The Treasury market’s inflation forecast has been falling for nearly two months, sending a warning sign that the economy is headed for a slowdown. The change for the worse in this indicator first caught our attention several weeks ago and the risk is even higher now. The basic problem is that the a sharp fall in inflation expectations is a sign of trouble for an economy that’s only been growing modestly, and unevenly. As a result, economic updates in recent days seem to confirm that disinflation/deflationary forces are on the rise again.

That’s certainly the message in the implied inflation forecast based on the yield spread between the 10-year nominal and inflation-indexed Treasuries. As of yesterday, the inflation outlook on this basis was 2.26%, down sharply from the post-recession peak of 2.64% set on April 8. A low-2% inflation outlook is hardly troubling per se; rather, it’s the rapid decline that’s disturbing.

The market’s downward revision for inflation expectations is accompanied by a fresh batch of weaker-than-expected news on the economic front. That sets up the possibility of a self-reinforcing cycle for the weeks (months?) ahead. The negative factors include what some are now calling a double dip correction for the housing market.
Perhaps more worrisome is the sharp deceleration in job creation reported by ADP on Wednesday. The Labor Department’s payrolls report for May that’s scheduled for release later today will surely set the tone for the coming weeks. Meantime, the Treasury market’s telling us that the risk to growth is rising. For the moment, it’s still possible to look at the market’s inflation forecast and write it off as statistical noise. But if this prediction of future pricing levels continues its descent, the odds rise that there’ll be a price to pay in the form of lower growth.