The market needs to abandon the dysfunctional old framework and find its footing with a valid credit-risk-free benchmark. The central bank factor needs to be factored out.
With existing interest rates and credit markets out of question, foreign exchange seems to be the only possibility. And here lies the clarifying thought: Inflation risk is currency credit risk, or more specifically, the central bank's credit risk.
Currency credit risk may be a new concept in finance theory, but it makes perfect sense. When a currency loses 50% of its value through inflation, that is a default, on the central bank's part, with a 50% present-value recovery.
In other words, in a normal inflationary environment that modern central banks consider healthy, central bank default by definition a certainty; the only question is recovery. It's a different type of default from the familiar, traditional ones: it's not a binary event, but rather a continuous process with varying recovery over time.For example, assuming the Fed achieves its new inflation target of 3%, in 10 years a dollar is worth 74 cents today, or 74% recovery; in 30 years, it's a 41% recovery. To put these numbers in perspective, the average U.S. corporate senior secured bond recovery (all ratings) from 1987-2008 is 64%, as shown by Moody's by way of ( gramercy.com). In the old interest rate and credit markets, the difference between the nominal interest rate and the real one is the inflation. Since the meaning of "interest rate" has become ambiguous, we are forced to transform this into the realm of FX forward rate: The difference between the nominal FX forward rate and the real one is the relative inflation expectation between the two currencies in question. The inflation expectation curve and the FX forward curve are both observable, at least for major currencies. Calculating the true credit-risk-free curve becomes a simple exercise in subtraction. The interest rate parity is not broken by this transformation. Instead, it's cast under a new, clearer interpretation: Currency credit risk can and should be quantified explicitly. There is one problem remaining, however. FX rates are all relative; thus the credit-risk-free curves derived this way are also relative. An obvious choice for the common reference asset is gold, although it's not perfect since the supply is not exactly constant.
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