Uneasy Money

I have been arguing for the past four months on this blog and before that in my paper “The Fisher Effect Under Deflationary Expectations” (available here), that the Fisher equation which relates the nominal rate of interest to the real (inflation-adjusted) interest rate and to expected inflation conveys critical information about the future course of asset prices and the economy when the expected rate of deflation comes close to or exceeds the real rate of interest. When that happens, the expected return to holding cash is greater than the expected rate of return on real capital, inducing those holding real capital to try to liquidate their holdings in exchange for cash. The result is a crash in asset prices, such as we had in 2008 and early 2009, when expected inflation was either negative or very close to zero, and the expected return on real capital was negative. Ever since, expected inflation has been low, usually less than 2%, and the expected return on real capital has been in the neighborhood of zero or even negative. With the expected return on real capital so low, people (i.e., households and businesses) are reluctant to spend to acquire assets (either consumer durables or new plant and equipment), preferring to stay liquid while trying to reduce, or at least not add to, their indebtedness.

According to this way of thinking about the economy, a recovery can occur either because holding cash becomes less attractive or because holding real assets more attractive. Holding cash becomes less attractive if expected inflation rises; holding assets becomes more attractive if the expected cash flows associated with those real assets increase (either because expected demand is rising or because the productivity of capital is rising).

The attached chart plots expected inflation since January 2010 as measured by the breakeven 5-year TIPS spread on constant maturity Treasuries, and it plots the expected real return over a 5-year time horizon since January 2010 as reflected in the yield on constant maturity 5-year TIPS bonds.

In the late winter and early spring of 2010, real yields were rising even as inflation expectations were stable; stock prices were also rising and there were some encouraging signs of economic expansion. But in the late spring and summer of 2010, inflation expectations began to fall from 2% to less about 1.2% even as real yields started to drop.  With stock prices falling and amid fears of deflation and a renewed recession, the Fed felt compelled to adopt QE2, leading to an almost immediate increase in inflation expectations. At first, the increase in inflation expectations allowed real yields to drop, suggesting that expected yields on real assets had dropped further than implied by the narrowing TIPS spreads in the spring and summer. By late fall and winter, real yields reversed course and were rising along with inflation expectations, producing a substantial increase in stock prices. Rising optimism was reflected in a sharp increase in real yields to their highest levels in nearly a year in February of 2011. But the increase in real yields was quickly reversed by a combination of adverse supply side shocks that drove inflation expectations to their highest levels since the summer before the 2008 crash. However, after the termination of QE2, inflation expectations started sliding back towards the low levels of the summer before QE2 was adopted. The fall in inflation expectations was accompanied by an ominous fall in real yields and in stock prices.

Although suggestions that weakness in the economy might cause the Fed to resume some form of monetary easing seem to have caused some recovery in inflation expectations, real yields continue to fall. With real yield on capital well into negative territory (the real yield on a constant maturity 5-year TIPS bond is now around -1%, an astonishing circumstance. With real yields that low, 2% expected inflation would almost certainly not be enough to trigger a significant increase in spending. To generate a rebound in spending sufficient to spark a recovery, 3 to 4% inflation (the average rate of inflation in the recovery following the 1981-82 recovery in the golden age of Reagan) is probably the absolute minimum required.

Update:  Daniel Kuehn just posted an interesting comment on this post in his blog, correctly noting the conceptual similarity (if not identity) between the Fisher effect under deflationary expectations and the Keynesian liquidity trap.  I think that insight points to a solution of Keynes’s puzzling criticism of the Fisher effect in the General Theory even though he had previously endorsed Fisher’s reasoning in the Treatise on Money.