Things Are Getting Worse, Fast

This isn’t the first time, and I doubt the last, that I have used a post by Scott Sumner as the basis for one of my own.  But a blogger’s gotta do what a blogger’s gotta do.  Scott is properly worried by the falling yield on the 5-year Treasury.  The entire yield-curve is shifting down rapidly.  The yield on the 10-year constant maturity Treasury, which I follow closely, because I use it in my empirical model correlating movements in the S&P 500 with inflation expectations, has fallen to 2.68%, 30 basis points less than it was last Thursday and 54 basis points less than it was on July 1.  In the meantime the S&P 500 at this moment is down about 40 points since Thursday and 70 points since July 1.

The sharp decline in Treasuries seems to have been triggered by the downward revision real GDP released by BEA on Friday.  As a result, the decline in Treasuries was reflected almost entirely in a decline in the inflation adjusted yield of TIPS-bonds.  Today, however, if I am reading Bloomberg’s quotations correctly, the yields on conventional Treasuries are dropping faster than the yields on TIPS bonds, as they did yesterday, suggesting that inflation expectations are also declining, perhaps explaining why the stock market decline is accelerating today.  Remember the stock market loves inflation.

All of this is starting to get really scary.  The markets obviously believe that the real economy is deteriorating.  They presumably interpret the recent budget deal as a sign of increasing fiscal tightness, but the news story quoted by Scott suggests that the Fed is not at all inclined to provide any new monetary stimulus to compensate for the loss of federal spending.  The dollar is appreciating against the Euro, providing further evidence that inflation expectations are falling.

I really don’t like what I am seeing out there.  HELP!

23 Responses to “Things Are Getting Worse, Fast”

  1. 1 João Marcus Marinho Nunes August 2, 2011 at 12:50 pm

    Unfortunately, with this Fed led by a famous student of the Great depression, don´t expect HELP. Maybe he´s written so much about it that he now wants to “live through it”!


  2. 2 Lars Christensen August 2, 2011 at 2:17 pm

    David, I fully agree that the markets are getting worried about the US growth story. I can not judge whether this is “fair” or not, but I, however, would note – as you do – that the drop in yields we have seen in recent days nearly fully reflect a drop in REAL yields. TIPS breakeven inflation has actually been inching up over the past week.

    One obviously should be careful in reading too much into daily or weekly market moves (there is a lot of white noise out there…), but to me at least that is an indication that the market is not turning back to the worst doomsday scenario with depression and DEFLATION.

    The lack of renewed deflationary fears in a situation with renewed growth fears to me actually is an indication that the Fed is regaining some credibility. Hence, compare the situation today with the situation during the summer of 2010. In 2010 deflation fears became very visible in the markets on the back Greek debt worries and a relatively modest worsening of US macroeconomic data (the drop in ISM for example was much smaller than what we are seeing at the moment). Now the US macroeconomic situation is worsening much more and the European debt crisis is escalating day-by-day (this time its Italy and Spain…), BUT we are not seeing deflation fears? So why is that? My answer is that market participants now believe the Fed will do everything to avoid deflation – or said in another the Fed might not be a credible price level and NGDP level targeter, but it seems like the markets at least think of the Fed as a credible inflation targeter and this is the reason why TIPS inflation expectations have not dropped.

    Is this good news or bad news? Well, it is good if we want to avoid deflation and depression, but obviously if you are Scott Sumner (and I tend to agree with Scott on most issues…) then you could be disillusioned that the Fed does not target the NGDP level instead of inflation. And maybe the worry is not really in the US – the market dynamic in the last couple of days in the European debt markets to me is much, much more worrying.


  3. 3 Lorenzo from Oz August 3, 2011 at 12:53 am

    Meanwhile, down here in Downunder, we are bothered because retail sales have fallen two months running and new home sales have had their biggest decline in five years. While unemployment is holding steady at 4.9% and the Reserve Bank has left the cash rate at 4.75% (an increase was thought likely). A different world.


  4. 4 Lorenzo from Oz August 3, 2011 at 1:11 am

    Oh, and our federal MPs give better value for money than members of Congress.


  5. 5 JP Koning August 3, 2011 at 8:31 am

    “The dollar is appreciating against the Euro, providing further evidence that inflation expectations are falling.”

