Attention shifts from activity to inflation (Jun 08)

The markets have recently shifted their attention away from the downside risks to activity to the upside risks to inflation. The bond market’s inflation expectations have risen to levels not seen since the inflation target was introduced in 1997. At the same time, real yields have continued to rise, presumably because the markets now believe that real interest rates will need to be higher to contain inflation. Indeed, the money markets have started to discount the possibility that the next move in rates may be up. We are not so sure. Either way, though, the cost of relatively high interest rates in the near-term will be a sharper downturn in activity and, eventually, much lower rates further ahead.