inflation | Uneasy Money

Archive for the 'inflation' Category

The Cleveland Fed Reports Inflation Expectations Are Dropping Fast; Bernanke Doesn’t Seem to Care

Published June 15, 2012 expectations , inflation , monetary policy 21 Comments

Coinciding with the latest report on the consumer price index, showing the largest one month drop in the CPI since 2008, the Cleveland Fed issued its monthly update on inflation expectations.

News Release: June 14, 2012

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.19 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

As the attached chart shows, the current expected rate of inflation over a 10-year time horizon is at an all-time low, dropping 30 basis points in the last two months. But in his testimony to Congress this week, Chairman Bernanke did not seem to think there was any problem with monetary policy. It’s all those other guys’ fault. Well, who exactly is responsible for falling inflation expectations, Mr. Bernanke, if not the FOMC? Does a sharp drop in inflation expectations, the sharpest since the horrific summer of 2008 give you any cause for concern? If so, is there any change in policy that the FOMC plans to undertake at its next meeting? Or is the FOMC only concerned about inflation expectations when they show signs of becoming unanchored on the upside, not the downside?

UPDATE (3:44 PM EDST): A quick look at the excel file showing the Cleveland Fed’s estimates of inflation expectations at maturities from 1 to 30 years shows that one-year expectation fell last month to 0.6% from 1.4% the previous month. That is the lowest one-year inflation expectation since March of 2009 (-.0.3%) when the S&P 500 fell to 676, 10% below the previous trough of 752, in November 2008. We are treading on very thin ice, and the only thing that may be keeping us afloat is the market’s expectation that the FOMC has no alternative but to adopt another round of Quantitative Easing. Let’s see if the confidence of the market is justified.

Alchian on Money Illusion and the Wage-Price Lag During Inflation

Published June 15, 2012 Alchian , inflation , Keynes 10 Comments

At the end of my post a couple of days ago, I observed that the last two sentences of the footnote that I reproduced from Alchian’s “Information Costs, Pricing, and Resource Unemployment,” required a lot of unpacking. So let’s come back to it and try to figure out what Alchian meant. The point of the footnote was to say that Keynes’s opaque definition of involuntary unemployment rested on a distinction between the information conveyed to workers by an increase in the price level, their money wage held constant, and the information conveyed to them by a reduction in their money wage, with the price level held constant. An increase in the price level with constant money wages conveys no information to workers about any change in their alternatives. Employed workers are not induced by an increase in prices to quit their current jobs in the expectation of finding higher paying jobs, and unemployed workers are not induced to refuse an offer from a prospective employer, as they would be if the employer cut the money wages at which he was willing pay his current employees or to hire new ones. That subtle difference in the information conveyed by a cut in real wages effected by rising prices versus the information conveyed by a cut in real wages effected by a cut in money wages, Alchian explained, is the reason that Keynes made his definition of involuntary unemployment contingent on the differing responses of workers to a reduced real wage resulting from a rising price level and from a falling money wage.

Here is where the plot thickens, because Alchian adds the following comment.

And this is perfectly consistent with Keynes’s definition of [involuntary] unemployment, and it is also consistent with his entire theory of market adjustment processes . . . , since he believed wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” Amer. Econ. Rev. 50 [March 1960]:43-66). Without this belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price-level rise is equivalent in real terms to a money-wage cut in a particular job.

So, according to Alchian, Keynes’s assumption that the information extracted by workers from a price-level increase is not the same as the information extracted from a nominal wage cut depends on the existence of a lag in the adjustment of wages to an inflationary disturbance. Keynes believed that during periods of inflation, output prices rise before, and rise faster than, wages rise, at least in the early stages of inflation. But if prices and wages rise simultaneously and at the same rate during inflation, then there would be no basis for workers to draw different inferences about their employment opportunities from observing price increases as opposed to observing a nominal wage cut. Alchian believes that the assumption that there is a wage-lag during inflation is both theoretically problematic, and empirically suspect, relying on several important papers that he co-authored with Reuben Kessel that found little support for the existence of such a lag in the historical data on wages and prices.

