A Rally Fueled by an Illusion

Ah, history! Those who forget its lessons are condemned to repeat it, and those who learn its lessons misapply their knowledge. The inflation experiences of the 1970s have induced us to go down both paths of error in the quarter-century since. Will we be dancing "The Time Warp" again this time?

One of the very many market reactions to Hurricane Katrina, discussed here last week in the context of petroleum prices, has been speculation that the Federal Reserve will back away from its near-stated path of an increase of 25 basis point in the federal funds rate at its Sept. 20 meeting. The market assumed, not without reason, that such an action would weaken the dollar and increase inflationary pressures by virtue of excess monetary creation.

Let's do some history, and place inflationary expectations in their broader context. The measure used for inflationary expectations (not reported inflation, as in the CPI) will be the difference between nominal yields and TIPS yields. The difference, ignoring the various options embedded in TIPS, is a break-even rate of inflation that should make an investor indifferent between holding the two securities.

The history of these break-evens for five-year and 10-year notes over the past six and a half years shows a marked downtrend between April 2000, near the stock market's peak, and November 2001, the aftermath of Sept. 11 -- and a steady uptrend from then until April 2005. The era of rate-cutting is marked for those who wish to make a causal connection between inflation and monetary policy....