I actually feel uncomfortable doing a day-by-day analysis of how the markets are moving, as I have done for three days in a row. If I had wanted to be a trader or a market commentator, I would have become one. And various commenters have correctly pointed out that price movements have more than one possible interpretation. So it should be understood that all I am doing is adding my own, possibly eccentric, perspective to the mix for whatever it is worth.
With that disclaimer, I will observe that yesterday, the inflation expectations implicit in the TIPS spread on the 2-, and 5-year Treasuries both dropped by more than 10 percentage points, which are pretty significant daily changes, while the implicit expectations on 10-year Treasuries dropped by 9 points. Interestingly, although the S&P 500 was down for most of the day, it rallied in the afternoon and closed up by almost half a percent. But the yield on the 5- year conventional Treasuries actually rose by 2 percentage points, so that the implied real return rose a little more than expected inflation dropped. Even though the market loves inflation, it also likes higher real interest rates, so the real-interest-rate effect, I could argue, offset the effect of declining inflation expectations. But today the market is again dropping, with rates on the 5-, 10-, and 30-year Treasuries dropping by about 4, 5, and 6 percentage points. So it seems likely that both real interest rates and inflation expectations are again dropping. It doesn’t look good to me.
So let me now reply to Lars Christensen (and I hope that he will respond with some cogent observations of his own) who has been arguing that declining inflation expectations are not so ominous, because the Fed has managed to stabilize expectations in the 2 to 2.5 percent range, after having dropped to dangerously low levels last summer before Bernanke, supported by some key members of the FOMC, decided to initiate QE2. My concern is that the level of inflation expectations that you need to prevent an asset price crash such as we experienced in September 2008 is not necessarily fixed at a particular level, say 2.5 percent. In my view, discussed in more detail in my paper on the Fisher Effect, asset prices crash when the expected yield from holding real assets (which one can think of as being represented by the real rate of interest, though this is a huge simplification) is less than the yield from holding money which is the negative of the rate of inflation. Thus, when asset holders expect deflation, but very little return on real assets, they shift out of holding real assets into money, triggering a decline in asset prices until the expected rate of return on real assets rises enough to make holding real assets preferable to holding money.
This I believe is what was going on, along with a bunch of other bad stuff, in the fall of 2008. Investors were anticipating falling asset prices concluded that holding money was preferable to holding real assets and there was a crash in asset prices. The FOMC, instead of counteracting the fall in asset prices by cutting interest rates immediately and flooding the markets with liquidity, sat back and watched happily as the dollar soared in the foreign exchange markets, believing that they had finally broken the back of rising inflationary expectations over which they had been obsessing since commodity prices spiked in the spring. Job well done.
What I am afraid is happening now is that the expected yield from holding real assets has fallen sharply over the past few months. Six months ago in early February the yield on a 10-year TIPS bond was 1.39%, so in the last six months the expected real interest rate has fallen by more than 1%. Just since July 1, the yield has fallen by almost half a percent. There were a number of reasons for this. Oil prices spiked in February (not because of QE2 as so many now disingenuously allege, but because of the revolt in Libya and other fallout from the Arab Spring) followed by the earthquake and Tsunami in Japan, renewed debt problems in Europe, the farcical soap opera over the debt ceiling that has been playing out in the US, and downward revisions in US GDP, all of which have clouded prospects for future GDP growth to which real interest rates are closely connected.
Now last August when the economy was teetering on the verge of falling into a recession, the stock market declined by about 8 percent before QE2 was announced, the real interest rate on the 10-year bond was just over 1% and inflation expectations were barely over 1.5%. So if real interest rates have fallen by nearly 1 percent since last August, and expected inflation as measured by the 10-year TIPS spread is 2.28% as of yesterday, I think that we may again be in a danger zone. I hope that I am wrong. Lars?
UPDATE: Well I just saw Lars’s comment on the previous post. I guess I can’t look for any solace from that source? Anyone else care to offer some words of encouragement? Please.
UPDATE II @ 1:12PM EDST: On Bloomberg, I just saw that gold is now down $15 from its opening today (it was up earlier this morning). Does that mean that people are trying to get more liquid now? Query for Ron Paul, when people want to be more liquid, do they prefer holding gold or holding dollars?
