Probabilty of defaltion low according to new paper

Yesterday I blogged about TIP’s and how they can be a forecaster of inflation and thereby mortgage rates (you can view that post HERE).  By coincidence the Federal Reserve Bank of San Francisco also released a paper on the topic of TIP’s and inflation as well and the summary suggests the markets believe that deflation is an unlikely scenario.

“The low level of inflation and the sluggish pace of economic recovery have raised concerns about sustained deflation—an inflation rate below zero with a general fall in prices. However, the relative prices of inflation-indexed and non-indexed Treasury bonds, which historically have proven to be good measures of inflation expectations, suggest that financial market participants consider the probability of deflation to be low.”

The threat of deflation is one of the primary reasons why long-term interest rates have been driven so low recently.  It is also the reason why the Fed has indicated they are likely to engage in another round of quantitative easing.  This further suggests that rates may have bottomed out at current levels.  It will be interesting to see what happens next week after the Fed provides details about QE2 but I am not entirely convinced that rates will move substantially lower.

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