What deflation?

The government’s most recent auction for Treasury Inflation Protected Securities, or TIPS, received such strong demand on Monday that yields went negative for the first time in the security's history.

The auction appears to reflect concerns that inflation -- which has essentially been non-existent since mid-2008 when the financial crisis hit -- could flare up again as the Federal Reserve begins a possible "quantitative easing" strategy in the coming weeks.

It's a shift in sentiment in the bond market from only a few weeks ago, when the focus was heavily on the issue of the U.S. economic experiencing deflation similar to Japan. For consumers sitting on the sidelines, traders said the TIPS auction is a sign that inflation is coming – and is already here in the form of higher energy prices and food costs.

TIPS are government bonds in which the principle of the bond rises and falls with the Labor Department’s consumer price index. At Monday’s auction investors paid about $105 on $100-worth of 5-year TIPS, effectively taking a loss in the short term on expectations that inflation will return and the short-term loss will be negated.

“We went through a market that was pricing in either deflation or inflation that was going to remain very low for a very long period of time,” said Mike Pond, chief fixed-income strategist with Barclays Capital. “With the Fed now preparing the market for its quantitative easing strategy, expectations are that inflation will eventually return to normal levels.”

The negative 0.55% yield priced at Monday’s auction was not a surprise, traders said. Analysts now believe that the Federal Reserve’s quantitative easing strategy, which the central bank has mentioned in its previous meeting minutes, will be forceful enough to produce some sort of inflationary environment.

The Fed has not provided any specific details on its quantitative easing program, which the bank is expected to lay out at next week’s meeting. Economists believe that the central bank will begin purchasing between $500 billion and $1 trillion-worth of securities on the open market, effectively pushing down interest rates and flooding the economy with a massive amount of liquidity.

Because the Fed will be printing money, for a lack of a better description, some inflation is expected.

Typically, fixed-income investors dislike inflation because it erodes their investments over time. However, any form of inflation at this point would be a sign of economic expansion and some parts of the economy, such as housing, could benefit from an inflationary environment. 

“I believe, in my own words, that the Federal Reserve wants to be careless with inflation,” said Tom di Galoma, director of fixed-income trading at Guggenheim Securities in New York. “With this quantitative easing strategy, the Fed would be absolutely pleased to have any type of inflation at this point.”

The Federal Reserve does not provide an official inflation target but previous comments from Fed Governors and Bernanke have generally indicated that central bankers want inflation to average between 1.5% and 2% a year. Currently inflation is averaging about 1.1% a year, based on October’s consumer price index, but that’s weighed heavily on the housing market, energy prices and food costs. Excluding food and energy, inflation was 0.8% last year. 

Without inflation, product and asset prices stagnate, causing a drag on the broader economy, economists said. Seniors saw their Social Security checks remain flat for a second year in a row because of the lack of inflation. Home prices fell 0.2% in August compared to a year ago, according to Wednesday's Case-Shiller home price index. 

But by causing inflation deliberately through quantitative easing, the Fed’s strategy carries significant risks. Consumers will most likely experience the brunt of the consequences of quantitative easing through higher energy costs, economists said. Since the Fed alluded to a QE strategy back in September, oil prices have increased nearly $10 a barrel.  Food prices have also increased.

“We’re going to see oil prices quickly, not slowly, and not a year or two down a road but relatively soon,” said Robert Dye, chief U.S. economist with PNC Financial. “It’s going to be a program that’s going to have to be monitored carefully -- because we’re already seeing the inflationary consequences.”

The bond markets are not pricing in any form of abnormally high or hyperinflation and investors believe there are few concerns that might occur. As of Wednesday, yields on 30-year bonds sit at around 4% and 10-year notes are at 2.674%.

“The market expectations are that the Fed will be successful in producing inflation and that’s very different from the market pricing in high inflation down the road,” Barclay’s Pond said.