    Some contra observations. The US Dollar Index has hardly budged in two weeks. Also, the price of gold is skyrocketing.


  6. 6 David Glasner August 3, 2011 at 9:20 am

    Marcus, Obviously I am becoming less and less hopeful about Bernanke every day, despite Lars’s valiant attempts to keep my spirits up.

    Lars, Thanks. It’s good to have you around, but I am worried that the budget agreement has strengthened the hand of those that oppose all efforts, fiscal or monetary, to promote recovery. Combined with evidence of a worsening economic outlook, one could infer that there will be even less inflation (already too little) than had been expected. That will just make things worse. So, nice try, Lars, but I’m still in a funk.

    Lorenzo, You guys are on top of the world aren’t you. About overpaying legislators, I always thought that it was a really bad idea for us not to raise salaries for Congressmen and Senators. The low pay induces self-selection (especially among Republicans who tend to work in higher paying occupations than Democrats) by the less intelligent members of pool of potential candidates to run for Congress.

    JP, For the dollar I was just looking at the last few days. On gold, two points. First, uncertainty is increasing, that makes gold more attractive. Second, real interest rates are falling; also makes gold more attractive. Actually, a third point, gold is a bubble.


  7. 7 Luis H Arroyo August 3, 2011 at 10:01 am

    Yes you are right, the expected inflation is falling, and your model correlating that with S&P´s movements is fascinating.
    That is the reason I am amazed: it seems most pundits economists are worried about some failure in the recent debt negociations.
    It seems that $ 2400 mm of less expenditure is alarming, just where I see the start of fixing the debt problem.
    That are inviting rating agencies to degrade the AAA level of US debt, when, as you say, the 10 yeras interets rate is well under 3%.
    Frankly, I don´t see so urgent the fiscal problems as the visible signs of stagnation (or contraction).
    I think the urgent problem now is (the lack of) growth.
    I don´tunderstand any thing.


  8. 8 JP Koning August 3, 2011 at 10:35 am

    Here is a chart of the USD.

    I don’t see a significant fall in inflation expectations here over the last few days. Just a bunch of noise.


  9. 9 JP Koning August 3, 2011 at 10:45 am

    You say gold is a bubble, presumably because that allows you to ignore the informational content of gold’s rise. By analogy I say the equity market’s recent tumble is a reverse bubble, and I can therefore discount as mere noise the informational content you find so important in the market’s recent tumble.

    My point being, bringing out the b-word in an economic argument is like playing the nazi card in a political or moral argument. It derails all debate.


  10. 10 David Glasner August 3, 2011 at 10:49 am

    Thanks. I replied before the drop in the dollar this morning (or at least before I saw the drop this morning). I may have been too hasty in my judgment, but I am still very worried and the yields on Treasuries were continuing to fall last time I checked.


  11. 11 David Glasner August 3, 2011 at 10:54 am

    Point well taken. But that wasn’t my only response. And I’m sorry, but I do think it’s a bubble.


  12. 12 JP Koning August 3, 2011 at 11:03 am

    Sorry to plaster your blog with comments, David, but you mentioned uncertainty might be pushing the gold price up. Might not that be the same uncertainty that is pushing stocks down?


  13. 13 David Glasner August 3, 2011 at 11:32 am

    The tone of your question somehow suggests that you are expecting me to say “no.” A big increase in uncertainty tend to freeze economic activity and induces people to increase holdings of cash, all of which tend to be deflationary unless counteracted by monetary policy.


  14. 14 Benjamin Cole August 3, 2011 at 1:18 pm


    Remember, it is “Bernanke-san” not Bernanke.

    The dithering, feeble uncertain Fed policy is leading to deflationary expectations rising again.

    No modern economy has ever thrived with sustained deflation, or even very low inflation. See Japan, under heading “Economic Seppuku”

    I would rather enjoy robust growth and some inflation than a perma-recession and no inflation. .


  15. 15 Lorenzo from Oz August 3, 2011 at 3:40 pm

    David: on paying legislators, I am reminded of someone in the bar of the House of Commons complaining loudly that “there are a lot of damn fools in Parliament”. One older MP put down his beer and replied “and there a lot of damn fools in the electorate, and they deserve representation”. I have mixed feelings about increasing the reward for being a politician. The Swiss went the opposite way, and seem to do quite well.

