Yesterday, the yield on the 10-year constant maturity Treasury was 2.17% and the yield on the 10-year constant maturity TIPS was 0.01%. So the implied expected rate of inflation for a 10-year time horizon was 2.16%. At the close of trading today, the corresponding rates were 2.08% and 0.09%, implying that expected inflation over the next 10 years fell to 1.99%, one of the largest single day declines in inflation expectations in the available data on 10-year TIPS going back to 2003. Not coincidentally, the S&P 500 fell by 4.6%.
What can account for the decline in inflation expectations? In my post earlier today I quoted from today’s lead editorial in the Wall Street Journal. Let me quote the passage in its entirety.
Merely by raising the Fed as a subject, Mr. Perry has sent a political signal to the folks at the Eccles Building to tread carefully as they conduct monetary policy in the coming months. This alone is a public service. Mr. Perry and the other GOP candidates should be more careful in their language, and more precise about the Fed’s mistakes. But they shouldn’t shrink from debating the subject of sound money that is so crucial to restoring American prosperity.
So the Journal, behind the cover of its admonition to Governor Perry to be more circumspect in his word choice, whole-heartedly endorses his message to the Fed not even to think about using monetary policy to promote economic recovery (“tread carefully as they conduct monetary policy in the coming months”), while encouraging other Republican candidates to join Governor Perry in sending that message to the Fed. Today’s editorial was coupled with the bad news that the CPI rose by half a percent in July, way above the .2% that had been expected, encouraging further scare mongering about inflation, while strengthening the hand of those on the FOMC opposed to any further monetary easing. Is it any wonder that the markets are revising their expectations of future monetary policy in a downward direction — in a sharply downward direction?
In the table below, I list 28 instances in which inflation expectations (measured by the TIPS spread on 10-year constant maturity Treasuries) suffered a decline of 11 basis points or more in a single day. Only one such instance took place before 2008, on March 14, 2003; another occurred on March 17, 2008. The remaining 26, have all occurred since the financial panic that occurred after the Lehman Brothers debacle in September 2008. Of those 26 instances, 17 were associated with declines in the S&P 500 greater than 1%.
In a paper available here, and discussed here, here, and here, I have shown that until early 2008, the there is no systematic correlation to be found in the data between asset prices (measured by the S&P 500) and inflation expectations. However, since 2008, the daily change in expected inflation (measure by the TIPS spread on 10-year Treasuries) has been highly correlated with the daily change in the S&P 500. To me that is persuasive evidence that in current atypical economic conditions, characterized by unusually pessimistic expectations of future economic activity, raising expected inflation tends to improve expectations of real economic growth, thereby, in and of itself, promoting increased investment, output and employment.
One would think that conservatives, who profess to favor unleashing the private sector, would favor a policy calculated to encourage additional private investment and promote increased output by and hiring by American business without any increase in government intrusion into the economy. Isn’t that what the magic of the market is all about? That’s what one would think, but the Wall Street Journal editorial page, in its almost infinite wisdom, seems to think otherwise.