First-time visitors to Chicago's futures pits (if you haven't visited yet, you'd better hurry before they become a Disney-like attraction) may be struck how the locals refer to contracts as "cars," a holdover from when all commodities were transported by railroad. A carload of wheat is manageable -- but a carload of Treasury bonds is truly a scary concept.

As if the bond traders' livelihoods weren't threatened enough by the inroads of electronic trading, the persistent and growing budgetary surplus has prompted a Treasury advisory panel to end the one-year Treasury bill and to recommend ending both the 30-year bond and the inflation-protected bonds, or TIPs. The former I don't care about, but TIPs can provide some nifty insights into what the market thinks about inflationary prospects ahead.

The total return on TIPs is adjusted for changes in inflation as measured by the consumer price index. TIPs never really caught on with the investing public during the generally disinflationary 1990s, so it's understandable why the Treasury may regard them as more trouble than they're worth. Of course, those gold-colored Sacagawea dollar coins are more trouble than they're worth, too, but don't hold your breath waiting for them to admit that clunker.

I'll miss the TIPs; they made it so easy for economists to measure inflationary expectations and to infer other relationships. But the government never had much use for economists poking around the attic, anyway.

The Last Full Measure

To see how we can use the TIPs to divine the market's collective view on inflation, compare the yields on a single TIP, the 3.625% coupon due Jan. 15, 2008, with an index yield of 10-year Treasuries as calculated by Bloomberg. This particular TIP is chosen as it most closely matches the maturity of the cheapest-to-deliver against the future's 10-year note, the 5.50% due Feb. 15, 2008.

The expected inflation premium in the TIP mirrored the base level of 10-year yields closely during 2000, with two notable exceptions: during the March-April Nasdaq collapse and later during the October-November Nasdaq re-collapse.

The TIP 10-Year Spread: A Signal of Inflationary Expectations

Source: Bloomberg

During both of those periods, base yields were rising -- but inflationary expectations were rising more rapidly.

Inflation Is a Monetary Phenomenon

The Fed's two rate cuts this January were not a quick elixir for stock prices, as predicted here in early December. Nor have they done much for bonds: Since Jan. 2, 10-year yields have risen to 5.20% from 4.91%, and 30-year yields have risen to 5.50% from 5.34%. Why has the Fed's much-needed and long-overdue action been so ineffectual to date?

The answer is both simple and frustrating: Inflation is defined best as more money chasing goods and services. Unless the supply of goods and services keeps pace with the growth in the money supply, inflation will result. If we're in a recession, which is still debatable, we won't, by definition, see rapid growth in output. (Disagree? Then debate it on our message board. ) To a great extent, this describes the stagflation of the 1970s in the U.S. The yawning gap between nominal and inflation-protected yields that has formed since the Fed's first rate cut is more than a warning light on the dashboard of the economy, to quote President Bush. It's a bomb going off in the basement.

Bonds have no greater enemy than inflation, so bond buyers must bid prices down at the first sign of incipient price increases. Decades ago, it was thought that stocks had some greater inflation protection, but this too was disproved during the 1970s. Not only is the real return on all productive capital diminished by inflation, the returns on growth stocks -- issues whose payoff streams lie further in the future -- are hurt the worst. Viewed in this light, the stock market's U-turn, especially for growth issues, after the second rate cut shouldn't be so surprising.

TIP a Canoe and Value, Too!

After a year like 2000, it's easy to conclude that bear markets are equal-opportunity destroyers of portfolios, but that is manifestly untrue. Value shares, those low-P/E, unglamorous workhorses of the market, have outperformed the riskier growth stocks rather handily since mid-August of last year. This assertion can be measured by the S&P Barra value and growth indices -- and was predicted back in August in this space. The divergence in the growth/value performance I forecast then expanded into this year.

The Value's in Value, Not Growth

Source: Bloomberg

Because we're in the business of forecasting tomorrow, what will it take for the growth/value gap to close -- and for growth issues to regain their luster? First and foremost, the Fed has to signal that its primary job is maintaining price stability. Its job is not jawboning the market down with inanities about irrational exuberance, not holding off on a rate cut during the fall of 2000 when credit quality spreads were widening out to crisis levels, not surprising the markets with rate cuts, and not pleasing the new administration with obsequious testimony. The bond market's biggest fear today is that monetary largesse could reignite inflation -- so if the Fed keeps the Nasdaq on its quote screen all day, we'll all be hurt in the long run.

Second, let's remember what got us out of the 1970s' stagflation: It was a cut in capital-gains taxes in 1978, stable monetary policies and reductions in marginal tax rates, topped off by a massive interest-rate hike that broke the back of inflationary expectations. This aggressive policy mix worked because it promoted risk-seeking behavior.