I have two problems with Alchian’s caveat about the existence of a wage-price lag.

First, Alchian’s premise (with which I agree totally) in the article from which I am quoting is that lack of information about the characteristics of goods being sold and about the characteristics of sellers or buyers (when the transaction involves a continuing relationship between the transactors) and about the prices and characteristics of alternatives induces costly search activities, the holding of inventories, and even rationing or queuing, as alternatives to immediate price adjustments as a response to fluctuations in demand or supply. The speed of price adjustment is thus an economically determined phenomenon, the speed depending on, among other things, the particular characteristics of the good or service being sold and the ease of collecting information about the good and service. For example, highly standardized commodities about which information is readily available tend to have more rapidly adjusting prices than those of idiosyncratic goods and services requiring intensive information gathering by transactors before they can come to terms on a transaction. If employment transactions typically involve a more intensive information gathering process about the characteristics of workers and employers than most other goods and services, then Alchian’s own argument suggests that there should be a lag in wage adjustment relative to the prices of most other goods. An inflation, on Alchian’s reasoning, ought to induce an initial response in the prices of the more standardized commodities with price adjustments in less standardized, more informationally complex, markets, like labor markets, coming later. So I don’t understand Alchian’s theoretical basis for questioning the existence of a wage lag.

Second, my memory is a bit hazy, and I will need to check his article on the wage lag, but I do believe that Alchian pointed out that there is a problem of interpretation in evaluating evidence on the wage lag, because inflation may occur concurrently, but independently, with another change that reduces the demand for labor and causes the real wage to fall. So if one starts, as did Keynes in his discussion of involuntary unemployment, from the premise that a recession is associated with a fall in the real demand for labor that requires a reduction in the real wage to restore full employment, then it is not clear to me why it would be rational for a worker to increase his reservation wage immediately upon observing that output prices are increasing. Workers will typically have some expectation about how rapidly the wage at which they can find employment will rise; this expectation is clearly related to their expectation of how fast prices will rise. If workers observe that prices are rising faster than they expected prices to rise, while their wage is not rising any faster than expected, there is uncertainty about whether their wage opportunities in general have fallen or whether the wage from their current employer has fallen relative to other opportunities. Saturos, in a comment on Tuesday’s post, argued that the two scenarios are indeed symmetrical and that to suggest otherwise is indeed an instance of money illusion. The argument is well taken, but I think that at least in transitional situations (when it seems to me theory supports the existence of a wage lag) and in which workers have some evidence of deteriorating macroeconomic conditions, there is a basis, independent of money illusion, for the Keynesian distinction about the informational content of a real wage cut resulting from a price level increase versus a real wage cut resulting from a cut in money wages. But I am not sure that this is the last word on the subject.

Alchian on Why Wages Adjust Slowly and Why It Matters

Published June 14, 2012 Alchian , inflation , Keynes 11 Comments

In my previous post, I reproduced a footnote from Armen Alchian’s classic article “Information Costs, Pricing and Resource Unemployment,” a footnote explaining the theoretical basis for Keynes’s somewhat tortured definition of involuntary unemployment. In this post, I offer another excerpt from Alchian’s article, elaborating on the microeconomic rationale for “slow” adjustments in wages. In an upcoming post, I will try to tie some threads together and discuss the issue of whether there might be, contrary to Alchian’s belief, a theoretical basis for wages to lag behind other prices, ata least during the initial stages of inflation. Herewith are the first four paragraphs of section II (Labor Markets) of Alchian’s paper.

Though most analyses of unemployment rely on wage conventions, restriction, and controls to retard wage adjustments above market-clearing levels, [J. R.] Hicks and [W. H.] Hutt penetrated deeper. Hicks suggested a solution consistent with conventional exchange theory. He stated that “knowledge of opportunities is imperfect” and that the time required to obtain that knowledge leads to unemployment and a delayed effect on wages. [fn. J. R. Hicks, The Theory of Wages, 2d ed. (London, 1963), 45, 58. And headed another type – “the unemployment of the man who gives up his job to look for a better.”] It is precisely this enhanced significance that this paper seeks to develop, and which Hicks ignored when he immediately turned to different factors – unions and wage regulations, placing major blame on both for England’s heavy unemployment in the 1920s and 30s.

