NEW YORK Rising inflation could become a big theme for 2011 as a double dose of fiscal and monetary stimulus hits the U.S. economy just as conditions may be starting to improve on their own accord.
Financial markets are bracing for higher prices. Dealers have pushed up the implied rates of inflation and driven up the yield on U.S. Treasury debt after a deal struck in Washington this week to extend tax cuts.
"There is the possibility that the capital markets are going to continue to interpret the monetary and fiscal policy as being pro-inflation," Tad Rivelle, chief investment officer of U.S. fixed income at TCW, said at the Reuters 2011 Investment Outlook Summit.
For months, the U.S. Federal Reserve has been focused on stamping out any possibility of deflation.
The core personal consumption expenditure index, which strips out food and energy costs, is the Fed's favored measure of inflation and was flat in October for the second straight month.
But some investors guess that the tipping point for inflation could come unexpectedly.
"To me, the real risk is -- and I don't know if next year, or when -- is inflation resurfacing, " said Charles de Vaulx, partner at the mutual fund International Value Investors.
"In 1972, like today, it seemed like there was no inflation, no evidence it was going to come back, and it came out of the blue."
Many economists raised their U.S. gross domestic product forecasts after the tax deal struck by President Barack Obama with Congressional Republicans, which included a surprise reduction in payroll taxes for 2011.
"Overall, the package over the next two years will boost people's incomes by almost $500 billion dollars more than would have occurred under a simple extension of the Bush tax cuts," said Robert Murphy, associate professor in the economics department at Boston College.
Goldman Sachs, which earlier this month raised its 2011 growth forecast to 2.7 percent, said tax cuts could add another 1 percentage point to that.
Higher economic growth should ultimately feed through to higher inflation, and the worries about the massive federal budget deficit have only worsened based on the tax changes.
The 10-year U.S. Treasury note, a key benchmark for home mortgages and other consumer loans, rose to 3.21 percent on Thursday from 2.96 percent early Monday.
TCW's Rivelle said 10-year yields should be closer to 4 percent, and that ultra-low short-term yields have a long way to rise.
Inflation expectations have been rising since late summer, when Federal Chairman Ben Bernanke hinted that the U.S. central bank was prepared to step up its efforts to combat deflation and a potential double-dip recession.
That vow has since become real, in the form of the so-called "QE2" program, a $600 billion second round of bond buying known as quantitative easing.
The Fed has also held short-term rates near zero since late 2008.
Earlier this week inflation expectations, as measured between the yield difference between regular 10-year Treasuries and 10-year Treasury Inflation-Protected Securities, touched their highest level since mid-May.
Ten-year TIPS breakevens, an inflation gauge that the Fed monitors, reached 2.26 percentage points on Tuesday, compared with 1.50 points before Bernanke's Aug 24 speech in Jackson Hole, Wyoming.
Influential investor Jim Rogers said that higher inflation has already arrived.
Government price data is "a sham" that relies too heavily on housing prices and is causing the Fed to vastly understate price pressures in the economy, he said.
"Everybody in this room knows prices are going up for everything," Rogers said at the summit.
Still, a major headwind to inflation is the economy's still-large output gap -- the gulf between potential output and actual output.
At the current U.S. unemployment rate of 9.8 percent, millions of unemployed workers will provide a natural dampener to wage gains, which are often a key driver of inflation.
Industrial capacity utilization in October was 74.8 percent, up 6.6 percentage points from its recession low of June 2009, but well below its average from 1972 to 2009.
(Additional reporting by Jennifer Ablan, Richard Leong and Daniel Bases; Editing by Padraic Cassidy)