    On why we are doing better, the answer seems to be reform, the Reserve Bank and China. That is, a long process of reform of the economy and public finances from 1983 onwards has produced a much more resilient economy with low public debt. Notable elements have been financial deregulation with, however, strong prudential regulation; some opening up of the labour market; tariff reduction; compulsory superannuation; considerable privatisation; introducing a GST and use of increased revenue to pay off public debt. Meanwhile, the Reserve Bank has managed a successful moderating monetary policy (no recession since 1992-3) and China is buying the stuff we dig out of the ground: with the extra proviso that we still coped with the dramatic, if temporary, drop in commodity prices.

    The Russian central bank recently bought a large tranche of $A: the notion of what used to be called “the Pacific Peso” as a quasi-reserve currency is a bit startling, but is probably a China-boom-proxy, since the renminbi is not freely exchangeable. (It suggests that the Russians are confident in the resilience of the Chinese economy.) In the mid 70s, the $A was higher than the $US: during the 1997 Asian crisis the $A hit around 52cUS, now it is higher than the $US again.

    That all said, our houses are ludicrously overpriced due to our UK/California style official-discretion-land-use-rationing. Since 1990, owner-occupied and investment property credit has expanded its share of total credit from 23 per cent to 58 per cent. (Business credit has dropped from 63 to 34 per cent.) Australia has become a country highly leveraged on regulatory approval. Whether house prices collapse or just continue to plateau is a big question.


  16. 16 David Glasner August 3, 2011 at 7:54 pm

    Luis, I agree with you that by far the most important task facing policy makers is not the deficit or the debt but improving macroeconomic performance. Tinkering with spending and taxes is of trivial significance compared with increasing output and employment. That so much energy and emotion and effort were expended on truly marginal budgetary adjustments ought to go down in history as one of the colossal policy mistakes of all time. And the precedent has been set for this farce to be repeated every time the debt ceiling will have to be raised ever again. Obama should not have allowed negotiations to begin and should have insisted on a clean debt ceiling bill or disregarded the law and dared the Congress to impeach him. But that is all history now.


  17. 17 David Glasner August 3, 2011 at 8:06 pm

    Benjamin, Well I think that most reasonable people would share your preference for full employment over price stability. The problem is that the trade-off between inflation and unemployment is complicated and not at all well understood. Republicans are willing to tolerate inflation only when they are in power; they scream bloody murder about inflation when they are out of power.

    Lorenzo, I guess the question is would we, i.e., the Amercan people, be better served by a smarter or by a stupider Republican party? I don’t think that I know the answer to that question. Just out of curiosity, what is Australia’s current population and how fast is it growing? Is growth coming from internal population growth or from immigration?


  18. 18 JP Koning August 4, 2011 at 5:10 am

    Thanks. I’m not trying to anticipate your responses, just curious.

    I think I’m confused with the terms “uncertainty” and “inflationary/deflationary expectations”. I can’t figure out if they are different words for the same force, or if one causes the other, or if they have different meanings entirely. If this is elementary, apologies in advance.


  19. 19 David Glasner August 4, 2011 at 1:25 pm

    JP, I agree that uncertainty is a key factor here, but uncertainty can cover a whole slew of possible scenarios. There could also be situations, however, in which there was an expectation of a rising or a falling price level without any increase in uncertainty. But on balance an increase in uncertainty would tend to make people less inclined commit to projects involving a substantial investment that could not easily be recovered. People desire to be liquid, which means they prefer to hold cash rather than real assets. There is increasing demand by lenders for repayment rather an extension of credit, which tends to increase pressure to sell and feeds an expectation of falling prices. So these sorts of situations feed on themselves, which is the idea behind having a lender of last resort that can supply liquidity when no else is willing to do so.


  1. 1 Browsing Catharsis – 08.03.11 « Increasing Marginal Utility Trackback on August 3, 2011 at 5:06 am
  2. 2 Does the stock market Love inflation? | Historinhas Trackback on August 3, 2011 at 11:02 am
  3. 3 Scott Sumner Bans Inflation « Uneasy Money Trackback on November 6, 2011 at 9:28 pm
  4. 4 Sumner, Glasner, Machlup and the definition of inflation « The Market Monetarist Trackback on November 7, 2011 at 2:27 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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