Deflation in the U.S. remains a risk - if you are willing to disregard rising food and energy prices - and that is helping to hold interest rates down.
The core consumer price index, which is scheduled for release today, is forecast to have increased only 1.2 per cent on a year-over-year basis during March, compared with 1.3 per cent in February. That would be the lowest inflation rate in six years.
The low rate reflects "the impact of weak housing markets and a still-significant degree of economic slack," said Michael Gregory, a senior economist with BMO Nesbitt Burns Inc. "And with the three- and six-month core inflation trends pointing to an even slower pace, the [U.S. Federal Reserve Board]is showing no inclination to raise policy rates any time soon."
The core rate should even dip below 1 per cent later this year as a result of the strong U.S. dollar, excess manufacturing capacity and continued weakness in the housing market, said Peter Buchanan, an economist with CIBC World Markets Inc.
If food and energy are included in the mix, the inflation rate on a year-over-year basis is expected to increase by 2.4 per cent during March, up from 2.1 per cent in February. But that increase looks worse than it is because a year ago consumer prices were under tremendous pressure amid fears the nascent recovery wouldn't take hold.
How will the market react? The yield on 10-year U.S. Treasuries has declined to 3.82 per cent, down sharply from 4 per cent earlier this month, a level that attracted a lot of buying interest for the U.S. Treasury auctions.
A depressed and declining core inflation rate is bullish for U.S. Treasuries, said David Rosenberg, the chief economist and strategist with Gluskin Sheff + Associates Inc.
Among the best correlations with bond yields - at 75 per cent - is core inflation, Mr. Rosenberg said. "With close to 30 per cent of manufacturing capacity sitting idle and the [unemployment rate at lofty levels] not to mention a near 11 per cent nationwide apartment vacancy rate, we have tremendous spare capacity when it comes to goods, labour and housing," he said. "Deflation, not inflation, is the primary risk going forward."
With a lack of appetite for additional fiscal stimulus from governments, including those of the U.S. and Britain, disinflationary risks have increased, said Mihir Worah, managing director and head of the real return bond desk for Pacific Investment Management Co., in a report this week.