Thoughts - news on inflation

Found this interesting article on inflation. I had a few questions which were clarified by a Phd student in finance. http://finance.yahoo.com/news/Goldman-Sachs-fails-to-excite-apf-879362838.html?x=0

1. Why did treasuries tumble on news of inflation

One of the Fed’s primary responsibilities in implementing its monetary policy is to guard against high inflation. It does this by acting to influence short-term interest rates. By buying or selling Treasury securities itself in the open market, the Fed is able to increase or reduce the money supply, for example. It is possible that investors, seeing news of higher-than-expected inflation, fear that the Fed will act sooner than they had expected to combat inflation, which would entail increasing rates. If investors believe that rates will be higher in the future, prices of Treasury securities must fall.

Practically speaking, however, the Fed might be constrained in its ability to raise rates, as doing so would be counter to the goals of promoting expansion of the economy in order to more quickly end the current recession. They’re in a particularly tough spot right now!

2. Long-term government debt tends to be sensitive to reports of higher prices, as inflation erodes the value of fixed-income securities over time - what does this mean.

Second question, think about how inflation affects lenders. Suppose that you lend me $100 today (interest-free, for simplicity), and I pay you back one year from now. Any inflation over that period reduces the purchasing power of the $100 that I return to you at the end of the year. The higher the inflation, the less I’m paying you back in real terms—the less you’re able to actually buy with that $100. This is good for me, as the borrower, but horrible for you, as the lender.

Holders of Treasury bonds are, in effect, loaning money to the government. Higher inflation means that the principal repayment to bondholders won’t be worth as much in real dollars, making the bonds less valuable, and leading to lower prices. The problem is worse for bonds with longer time to maturity, since inflation has an affect over many more periods for long-term bonds. Thus, one might expect long-term treasuries to suffer disproportionately from this report.