NEW YORK (MarketWatch) -- Deflation has probably hit the U.S., the December consumer price index is expected to show Friday, and one gauge widely watched by the bond market indicates it may stick around for years to come.
Economists anticipate consumer prices fell in December by 0.8% from November, according to a MarketWatch survey. This monthly decline would mean prices fell 0.2% from the prior year, the first year-over-year decline since 1955. Prices have already been tumbling at the wholesale level.
While much of December consumer price drop can be chalked up to plunging energy prices at year-end, deflation may not end there. The $530 billion market for Treasury Inflation Protected Securities shows prices are expected to continue dropping for several years as a shrinking economy curtails demand.
"The market is forecasting a deflation scenario for years," said Tim Wilhide, co-manager of the $831-million Hartford Inflation Plus Fund. "Nothing on the horizon says right now that the economy is turning around."
The gap between yields on regular five-year notes
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and five-year TIPS is negative 0.33 percentage point, suggesting consumer prices will decline 0.33% on average over the next five years. That difference is known as the break-even rate and is considered a signal for what investors expect inflation to be over the life of the debt.
TIPS pay investors a coupon rate plus inflation as measured by the consumer price index.
Shorter-term TIPS are pointing to even more deflation, pricing in a drop of nearly 2% over the next year, Wilhide said.
That's quite a switch from July, when the break-even rate topped two percentage points as oil prices hit their record highs.
The sharp drop-off in commodities prices since oil hit its $147-a-barrel record in July is one reason TIPS are now suggesting deflation over the coming years. Oil prices have dropped from around $92 a barrel a year ago.
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Propelled largely by falling energy prices, a report Thursday showed producer prices fell 0.9% in 2008, the biggest since October 2006.
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"We expect that the theme of global deflation is still set to dominate in the coming months," said Alan James, head of global inflation-linked strategy for Barclays Capital.
Not the whole story
But a particular dynamic in the bond market has also sent that break-even rate lower: As investors rushed to hide their money in the safest, most liquid assets -- conventional U.S. Treasurys -- demand for the less liquid, inflation-protected Treasurys has dwindled rapidly.
Distaste for TIPS has squeezed the break-even rate to levels some investors say belies the true inflation story.
"The break-even is completely unrealistic," said Ellen Safir, chief executive and founder of New Century Advisors. "Nobody is forecasting deflation out for five years when we think of what the government is geared to do to re-inflate the economy."
She thinks return to eventual growth means TIPS are undervalued, because they aren't being discounted to account for any inflation that is sure to come back at some point.
San Francisco Federal Reserve President Janet Yellen on Thursday also said she doubted that TIPS spreads are signaling several years' of falling prices.
"I think you do not get a clear read on inflationary expectations from those spreads because nominal Treasurys, especially short-term nominal Treasurys, are very liquid and TIPS are a lot less liquid," she told reporters after a speech in San Francisco.
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Some economists do see deflation lasting through much of this year, however, and lingering longer if economic growth doesn't turn around.
"The big risk is that we don't see the economy pick up towards the end of 2009," CIBC Global Markets senior economist Meny Grauman said. "If energy markets continue to slide lower, or even don't do much at all, that will make it harder to break out of the slide in the CPI."
The bank anticipates high prices from last year will propel more negative CPI readings, starting with December's figure. It then forecasts economic growth to resume by the very end of 2009, and with it, energy prices and inflation.
Deborah Levine is a MarketWatch reporter, based in New York.