Inflation Expectations Are Falling; Run for Cover

The S&P 500 fell today by more than 1 percent, continuing the downward trend began last month when the euro crisis, thought by some commentators to have been surmounted last November thanks to the consummate statesmanship of Mrs. Merkel, resurfaced once again, even more acute than in previous episodes. The S&P 500, having reached a post-crisis high of 1419.04 on April 2, a 10% increase since the end of 2011, closed today at 1338.35, almost 8% below its April 2nd peak.

What accounts for the drop in the stock market since April 2? Well, as I have explained previously on this blog (here, here, here) and in my paper “The Fisher Effect under Deflationary Expectations,” when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. Real interest rates have been consistently negative since early 2008, except in periods of acute financial distress (e.g., October 2008 to March 2009) when real interest rates, reflecting not the yield on capital, but a dearth of liquidity, were abnormally high. Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. That is why ever since 2008, movements in stock prices have been positively correlated with expected inflation, a correlation neither implied by conventional models of stock-market valuation nor evident in the data under normal conditions.

As the euro crisis has worsened, the dollar has been appreciating relative to the euro, dampening expectations for US inflation, which have anyway been receding after last year’s temporary supply-driven uptick, and after the ambiguous signals about monetary policy emanating from Chairman Bernanke and the FOMC. The correspondence between inflation expectations, as reflected in the breakeven spread between the 10-year fixed maturity Treasury note and 10-year fixed maturity TIPS, and the S&P 500 is strikingly evident in the chart below showing the relative movements in inflation expectations and the S&P 500 (both normalized to 1.0 at the start of 2012.

With the euro crisis showing no signs of movement toward a satisfactory resolution, with news from China also indicating a deteriorating economy and possible deflation, the Fed’s current ineffectual monetary policy will not prevent a further slowing of inflation and a further perpetuation of our national agony. If inflation and expected inflation keep falling, the hopeful signs of recovery that we saw during the winter and early spring will, once again, turn out to have been nothing more than a mirage


16 Responses to “Inflation Expectations Are Falling; Run for Cover”

  1. 1 Marcus Nunes May 14, 2012 at 7:57 pm

    “Consumate statemanship” indeed! Don´t know if you´ve seen this from the NY Fed, but it appears these guys are all in for technical showmanship and blind to the underlying substance:


  2. 2 Ritwik May 15, 2012 at 2:22 am

    China doesn’t have deflationary expectations necessarily – imports crashed. In India, there’s the problem of not being able to control inflation.

    Both India and China could do with higher exchange rates followed by rate reductions at home. Both US & Europe could do with lower exchange rates. Some kind of global monetary coordination is definitely in order – national interests will almost never be as well aligned as they are now.


  3. 3 Tas von Gleichen May 15, 2012 at 3:07 am

    China will find a way to combat a slowing economy. They simply have too. Huge numbers of unemployment is the real threat to China. This is what they are trying to stop. Honestly that is what Spain, and Greece should do as well. The US is not much better off. For to long this has been a case for kicking the cane down the road. As longest the system keeps together while I’m in Office nothing will change. That has been the attitude of the past Presidents. I’m hoping for the elites to change there mind.


  4. 4 JP Koning May 15, 2012 at 6:39 am

    David: “…when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. ….Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. ”

    Curious where you think gold fits in here. Presumably if holding zero-yielding money becomes more attractive than investing in real capital, then holding some durable asset that also yields zero (and requires minimal storage costs) becomes more attractive than investing in real capital?


  5. 5 Steve May 15, 2012 at 2:23 pm

    Gold is an industrial metal. Gold is attractive to hold when the price of gold is less than the full cycle cost of extracting gold. It’s unattractive to hold when it exceeds the cost of extraction.


  6. 6 billhopen May 16, 2012 at 6:24 am

    “unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital.”

    I grabbed that quote as well, JPKoning…its the crux of the situation the article describes. I differ with Steve, Central banks don’t horde “industrial metal” gold’s use in dentistry is not irreplaceble, in electronics, silver and other metals will do, and one never sees aluminum, zinc, etc get volitile and reach heady hights like gold……Golds value, is its value……..its the historical definition of wealth since the begining of “money” as a concept.

    From time to time “money” is worth less to horde and its best expended on real goods and assets. The weird thing happening now is the mad creation of money by digital printing…..that is in turn chasing the tail of huge “vaporization” of assets by default. “Money” can evaporate when it is a chimera like debt that is promised to repay in the future….or collateralized by assets such as 500ksuburb homes with amazing shrinking value. As more deflation occurs, and more printing to replace that lost currency occurs, the holders of wealth will be more dubious of paper and promises, and more drawn to the old reliable, unprintable, immutable treasure measure of Gold.


  7. 7 David Glasner May 17, 2012 at 5:57 pm

    Marcus, I didn’t see it. As usual, you are right on target.

    Ritwik, Right now the main use for exchange rates is as a mechanism for commitment to a higher price level.

    Tas, So far there is little sign of change in attitudes, but election results may compel some rethinking.

    JP, Barsky and Summers had a paper in 1987 or 1988 in JPE on Gibson’s Paradox in which they argued that changes in real interest rates caused the value of gold to change (the value of gold being inversely related to the rate of interest). The price of gold has to adjust to make holding gold equally attractive as holding any other asset, net of storage costs and whatever real services gold provides to holders of it.

    The value of gold depends on the current stock, and expectations of the size of its future stock, and expectations of the future demand. Current production costs affect the value of gold only insofar as they affect expectations of the size of the future stock. Despite all that, the value of gold seems like a bubble to me.

    billhopen, People are holding gold in the expectation that its price will rise. But value of gold is now dominated by speculative holding in the expectation of further increases in price. That sounds like a classic bubble to me.


  1. 1 Inflation Expectations Are Falling; Run for Cover | George Street Review Trackback on May 14, 2012 at 9:22 pm
  2. 2 Inflation Expectations Are Falling; Run For Cover « Economics Info Trackback on May 16, 2012 at 11:00 am
  3. 3 Chart of the Day | Taegan Goddard's Wonk Wire Trackback on May 16, 2012 at 12:44 pm
  4. 4 Expected Inflation and the S&P 500 Redux « Uneasy Money Trackback on May 17, 2012 at 10:23 am
  5. 5 2nd June 2012: United States Jobs Report | Alex Burns Trackback on June 2, 2012 at 12:33 am
  6. 6 More on Inflation Expectations and Stock Prices « Uneasy Money Trackback on June 6, 2012 at 8:41 pm
  7. 7 Skepticlawyer » Broken by the fix Trackback on July 29, 2012 at 11:15 pm
  8. 8 Skepticlawyer » None so blind Trackback on August 6, 2012 at 7:31 pm
  9. 9 The Wisdom of David Laidler « Uneasy Money Trackback on September 11, 2012 at 4:49 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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