Inflation: Shoppers vs. The Bond Market

Consumers are spooked by high prices. Traders aren't. Who is right?

Has the bond market visited the produce aisle lately? Has the bond market filled up its gas tank this fall? Has the bond market paid the college tuition bills for its smart little offspring?

Apparently not. Because the multitrillion-dollar bond market -- which is ordinarily terrified of inflation -- is still fairly relaxed about the recent leap in consumer prices. As of Nov. 8, investors were expecting inflation to average only 2.6% annually over the next decade, the same as over the past one. That's based on the Federal Reserve's analysis of yields on ordinary Treasury bonds and inflation-protected securities. Bond traders seem convinced that the 4.7% jump in prices during the past year, led by energy and fresh fruits and vegetables, won't be repeated.

Ordinary Americans aren't as nonchalant. Expectations of inflation are at an eight-year high in the University of Michigan's Consumer Sentiment Survey, with consumers predicting a 3.2% inflation rate over the next 5 to 10 years, up from the 2.7% expected last January. "Gasoline has gone up," says Marguerite Melvin, a legal secretary in Manhattan. "Taxes keep going up. College tuition. Even the clothing stores where you used to find good value -- they've raised their prices."

This disagreement matters because beliefs about where prices will go tomorrow are a critical determinant of behavior today. For example, businesses that expect more inflation will negotiate higher prices with suppliers and customers -- and will probably allow higher pay raises. And if the Fed sees inflation expectations rising, it's more likely to boost interest rates to avoid an inflationary spiral.


Right now, business executives are torn over whether consumers or the bond market are right about inflation. A survey by forecaster Inc. shows nervousness -- with 25% of businesses listing "labor costs and availability" as their most pressing problem, up from 11% in March. Rising material prices have socked many. "Inflation is not as tame as it was over the past 10 years," says Kenneth Phillips, CEO of Impaxx Inc., a Lakewood (Calif.) specialty packager. Some industries, such as hotels, have been able to raise prices because demand is strong: "Rarely have we seen a more favorable pricing climate," Marriott International (MAR ) CEO J.W. Marriott Jr. said last month. Others, though, don't believe they can raise prices even though their costs are up. On Nov. 8, the National Federation of Independent Business announced that the share of companies planning to raise prices in the next three months fell in October to its lowest level in 1 1/2 years.

Why the disparity in expectations? Economist Ricardo Reis of Princeton University says that consumers absorb new information more slowly than the bond market does. So the bond market may be reflecting the latest drop in energy prices, while consumers are still focused on the September peak. "Businesses have the best fix" on inflation, argues Mark M. Zandi, chief economist of "It's not the screaming problem that consumers make it out to be. But neither is it the nonproblem investors see. It's a problem in the making."

If inflationary expectations become ingrained in consumers and businesses, the Fed will have to crank interest rates very high to squeeze them out, most likely causing a recession. If they can be lowered quickly and gently, the economy will continue to thrive. The bottom line: What matters most is not what inflation was, but what people think it's going to be.

By Peter Coy and Rich Miller

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