Deflation?

In a previous post, I expressed surprise that yields on inflation-indexed Treasury notes are rising. Readers have emailed me a variety of hypotheses, the most common of which is deflation. As one smart economist put it:

Here's one possible answer -- the credit crunch has precipitated a massive expansion of money demand -- a scramble for cash. Despite its best efforts, the Fed has not matched this with a sufficient expansion of money supply. As simple IS-LM would predict, this surge in money demand has raised real interest rates (indicating that monetary policy is perhaps still too tight).

Rising real rates on inflation-indexed bonds and falling rates on nominal bonds also tell us that markets expect this surge in money demand to result in near-zero inflation or even deflation in the years ahead. It's starting to look more and more like 1990s Japan, though hopefully for not as long.

Maybe. But let me point out two things. First, the survey of professional forecasters has not seen much change in expected inflation over the next 10 years (although I can think of several reasons to be skeptical of this fact). Second, note this unusual feature of Treasury Inflation-Protected Securities (TIPS):

What happens to TIPS if deflation occurs?

The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal.

That is, in a period of substantial inflation uncertainty (e.g., now), TIPS are an attractive bet. You get inflation protection if prices rise, but you get your full nominal principal back at maturity if prices fall.

My guess is that Tyler Cowen is on the right track when he suggests that the answer to the puzzle involves credit market segmentation of some sort.