We digress to note that Keynes, in using a quantity-, instead of a price-, adjustment theory of exchange, merely postulated a “slow” reacting price without showing that slow price responses were consistent with utility or wealth-maximizing behavior in open, unconstrained markets. Keynes’s analysis was altered in the subsequent income-expenditure models where reliance was placed on “conventional” or “noncompetitive” wage rates. Modern “income-expenditure” theorists assumed “institutionally” or “irrationally” inflexible wages resulting from unions, money illusions, regulations, or factors allegedly idiosyncratic to labor. Keynes did not assume inflexibility for only wages. His theory rested on a more general scope of price inflexibility. [fn. For a thorough exposition and justification of these remarks on Keynes, see A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford, 1968).] The present paper may in part be viewed as an attempt to “justify” Keynes’s presumption about price response to disturbances in demand.

In 1939 W. H. Hutt exposed many of the fallacious interpretations of idleness and unemployment. Hutt applied the analysis suggested by Hicks but later ignored it when discussing Keynes’s analysis of involuntary unemployment and policies to alleviate it. [fn. W. H. Hutt, The Theory of Idle Resources (London, 1939), 165-69.] This is unfortunate, because Hutt’s analysis seems to be capable of explaining and accounting for a substantial portion of that unemployment.

If we follow the lead of Hicks and Hutt and develop the implications of “frictional” unemployment for both human and nonhuman goods, we can perceive conditions that will imply massive “frictional” unemployment and depressions in open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.

So Alchian is telling us that it is at least possible to conceive of conditions in which massive unemployment and depressions are consistent with “open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.” And presumably would be more going on in such periods of massive unemployment than the efficient substitution of leisure for work in periods of relatively low marginal labor productivity.

Alchian on the Meaning of Keynesian “Involuntary” Unemployment

Published June 13, 2012 Alchian , expectations , inflation , Keynes 17 Comments

In his classic paper “Information Costs, Pricing, and Resource Unemployment,” Armen Alchian explains how the absence of full information about the characteristics of goods and services, and about the prices at which they are available leads to a variety of phenomena that are inconsistent with implications of idealized “perfect markets” at which all transactors can buy or sell as much as they want to at known, market-clearing, prices. The main implications of less than full information are the necessity of search, less than instantaneous price adjustment to changes in demand or cost conditions, the holding of (seemingly) idle or unemployed inventories, queuing, and even rationing. The paper was originally published in 1969 in the Western Economic Journal (subsequently Economic Inquiry) and was republished in a 1970 volume edited by Edmund Phelps, Microeconomic Foundations of Employment and Inflation Theory. It is included in The Collected Works of Armen Alchian (volume 1) published by the Liberty Fund.

Alchian’s explanation of Keynes’s definition of involuntary unemployment appears in footnote 27 in the version published in the Phelps volume (23 in the version published in volume 1 of The Collected Works). Here is the entire footnote:

An intriguing intellectual historical curioso may be explainable by this theory, as has been brought to my attention by Axel Leijonhufvud. Keynes’ powerful, but elliptical, definition of involuntary unemployment has been left in limbo. He wrote:

Men are involuntary unemployed if, in the event of a small rise in the price of wage-goods relative to the money-wage, both the aggregate supply of labour willing to work for the current money wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.

[J. M. Keynes, The General Theory of Employment, Interest, and Money (The Macmillan Company, London, 1936).] To see the power and meaning of this definition (not cause) of unemployment, consider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference. And this is perfectly consistent with Keynes’ definition of [involuntary] unemployment, and it is also consistent with his entire theory of market-adjustment processes (Keynes, The General Theory of Employment, Interest, and Money) since he believed that money wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” American Economic Review 50 (March 1960): 43-66). Without that belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price level rise is equivalent in real terms to a money wage cut in a particular job.

PS There is a lot of unpacking that needs to be done in the last two sentences, but that is best left for another post.

How Did We Get into a 2-Percent Inflation Trap?

