The Sky Is Not Falling . . . Yet

Possibly responding to hints by ECB president Mario Draghi of monetary stimulus, stocks around the world are up today; the S&P 500 over 1900 (about 2% above yesterday’s close). Anyone who wants to understand why stock markets have been swooning since the end of 2015 should take a look at this chart showing TIPS_FREDthe breakeven TIPS spread on 10-year Treasuries over the past 10 years.

Let’s look at the peak spread (2.56%) reached in early July 2008, a couple of months before the onset of the financial crisis in September. Despite mounting evidence that the economy was contracting and unemployment rising, the Fed, transfixed by the threat of Inflation (manifested in rising energy prices) and a supposed loss of Fed credibility (manifested in rising inflation expectations), refused to continue reducing its interest-rate target lest the markets conclude that the Fed was not serious about fighting inflation. That’s when all hell started to break loose. By September 14, the Friday before the Lehman bankruptcy, the breakeven TIPS spread had fallen to 1.95%. It was not till October that the Fed finally relented and reduced its target rate, but nullified whatever stimulus the lower target rate might have provided by initiating the payment of interest on reserves. As you can see the breakeven spread continued to fall almost without interruption till reaching lows of about 0.10% by the end of 2008.

There were three other episodes of falling inflation expectations which are evident on the graph, in 2010, 2011 and 2012, each episode precipitating a monetary response (so-called quantitative easing) by the Fed to reverse the fall in inflation expectations, thereby avoiding an untimely end to the weak recovery from the financial crisis and the subsequent Little Depression.

Despite falling inflation expectations during the second half of 2014, the lackluster expansion continued, a possible sign of normalization insofar as the momentum of recovery was sustained despite falling inflation expectations (due in part to a positive oil-supply shock). But after a brief pickup in the first half of 2015, inflation expectations have been falling further in the second half of 2015, and the drop has steepened over the past month, with the breakeven TIPS spread falling from 1.56% on January 5 to 1.28% yesterday, a steeper decline than in July 2008, when the TIPS spread on July 3 stood at 2.56% and did not fall to 2.30% until August 5.

I am not saying that the market turmoil of the past three weeks is totally attributable to falling inflation expectations; it seems very plausible that the bursting of the oil bubble has been a major factor in the decline of stock prices. Falling oil prices could affect stock prices in at least two different ways: 1) the decline in energy prices itself being deflationary – at least if monetary policy is not specifically aimed at reversing those deflationary effects – and 2) oil and energy assets being on the books of many financial institutions, a decline in their value may impair the solvency of those institutions, causing a deflationary increase in the demand for currency and reserves. But even if falling oil prices are an independent cause of market turmoil, they interact with and reinforce deflationary pressures; the only way to counteract those deflationary pressures is monetary expansion.

And with inflation expectations now lower than they have been since early 2009, further reductions in inflation expectations could put us back into a situation in which the expected yield from holding cash exceeds the expected yield from holding real capital. In such situations, with nominal interest rates at or near the zero lower bound, a perverse Fisher effect takes hold and asset prices have to fall sufficiently to make people willing to hold assets rather than cash. (I explained this perverse adjustment process in this paper, and used it to explain the 2008 financial crisis and its aftermath.) The result is a crash in asset prices. We haven’t reached that point yet, but I am afraid that we are getting too close for comfort.

The 2008 crisis. was caused by an FOMC that was so focused on the threat of inflation that they ignored ample and obvious signs of a rapidly deteriorating economy and falling inflation expectations, foolishly interpreting the plunge in TIPS spreads and the appreciation of the dollar relative to other currencies as an expression by the markets of confidence in Fed policy rather than as a cry for help.

In 2008, the Fed at least had the excuse of rising energy prices and headline inflation above its then informal 2% target for not cutting interest rates to provide serious monetary stimulus to a collapsing economy. This time, despite failing for over three years to meet its now official 2% inflation target, Dr. Yellen and her FOMC colleagues show no sign of thinking about anything other than when they can show their mettle as central bankers by raising interest rates again. Now is not the time to worry about raising interest rates. Dr. Yellen’s problem is now to show that her top – indeed her only – priority is to ensure that the Fed’s 2% inflation target will be met, or, if need be, exceeded, in 2016 and that the growth in nominal income in 2016 will be at least as large as it was in 2015. Those are goals that are eminently achievable, and if the FOMC has any credibility left after its recent failures, providing such assurance will prevent another unnecessary and destructive financial crisis.

The 2008 financial crisis ensured the election of Barak Obama as President. I shudder to think of who might be elected if we have another crisis this year.


14 Responses to “The Sky Is Not Falling . . . Yet”

  1. 1 Lars Christensen January 22, 2016 at 12:59 pm

    Great post David! The Fed is squarely to blame for this. Yellen has completely ignored the signals from both monetary and market indicators and as a result pushed the US economy close to recession. Blame the terrible Phillips curve logic of the 1970s style Keynesians.


  2. 2 Thomas Aubrey January 22, 2016 at 2:19 pm

    David, as you know the basic valuation equation – the dividend discount model – is dependent on expected future cash flows which is driven by profits. But the rate of profit growth, which has been reasonably robust since 2009, with the exception of 2011, tailed off in 2015. As valuations tend to get ahead of themselves, this is a natural correction and actually pretty straight forward to predict. The signals were highlighting this way before the Fed raised interest rates.

    The long run econometric analysis seems reasonably conclusive that equity returns and GDP growth not correlated. Ie profits can grow at very different rates to output.

