On August 18, I did a post after the S&P 500 fell by 4.6% to 1140.65, observing that inflation expectations as reflected in the breakeven TIPS spread on constant-maturity 10-year Treasuries fell by a whopping 18 basis points from 2.17% to 1.99%. I also provided a table showing that in 26 instances in which inflation expectations (measured by the 10-year constant maturity TIPS spread) had fallen by 11 basis points or more in a single day since September 2008, 17 had been associated with a decline of more than 1% in the S&P 500. Today, the TIPS spread fell by 15 basis points from 1.86% to 1.71% while the S&P 500 fell by 3.2%. (For an explanation of the theory behind this relationship and for a description of the econometric evidence supporting it, see my paper here and an earlier post on this blog.) Inflation expectations are now at their lowest point in over a year just about the time that Chairman Bernanke and other Fed officials began signalling that they were concerned about the dangers of deflation. The S&P 500 is now barely above its low for 2011, and only about 7-8% above its level in August 2010 just before the Fed moved to ease deflationary fears.
Josh Hendrickson provides a good explanation for why the Fed’s feeble moves to flatten the yield curve are irrelevant to the problem now staring us in the face: price level expectations are not high enough to make capacity-expanding investment worthwhile. Even though profits are high at current levels of output, businesses have no confidence that they can sell increased output at prices that will generate a return on investment. They therefore hold on to their cash hoards, investing only in projects that reduce their costs without expanding capacity, carefully limiting the hiring of new workers, lest they have to lay them off later because of insufficient demand.
And with inflation expectations dropping like a stone, Professor John Taylor can think of nothing better than to admonish the Fed for even mentioning that it has a mandate to promote full employment in addition to ensuring price stability.
[F]or most of the 1980s and 1990s — starting when Paul Volcker became chairman — the Fed stressed the goal of price stability in its actions. The result was much lower unemployment than before or since.
Sorry to be pedantic, but what exactly does Professor Taylor mean when he says “the Fed stressed the goal of price stability in its actions?” I know actions speak louder than words, but is Professor Taylor saying that inflation was lower under Paul Volcker’s chairmanship than it is now? I don’t think so! Even after the 1981-82 recession, the average rate of inflation was higher under Chairman Volcker than it has been since 2008 (see here). Is he saying that the Fed under Chairman Volcker was aiming (and, evidently, missing) at a lower rate of inflation than the Fed is now? Well since the Fed did not even have an explicit inflation target under Chairman Volcker while the current inflation target is 2% or a bit less, I can’t see how that is possible, though I would love to hear Professor Taylor’s explanation. But perhaps Professor Taylor, in his wisdom, knows how to infer something else from his “reading” of the Fed’s “actions” under Chairman Volcker? Or perhaps Professor Taylor knows how to compare Chairman Volcker’s body language to Chairman Bernanke’s body language. Or maybe Professor Taylor is playing to a certain audience that likes to hear a respected academic economist bash the Fed? But I can’t imagine who could possibly be in that audience. I must be hallucinating.