Published June 11, 2012 expectations , Friedman , inflation , monetary policy 13 Comments

It is now over 50 years since Paul Samuelson and Robert Solow published their famous paper “Analytical Aspects of Anti-Inflation Policy,” now remembered mainly for offering the Phillips Curve as a menu of possible combinations of unemployment and inflation, reflecting a trade-off between inflation and unemployment. By accepting a bit more inflation, policy-makers could bring down the rate of unemployment, vice-versa. This view of the world enjoyed a brief heyday in the early 1960s, but, thanks to a succession of bad, and sometimes disastrous, policy choices, and more than a little bad luck, we seemed, by the late 1970s and early 1980s, to be stuck with the worst of both worlds: high inflation and high unemployment. In the meantime, Milton Friedman (and less famously Edmund Phelps) countered Samuelson and Solow with a reinterpretation of the Phillips Curve in which the trade-off between inflation and unemployment was only temporary, inflation bringing down unemployment only when it is unexpected. But once people begin to expect inflation, it is incorporated into wage demands, so that the stimulative effect of inflation wears off, unemployment reverting back to its “natural” level, determined by “real” forces. Except in the short run, monetary policy is useless as a means of reducing unemployment. That theoretical argument, combined with the unpleasant experience of the 1970s and early 1980s, combined with a fairly rapid fall in unemployment after inflation was reduced from 12 to 4% in the 1982 recession, created an enduring consensus that inflation is a bad thing and should not be resorted to as a method of reducing unemployment.

I generally accept the Friedman/Phelps argument (actually widely anticipated by others, including, among others, Mises, Hayek and Hawtrey, before it was made by Friedman and Phelps) though it is subject to many qualifying conditions, for example, workers acquire skills by working, so a temporary increase in employment can have residual positive effects by increasing the skill sets and employability of the work force, so that part of the increase in employment resulting from inflation may turn out to be permanent even after inflation is fully anticipated. But even if one accepts Friedman’s natural-rate hypothesis in its most categorical form, the Friedman argument does not imply that inflation is never an appropriate counter-cyclical tool. Indeed, the logic of Friedman’s argument, properly understood and applied, implies that inflation ought to be increased when the actual rate of unemployment exceeds the natural rate of unemployment.

But first let’s understand why Friedman’s argument implies that it is a bad bargain to reduce the unemployment rate temporarily by raising the rate of inflation. After all, one could ask, why not pocket a temporary increase in output and employment and accept a permanently higher rate of inflation? The cost of the higher rate of inflation is not zero, but it is not necessarily greater than the increased output and employment achieved in the transition. To this there could be two responses, one is that inflation produces distortions of its own that are not sustainable, so that once the inflation is expected, output and employment will not remain at old natural level, but will, at least temporarily, fall below the original level, so the increase in output and employment will be offset by a future decrease in output and employment. This is, in a very general sense, an Austrian type of argument about the distorting effects of inflation requiring some sort of correction before the economy can revert back to its equilibrium path even at a new higher rate of inflation, though it doesn’t have to be formulated in the familiar terms of Austrian business cycle theory.

But that is not the argument against inflation that Friedman made. His argument against inflation was that using inflation to increase output and employment does not really generate an increase in output, income and employment properly measured. The measured increase in output and employment is achieved only because individuals and businesses are misled into increasing output and employment by mistakenly accepting job offers at nominal wages that they would not have accepted had they realized that pries and general would be rising. Had they correctly foreseen the increase in prices and wages, workers would not have accepted job offers as quickly as they did, and if they had searched longer, they would have found that even better job offers were available. More workers are employed, but the increase in employment comes at the expense of mismatches between workers and the jobs that they have accepted. Since the apparent increase in output is illusory, there is little or no benefit from inflation to outweigh the costs of inflation. The implied policy prescription is therefore not to resort to inflation in the first place.