    I wholly agree with you that the obsession of runaway inflation does not make much sense, but I also don’t think that the falling TIPS rate is telling you much beyond the fact that the cost of oil is falling either. What really matters is future productivity growth, and that is where the bigger concern lies for stock prices.


  3. 3 ariobarzanes January 22, 2016 at 6:43 pm

    i shudder to think that so many inflationists such as you draw breath and write blogs


  4. 4 Tom Brown January 25, 2016 at 10:48 am

    @ariobarzanes, what evidence would it take to convince you that you’re wrong?


  5. 5 Henry January 25, 2016 at 3:13 pm

    @ Lars Christensen

    “Yellen has completely ignored the signals from both monetary and market indicators and as a result pushed the US economy close to recession.”

    Which recession?


  6. 6 Henry January 25, 2016 at 3:24 pm

    @ David

    “Dr. Yellen’s problem is now to show that her top – indeed her only – priority is to ensure that the Fed’s 2% inflation target will be met, or, if need be, exceeded, in 2016 and that the growth in nominal income in 2016 will be at least as large as it was in 2015.”


    Equity markets suffer slippage and everybody panics.

    US equities were spoiling for a retraction given the high P/Es that were on offer – and there may be more to come.

    A change in trend for official interest rates was always going to force a repricing of US equities.


  7. 7 Benjamin Cole January 25, 2016 at 7:41 pm

    Excellent blogging.

    The Fed’s monomania with inflation has become a bar to good policy-making.


  8. 8 Tom Brown January 26, 2016 at 11:34 am

    “I shudder to think of who might be elected if we have another crisis this year.”

    Lol… yes, so do I! Especially if they’re racial immigration policies lead to a decay in the civilian labor force (CLF). Take a look: USA, Japan, Canada. All from the relation
    log CPI = b + a log CLF
    with a and b as parameters selected to fit the data. Causation or correlation? I don’t know (but I’d think CLF depends on “big” things like birth rates in preceding decades, social changes (women entering the work force) and immigration patters, etc). More here and here (the NGDP version).

    And if you-know-who(s) is/are elected, and their policies cause a turn for the worst, it won’t be THEM to blame: they’ll find convenient scapegoats to blame for “stabbing America in the back.”


  9. 9 David Glasner January 26, 2016 at 12:20 pm

    Lars, Many thanks. The Philips curve logic is really funny, because Yellen claims to be upset that real wages haven’t been rising fast enough.

    Thomas, Thanks for your comment. I guess it’s a puzzle for any attempt to explain the recent market pessimism, but if all that’s happening is that the market is processing information suggesting slower earnings growth, why was there a sudden nearly 10% drop in stocks over a three week period? I agree that profits can grow at different rates from GDP, but certainly expectations of a recession would be correlated with expectations of reduced profits.

    ariobarzanes, Trust me, I am really not such a scary guy.

    Henry, A 10-percent drop in equities in three weeks may not be cause for panic, but it is not irrelevant. As I observed in my recent post about Martin Feldstein high P/E ratios can be at least partially attributed to historically low real interest rates. You say that a change in trend for official interest rates was always going to force a repricing of US equities. I don’t disagree that an increase in real interest rates could cause equities to fall, but, as I also pointed out in my post about Feldstein, the increase in the Fed interest rate target has been followed by falling long-term interest rates, suggesting a) that the Fed has little if any direct control over long term interest rates via its control over the overnight rate and b) that the fall in equities has little if anything to do with interest rates and a lot to do with expectations about future profits.

    Benjamin, Thanks. It may not even be inflation; I think they want to raise interest rates just for the sake of raising them.

    Tom, We do have a lot to worry about.


  10. 10 Tom Brown January 26, 2016 at 3:32 pm

    In my comment above:

    “racial immigration”

    should have been

    “radical immigration”

    I wasn’t trying to bring race into this! Consciously anyway… ;D


  11. 11 Thomas Aubrey January 26, 2016 at 11:36 pm


    Trying to generalise why thousands of independent decisions are made to sell equities is difficult at the best of times, but in this instance the falling oil price is likely to have had an impact on many trading algorithms as it is signalling lower future dividends on oil (and other basic resources stocks). These stocks are some of the biggest dividend payers and were also some of the main beneficiaries of QE. As yields fell, many investors switched to own these assets which have bond-like characteristics, which is now reversing somewhat. As these stocks fell, it probably triggered other algorithms to sell causing the adjustment.

    When thinking about equity markets it’s worth bearing in mind Fisher Black’s view where equity markets are doing a reasonable job if they are valuing between half and double what they are really worth.


  12. 12 Henry January 27, 2016 at 2:28 am

    The larger concern with the oil patch is that the banking system has lent hundreds of billions to the oil shale industry, much of which is looking worrisome with the collapse in the oil price. And of course China and now talk of eastern Europe’s poor finances is putting the frighteners on markets.

    Confidence is been shaken and expectations changed.

    The interest rate regime and monetary policy is only one of many factors.

    And of course Lars loves any excuse to whip the Fed and Keynesians. 🙂


  13. 13 TravisV January 27, 2016 at 2:58 pm

    Are gold prices increasing because real interest rates are falling?


  14. 14 pliu412 (@pliu412) January 31, 2016 at 11:59 am

    The sky is uprising!?

    From NIPA/FOFA accounting identities for P and GDI relationship, we should know Unit Labor Cost(ULC) is a better inflation estimation than others. ULC measures both labor cost from labor market and labor productivity from goods market in a single indicator. ULC is aligned with core CPI historically shown here: (ULC in green, core in CPI in blue, 10-year note in pink and 10-year breakeven rate in red)

    The breakeven rate is from market expectation and lower than core CPI in the past.


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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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