Uneasy Money 
Excellent commentary. inflation is dead, and will be dead, along with interest rates for some time. See Japan.
BTW, I have been thinking of a long-ago book by George Gilder, “Wealth & Poverty.” In it, Gilder exults about boom times, in which innovation flourishes, and also dismisses worries about inflation. (Gilder was a Reaganaut hero, in the days when 5 percent inflation was considered a victory).
As Gilder pointed out, what is more important than minute rates of inflation is freedom for capitalism, innovation and entrepreneurship. You ain’t going much of any in a perma-recession. Gilder almost exulted in the fact the growth booms and innovations booms were often linked to inflation.
Gilder even chided Milton Friedman for speaking darkly to Commie officials in Russia (after the fall, on a joint trip there) about the need to “control” the Russian money supply. “The commies don’t need to be lectured to about control,” huffed Gilder. “They know all about control. They need to be talked to about opening thing up, entrepreneurship, and less control.” Friedman came off as some loony obsessed with money, when what Russia needed was advice and encouragement on how to start up a vibrant business creation culture.
Gilder is right. Certainly the sad eclipse of Japan is a reminder that control of the money supply can easily become too tight.
More important than championing minute rates of inflation is championing growth, innovation, prosperity and optimism.
I write this as i think the NGDP’ers desperately need to start devising arguments to win the public debate. Ot will be easier if we cite right-wing heroes and idealogues.
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David
It´s the “summer bug” attacking again. Las August, this August. And the Jackson Hole get together is coming up soon…
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Very good, both, David & Benjamin. I like very much what you, David, say on assets prices, the key question today.
The fall of assets prices (and the expectacion of more fall) should be the main concern of the central banks today.
See Trichet, this “Magister” of finance: He rose twice interest rate, acelerating the crisis of bonds market just when Greece was rescued..
Today he has been forced to buy bonds, triyng to keep some level, but he has choose Ireland´s and Portugal´s bonds; as he has not intervened in Spain and Italian bonds, these have trembled a lot.
And yes, I am for more inflation, or at least not so worry about.
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Here, about “Operation Trichet”:
http://www.ft.com/intl/cms/s/0/4e5a3348-beb8-11e0-a36b-00144feabdc0.html#axzz1U54USOvZ
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Investors want real returns. When currencies offer real returns (as in either high growth or deflation), investors prefer to hold currency. When currencies offer negative real returns, investors will prefer to hold gold or some other commodity with inelastic supply/demand.
The question markets are trying to answer today: does currency offer positive real returns (deflation) or negative ones (inflation/ZIRP). During a financial crisis (like the budding European banking crisis), this is an open question.
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Generally, I’m in agreement with your economics, though as a market practitioner, I would quibble with your interpretation of market events. The market crash of 2008 was a situation of extensive forced selling related to the sudden withdrawal of liquidity from the credit markets, a form of selling that can be self-spiraling and indicated significant indirect leverage in the stock market (more than anyone knew existed). It was essentially a giant margin call on the market, which is why it bounced in the spring of 2009.
This may happen again when Europe finally succumbs to the inevitable, though this time investors have already been through it once and the European crisis is largely obvious to most investors who are awake.
Which is not to say that investors expected a recession in the second half or expected the Euro crisis to hit this soon.
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Ten years Treasury bonds at 2,43%… German 10Y bonds, at 2,30%…
Commodities % Stocks markets falling (8% and 6% in 5 days, respectively).
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And gold has fallen today
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David, yes I must admit I have been trying to put a positive spin on recent market moves, but what we are seeing today it pure capitulation in the markets and it is deeply worrying.
That said, I will say that in my view the problems do not originate in the US. Rather this is the European debt worries – and particularly the developments in the Spanish and Italian fixed income markets – which are driving the global stock off in stocks and the rise in risk aversion. Today’s ECB meeting did not make investors happy and despite the fact that the ECB apparently have been in the market today and bought peripheral European bonds the crisis has just escalated.
Hence, I think one should be very careful in analysis market events from a US centric perspective, but I agree that this likely necessitates some kind of policy response from the Fed…and don’t you think that we could get it already next week??
Overall, ECB is facing serious institutional challenges and there is wide agreement that the euro construction is flawed – or at least partly flawed. So again I would like to stress the core of the problem terms of both US and European monetary policy is the lack or “rules”. There is far too much muddling through.