Even if we accept it as valid, this argument works only when the economy is starting from a position of full employment. But if output and employment are below their natural or potential levels, the argument doesn’t work. The reason the argument doesn’t work is that when an economy starts from a position of less than full employment, increases in output and employment are self-reinforcing and cumulative. There is a multiplier effect, because as the great Cambridge economist, Frederick Lavington put it so well, “the inactivity of all is the cause of the inactivity of each.” Thus, the social gain to increasing employment is greater than the private gain, so in a situation of less-than-full employment, tricking workers to accept employment turns out to be socially desirable, because by becoming employed they increase the prospects for others to become employed. When the rate of unemployment is above the natural level, a short-run increase in inflation generates an increase in output and employment that is permanent, and therefore greater than the cost associated with a temporary increase in inflation. As the unemployment rate drops toward the natural level, the optimal level of inflation drops, so there is no reason why the public should anticipate a permanent increase in the rate of inflation. When actual unemployment exceeds the natural rate, inflation, under a strict Friedmanian analysis, clearly pays its own way.

But we are now trapped in a monetary regime in which even a temporary increase in inflation above 2-percent apparently will not be tolerated even though it means perpetuating an unemployment rate of 8 percent that not so long ago would have been considered intolerable. What is utterly amazing is that the intellectual foundation for our new 2-percent-inflation-targeting regime is Friedman’s natural-rate hypothesis, and a straightforward application of Friedman’s hypothesis implies that the inflation rate should be increased whenever the actual unemployment rate exceeds the natural rate. What a holy mess.

How Monetary Policy Works

Published June 7, 2012 Eurozone crisis , expectations , Great Depression , Hawtrey , inflation , Little Depression , monetary policy 16 Comments

These are exciting times. Europe is in disarray, unable to cope with a crisis requiring adjustments in relative prices, wages, and incomes that have been rendered impossible by a monetary policy that has produced almost no growth in nominal GDP in the Eurozone since 2008, placing an intolerable burden on the Eurozone’s weakest economies. The required monetary easing by the European Central Bank is unacceptable to Germany, so the process of disintegration continues. The US, showing signs of gradual recovery in the winter and early spring, remains too anemic to shake off the depressing effects of the worsening situation in Europe. With US fiscal policy effectively stalemated until after the election, the only policy-making institution still in play is the Federal Open Market Committee (FOMC) of the Federal Reserve. The recent track record of the FOMC can hardly inspire much confidence in its judgment, but it’s all we’ve got. Yesterday’s stock market rally shows that the markets, despite many earlier disappointments, have still not given up on the FOMC. But how many more disappointments can they withstand?

In today’s Financial Times, Peter Fisher (head of fixed income at BlackRock) makes the case (“Fed would risk diminishing returns with further ‘QE'”) against a change in policy by the Fed. Fisher lists four possible policy rationales for further easing of monetary policy by the Fed: 1) the “bank liquidity” rationale, 2) the “asset price” rationale, 3) the “credit channel” rationale, and 4) the “radical monetarist” rationale.

Fisher dismisses 1), because banks are awash in excess reserves from previous bouts of monetary easing. I agree, and that’s why the Fed should stop paying banks interest on reserves. He dismisses 2) because earlier bouts of monetary easing raised asset prices but had only very limited success in stimulating increased output.

While [the Fed] did drive asset prices higher for a few months, there was little follow-through in economic activity in 2011. This approach provides little more than a bridging operation and the question remains: a bridge to what?

This is not a persuasive critique. Increased asset prices reflected a partial recovery in expectations of future growth in income and earnings. A credible monetary policy with a clearly articulated price level of NGDP target would have supported expectations of higher growth than the anemic growth since 2009, in which asset prices would have risen correspondingly higher, above the levels in 2007, which we have still not reached again.

Fisher rejects 3), the idea “that if the Fed holds down long-term interest rates it will stimulate private credit creation and, thus, economic expansion.” Implementing this idea, via “operation twist” implies taking short-term Treasuries out of the market and replacing them with longer-term Treasuries, but doing so denies “banks the core asset on which they build their balance sheets,” thus impairing the provision of credit by the banking system instead of promoting it.

I agree.

Finally Fisher rejects 4), “the idea more central bank liabilities will eventually translate into ‘too much money chasing too few goods and services’ at least so as to avoid a fall in the general price level.” Fisher asks:

What assets would the Fed buy? More Treasuries? Would the Fed embark on such a radical course in a presidential election year?

