Deflation dismissed by bond measure amid QE3 anticipation

July 30 (Bloomberg) -- For all the handwringing over the slowdown in the U.S. economy, the bond market shows there’s less risk of deflation now than before the Federal Reserve’s first two rounds of large-scale debt purchases.

The expectation that consumer prices will rise, measured by the five-year, five-year forward breakeven rate, means that Fed Chairman Ben S. Bernanke has persuaded traders the U.S. will avoid the chronic deflation that has slowed Japan’s economy since 1995. It also complicates the central bank’s decision about starting more quantitative easing to boost an economy that grew at the slowest pace in a year during the second quarter. Commodity prices surged during QE1 and QE2 in 2008 and 2010.

“Higher inflation results in a tax on consumers and slows the economy down,” Michael Materasso, a senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments, which oversees $320 billion of bonds, said in a July 24 interview at Bloomberg headquarters in New York. “If you end up with a spike in commodity prices, have you done more harm than good?”

The Fed’s favored bond-market gauge of inflation expectations ended last week at 2.39 percent, above the 2 percent levels in 2008 and 2010 that led the central bank to inject $2.3 trillion into the economy by purchasing Treasuries and mortgage-related bonds, the policy known as quantitative easing. The five-year, five-year measure shows how much traders anticipate consumer prices will rise during a period of five years starting in 2017.

‘Sticking Point’

The Standard & Poor’s GSCI Total Return Index of 24 raw materials rose as much as 85 percent during the past two easings, pushing the consumer price index to 3.9 percent in September 2009, higher than its long-term average of 2.5 percent since 1992.

Measures that track where bond traders see inflation in the future are key since January when the Fed adopted a 2 percent target for the personal consumption expenditures index. The gauge, excluding food and energy, rose 1.8 percent in May from a year earlier, increasing from as low as 0.9 percent at the end of 2010. It has averaged 1.9 percent since the 1990s.

While the Fed can ignore its target, traders’ outlook for consumer prices “could be a sticking point for more QE,” Chicago-based Bianco Research LLC said in a report to clients on July 27. “These measures show too much inflation for the time being.”

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