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“Query for Ron Paul, when people want to be more liquid, do they prefer holding gold or holding dollars?”
Well, I’m not Ron Paul (although my name rhymes with his), but when people want to be liquid they definitely prefer dollars. Just look at what happened in fall 2008 when gold fell by $200 or so.
But that doesn’t mean they prefer cash.
For instance, right now gold is down 0.8% in US dollars, but up against Canadian dollars (+1.2%) , Aussie dollars (+2%), and most other currencies. If today was a scramble for liquidity, gold ranked below the dollar but above most brands of cash in terms of liquidity-preference.
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David, I wonder what you view would be on the impact of the following idea. The Fed should tomorrow announce that it target 5% inflation expectations in 2y-TIPS. I would like to hear your view on the macroeconomic and financial impact. And would you think that? The Fed could at the same time say it would permanently target 2 or 3% inflation in 5y/5y TIPS.
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I ´m very interested in the gold evolution near future.
What is clear for me is that euro´s problems radiate uncertainty all the world around. And I don´t discard that the fall of German yield and the rise spanish and other yields are a sign of rising risk of euro rupture. I suppose thay it is not time yet, but it seems clear that ECB & EU have lost control.
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Yeah, sometimes you shouldn’t write the first thing that comes into your head. I was just recalling Ron Paul’s idiotic questioning of Bernanke about whether Bernanke thinks gold is money. It was on youtube and it was classic, because you could see that both of them were thinking that the other one had to be the dumbest person in the whole world, but wasn’t actually willing to say so. Of course only one of them could be right, and I happen to know who it was.
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Dan,
I think as market practitioners, we do always hear interpretation of market events in terms of market dynamics like liquidity squeeze, short covering and so on.
But I think the economic interpretations is as valid. In fact, I tend to think that they are just the 2 different sides of the same coin and they sorta magnify each other. I mean, how often do we get a severe liquidity squeeze if people expecting a booming economy?
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As we are speaking…the US stock markets are turning – on budget news out of Italy. Apparently the Italian government will implement a balance budget amendment….Hence, once again European news seems to move the US markets. If they Italian government delivers on this then we are likely to see the ECB buying Italian bonds next week…paradoxically that could postpone any decision from the Fed on QE3…
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Lars, I am afraid that I have little to say off the top of my head on your suggestion beyond the point that the general concept is seems right. We should get a rapid, but short-term, increase in the price level, followed by stability. That seems to be what your idea is aimed at, so it seems generally right in spirit to me. About the precise details I don’t know how to evaluate it. Is that helpful? Perhaps if you gave me an alternative proposal I might be able to give you some further thoughts.
Luis, It seems to me (based on very little thought but just reasoning from general principles) that the only way to save the euro is to increase the target rate of inflation substantially and hope that by reducing the debt burden on the troubled countries they can meet their debt obligations without leaving the euro.
Lars, It’s not clear to me that US markets are following the Italian situation that closely. I don’t say that they are not, but there is a lot of news for them to keep track of. What effect do you think that the downgrade of US debt by S&P will have. I suspect very little, but that is just my intuition.
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I apologize for neglecting to respond to the comments on this post, but I have been busy with responding to other more recent posts and this one slipped through the cracks.
Benjamin, Thanks so much for reminding me about Gilder. His book Wealth and Poverty was a very good read, with many valuable insights, but definitely quirky. As you point out, he had a pretty relaxed view of inflation as long as it was held below about 4 percent or so, which is where it was for most of Reagan’s tenure. I don’t know if he has made any recent pronouncements on inflation. It would be interesting to see what he has been saying of late.
Marcus, Yes just about 3 weeks till Jackson Hole. Will Bernanke pull a rabbit out of his hat?
Luis, Do you think Trichet is the Emile Moreau of the Little Depression?
David, I think that we agree on this one.
Dan and Mark. Thanks for your comments. I agree that the switch from holding real assets to cash and the liquidity squeeze are very closely related and mutually reinforcing. To say that they are literally two sides of the same coin may actually be a stronger statement than I would be willing to make, but it is an interesting thought.
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Sure (sorry , I just have not read your comment until now)
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