Perhaps the Fed could buy foreign currencies, engineer a much weaker dollar and, thereby, stimulate inflation and growth. Would the rest of the world permit this? I doubt it. They would probably respond in kind and we would all have a real currency war. Nor is it clear the US external sector is large enough to import enough inflation to make a difference. If energy and commodity prices soared, would American consumers “chase” consumption opportunities or would they suppress consumption and trigger a recession? Recent experience suggests the latter. How much “chasing behaviour” would we get in a recession? Engineering a dollar collapse would be to play with fire and gasoline. It might create inflation or it might create a depression.

These are concerns that have been expressed before, especially in astute and challenging comments by David Pearson to many of my posts on this blog. They are not entirely misplaced, but I don’t think that they are weighty enough to undermine the case for monetary easing, especially monetary easing tied to an explicit price level or NGDP target. As I pointed out in a previous post, Ralph Hawtrey addressed the currency-war argument 80 years ago in the middle of the Great Depression, and demolished it. FDR’s 40-percent devaluation of the dollar in 1933, triggering the fastest four-month expansion in US history, prematurely aborted by the self-inflicted wound of the National Recovery Administration, provides definitive empirical evidence against the currency-war objection. As for the fear that monetary easing and currency depreciation would lead to an upward spiral of energy and commodity prices that would cause a retrenchment of consumer spending, thereby triggering a relapse into recession, that is certainly a risk. But if you believe that we are in a recession with output and employment below the potential output and employment that the economy could support, you would have to be awfully confident that that scenario is the most likely result of monetary easing in order not to try it.

The point of tying monetary expansion to an explicit price level or spending target is precisely to provide a nominal anchor for expectations. That nominal anchor would provide a barrier against the kind of runaway increase in energy and commodity prices that would supposedly follow from a commitment to use monetary policy to achieve a price-level or spending target. Hawtrey’s immortal line about crying “fire, fire” in Noah’s flood is still all too apt.

More on Inflation Expectations and Stock Prices

Published June 6, 2012 expectations , inflation , Little Depression 11 Comments

It was three and a half weeks ago (May 14) that I wrote a post “Inflation Expectations Are Falling; Run for Cover” in which I called attention to the fact that inflation expectations, which had been rising since early in 2012, had begun to fall, and that the shift had coincided with falling stock prices. I included in that post the chart below showing the close correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year constant-maturity Treasuries and 10-year constant-maturity TIPS).

Then I noted in two posts (May 24 and May 30) that since early in May, I had detected an anomaly in the usual close correlation between short-term and long-term real interest rates, longer-term real interest rates having fallen more sharply than shorter-term real interest rates since the start of May. That was shown in the chart below.

I thought it would now be useful to look at my chart from May 14 with the additional observations from the past three weeks included. The new version of the May 14 chart is shown below.

What does it teach us? There still seems to be a correlation between inflation expectations and stock prices, but it is not as close as it was until three weeks ago. I confirmed this by computing the correlation coefficient between inflation expectations and the S&P 500 from January 3 to May 14. The correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices. The chart below plots the movement in inflation expectations and stock prices for just the last three weeks.

One other point bears mentioning: the sharp increase in stock prices yesterday was accompanied by increases in nominal and real interest rates, for all durations. That is not an anomalous result; it has been the typical relationship since the early stages of the Little Depression. Expected inflation implies increased nominal rates and increased borrowing costs. Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment. So the conventional textbook theory that loose monetary policy increases stock prices and economic activity by reducing borrowing costs is simply not reflected in the data since the start of the Little Depression.

A Recent Anomaly in the Real Term Structure of Interest Rates

Published May 24, 2012 expectations , inflation 21 Comments

Regular readers of this blog know that I track the break-even TIPS spread to follow changes in inflation expectations. Doing so also provides an implicit (and imperfect) estimate of changes in the real interest rate. (For an explanation of why the break-even TIPS spread is an imperfect estimate of inflation expectations and the real interest rate, see the Cleveland Federal Reserve Bank website.) Since early in May, the data show a fairly striking anomaly in real interest rates: real interest rates over a 5-year time horizon have been rising (though still negative) while real interest rates over a 10-year horizon have been falling.

