Markets, Fed have very different ideas about inflation

The Federal Reserve now looks set to raise rates in December, partially based on expectation that inflation is set to finally rise to its 2 percent target. There's only one potential problem.

There's actually a way that markets can see where investors think inflation will go. And they do not exactly see eye to eye with America's central bank.

Over the next five years, annual inflation is expected to run at less than 1.3 percent. Even over the next ten, investors are looking for no more than 1.6 percent per year.

The Fed is well aware of this thinking among investors. In fact, the minutes to the Fed's October meeting record that "a couple of members expressed concern about the continued decline in market-based measures of inflation compensation."

To be sure, the comparison here is not apples-to-apples.

The popular market-based measures of inflation referenced above are simply found by comparing the yield on a Treasury bond and a Treasury Inflation-Protected Security (or TIPS) of the same maturity.

Since a TIPS bond pays an investor an amount that varies with the Consumer Price Index (CPI), and a Treasury bond is not adjusted for inflation, the Treasury yield minus the TIPS yield should theoretically produce the market's expectations of inflation. That number is known as a "breakeven rate" (since it is the inflation amount that will make the TIPS investor and the Treasury investor break even with each other).

While the breakeven rate reflects expectations about the more popular CPI inflation rate, the Fed targets the alternative personal consumption expenditures (PCE) metric.

Still, it is the trend in the breakeven rate that the Fed has its eye on, rather than the absolute percentage. And while the PCE and CPI readings may differ from month to month, the measures are almost perfectly correlated over time.

Read MoreUS inflation to rebound next year: Fed's Fischer

So while the Fed continues to bang the drum on its 2 percent inflation target, and is now apparently trying to prevent inflation from rising above that in the future, it is striking to note just how quickly the bond market's expectations of inflation have been decreasing.

To be fair, it might be a bit foolhardy to expect investors to anticipate an inflation surge purely based on what the Fed policymakers are saying.

Betting on higher inflation "would be hard to rationalize, given that we just haven't been there for so long," commented Mark Vitner, senior economist at Wells Fargo.

Over the past year, almost no inflation has been seen, with prices actually falling year-over-year during some months. And while this is partially a reflection of falling oil prices, inflation has generally been declining for the past quarter of a century.

"We are living in an era of diminishing expectations. And in many ways, it's self-reinforcing," Vitner added, given that low inflation reduces expectations of future price increases, which reduces actual price increases. That reduces expectations of future price increases, and so on.

Bob Andres, the chief investment officer of $800 million bond fund Andres Capital Management, is more blunt.

"The Fed is never right. Maybe it's that they're using too many models. But I think some of those Fed governors should open up the window, and take a look at the real world," Andres said. "Where is this inflation going to come from?"

The Fed is worried about inflation, but maybe it shouldn't be

He would put a good deal more trust in market-based inflation measures.

"The bond market is more rational than the equity market, and it's certainly more rational than a political Fed," he said. "And the bond market has been more right over the past five years."

Still, for investors who want to protect against future inflation, an opportunity may present itself.

"If people have a lot of exposure to bonds, it wouldn't hurt to have exposure to TIPS, or commodities, or commodity-related equities," said David Allison, of Columbia, South Carolina-based Allison Investment Management.

"If you're going to put on an inflation hedge, now might not be a bad time to consider it, with market-based expectations of inflation so historically low."

—By CNBC's Alex Rosenberg.

Watch "Futures Now" Tuesdays & Thursdays 1 p.m. ET exclusively on FuturesNow.CNBC.com!

Videos

Host Bio & Watch Now

Trader Bios