIPS.

Michael Pond, interest-rate strategist at Barclays Capital Inc. in New York, isn't a buyer of that idea.

``In 2003, the Fed forcefully put a floor under inflation,'' cutting the overnight rate to 1 percent, where it overstayed its welcome, Pond says. ``They will not let inflation go much lower'' than it was then.

He has a point. The Fed wants to avoid deflation at all costs, even the ``good'' technology-driven kind.

Still, there are good reasons to think inflation is peaking. Commodity prices, which don't cause inflation but can be a reflection of it, are falling.

Margin Squeeze

Before you get too excited about the potential for soaring producer prices to be passed through to consumer prices, consider what's been happening to the relationship between consumer goods prices and producer prices of finished consumer goods.

``The ratio is trending lower, indicating that businesses are unable to fully pass on their higher costs to consumers,'' says Northern Trust Corp. chief economist Paul Kasriel. ``Even with necessities like gas, refiners can't pass on the full cost of higher crude,'' which is manifesting itself in weak refinery profits, he says.

In other words, it's a profit margin story rather than an inflation story.

Consumers, for their part, aren't likely to act out on their elevated inflation expectations. The idea that consumers hoard in anticipation of higher prices is a theory in need of a reality check, according to Doug Lee, president of Economics from Washington, a private consulting firm in Potomac, Washington.

Born to Hoard

Lee deconstructed the CPI and found that 59 percent of the index is services, which can't be hoarded. Of the 41 percent of the CPI that is goods, or commodities, 11 percent is durable goods, ``which are expensive, purchased infrequently and therefore unlikely to be hoarded,'' Lee says.

Throw in 14 percent for food, much of which is perishable, and 10 percent for energy, which is hard to store unless you happen to own a corner gas station, and there's a whopping 6 percent that is subject to hoarding.

In all fairness, the Fed is more concerned about a wage- price spiral than hoarding behavior, a subject I addressed in a recent column. Labor has neither the power nor the wherewithal to command a higher wage when unemployment is rising.

The yield on the 10-year Treasury note plummeted 200 basis points to about 3.3 percent between June 2007 and March 2008. Yields shot up 100 basis points before they started falling again in June.

Theory of Relativity

And for good reason. With a growing belief that the Treasury will have to inject capital into Fannie and Freddie, even debt holders have become gun shy. This week, Freddie Mac sold $3 billion of five-year reference notes at a yield of 4.172 percent, the highest spread over like-maturity Treasuries in at least 10 years.

Foreign central banks holdings of agency securities have leveled off in the past month, according to data on the Fed's custody holdings for foreign central banks. And yes, their purchases of Treasuries have shot up.

``The supply of debt hasn't gone up as fast as the demand from credit-risk-averse official investors,'' says Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Treasuries can stay expensive longer than the shorts can stay solvent, to paraphrase the late economist John Maynard Keynes.

Keynes also said that ``when the facts change, I change my mind.''

It may be that the fundamental facts -- on inflation and growth -- will change so that it's perceptions about yields, not the reality, that is altered.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: August 21, 2008 00:02 EDT