Why is this anomalous? Because real interest rates at the 5-year and 10-year time horizons are generally closely correlated. The chart below shows fluctuations in real interest rates at constant 5- and 10-year maturities since the beginning of 2012. The two lines track each other closely until the beginning of May when the 5-year real interest rate begins to rise while the 10-year real interest rate continues to fall. The coefficient between the 5-year and 10-year real interest rates from January 3 to May 24 is slightly over .8. From January 3 to May 3, the correlation coefficient is almost .86; the correlation coefficient since May 3 is -.72.

I have no explanation for this anomaly. Anybody out there like to take a crack at it?

UPDATE: It just occurred to me that the increase in short term real rates is reflecting a liquidity premium associated with an increasing perceived likelihood of a financial crisis associated with a breakdown of the euro. Not a very happy thought as I prepare to call it a night.

Expected Inflation and the S&P 500 Redux

Published May 17, 2012 expectations , inflation , Little Depression , monetary policy 4 Comments

On Monday I wrote a post with the chart below showing the close correlation since January of this year between the S&P 500 and expected inflation as (approximately) reflected in the spread between the constant maturity 10-year Treasury note and the constant maturity 10-year TIPS. A number of other bloggers noticed the post and the chart. One of those was Matthew Yglesias who coupled my chart with a somewhat similar one posted by Marcus Nunes on his blog on the same day as mine.

One commenter (“Fact Checker”) on Matthew’s blog criticized my chart accusing me of cherry picking.

The second graph is meaningless, as it does not work through time.

Here it is from 1990: http://research.stlouisfed.org/fredgraph.png?g=7gX
Again from 2000: http://research.stlouisfed.org/fredgraph.png?g=7gY
From 2005: http://research.stlouisfed.org/fredgraph.png?g=7gZ
From 2009: http://research.stlouisfed.org/fredgraph.png?g=7h0

And in another comment:

The S&P + inflation chart is reproduced below, with longer windows. And as you suggest there is no correlation in any time frame but the very short window cherry picked by MY.

Two points to make about his comment. First, if Fact Checker had read Yglesias’s post carefully, or, better yet, actually read my post (let alone the original paper on which the post was based), he would have realized that my whole point is that the close correlation between expected inflation and stock prices is generally not observed, and that one would expect to observe the correlation only when deflation exceeds the real rate of interest (as it does now when slightly positive expected inflation exceeds the negative real real rate of interest). So the fact that the correlation doesn’t work through time was precisely the point of my post. Second, the graphs to which Fact Checker links use survey data by the University of Michigan of the inflation expectations of households. I do not totally discount such data, but I regard survey estimates of expected inflation as much less reliable than the implicit market expectations of inflation reflected in the TIPS spread.

To show that the correlation I have found is reflected in the data since approximately the beginning of the downturn at the very end of 2007, but not before, here is a graph similar to the one I posted on Monday covering the entire period since 2003 for which I have data on the 10-year TIPS spread.

Before the beginning of 2008, there is plainly no correlation at all between inflation expectations and stock prices. It is only at some point early in 2008 that the correlation begins to be observed, and it has persisted ever since. We will know that we are out of this Little Depression when the correlation vanishes.

News Flash: Cleveland Fed Reports that Inflation Expectations Fell in April

Published May 15, 2012 expectations , inflation , monetary policy 10 Comments

From a news release issued by the Federal Reserve Bank of Cleveland after the BLS reported that the CPI was unchanged in April.

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.38 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the “break-even” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium.

The Cleveland Fed’s estimate of expected inflation was 1.47 percent, so expected inflation dropped by .09 basis point in April. It undoubtedly has continued falling in May. The lowest monthly estimate of expected inflation over a 10-year time horizon ever made by the Cleveland Fed was 1.34% in February of this year, so we may now already be stuck with the lowest inflation expectations ever. Is anyone at the FOMC paying attention?

« Previous Page — Next Page »

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

Uneasy Money