Wednesday, October 15, 2008

Inflation expectations collapse

Following on my previous post, here is a chart that compares the market's expectation of inflation (red line) versus actual inflation. The chart suffers from an apples vs oranges problem, though, since the red line is the market's expectation for what inflation will average in the next 10 years, whereas the blue line is actual inflation over the past year. But even if I corrected for that, the story would be the same: the market's inflation expectations have literally collapsed in the past few weeks, at a time when inflation (outside of energy prices) is still alive and well. (Inflation expectations for the next two years are actually negative!)

So I'm a market detective: what is all this telling me? What does it mean that credit spreads are at nose-bleed highs, stocks are in the tank and deflation fears are rampant? I think it means that the market expects to see a significant decline in prices throughout the economy, accompanied by a pretty serious recession. It would take outright deflation and a near-depression to produce the defaults that are implied by credit spreads and to justify severely depressed equity prices. Deflation and depression are the two worst enemies of business, since deflation makes every marginal dollar more expensive to acquire, and depression makes every marginal sale harder to make. If they both hit at the same time, as they did in Japan during the 1990s, we would be in big trouble.

So does that seem likely to happen? It does if you believe that inflation comes and goes with the strength of the economy. But if you believe like I do, and Milton Friedman did, that inflation happens when the supply of money exceeds the demand for it, then you have to disagree with today's market. The Fed has never before undertaken such massive efforts to ensure that there is no shortage of money in the system. (Whereas the Bank of Japan was simply way too tight, and that was the source of their lost deflationary decade.) When the Fed tries hard to do something, they have the unique ability to succeed, and you underestimate them at your peril. I've shown in many charts here that most measures of money are at all time highs.

The problem today is not a shortage of money, it's that people are reluctant to spend the money. Economists call this a decline in money velocity. It's as if everyone decides to hold a lot more cash in their wallets and/or under their mattress. Fear of loss thus translates into a slowdown in economic activity. But once the fear dissipates, all that stored-up money can come back out of hiding and the economy can normalize. And perhaps prices can even rise, instead of declining as the market expects.

10 comments:

thudbear said...

Scott . . .

As a daily reader of your marvelous insights in these troubled times, I want to express my gratitude for the gratis Master's Class in economics. I'm sure you realize there are many out there without your expertise and background that are charging large fees for their newsletters.

A few weeks ago I came across a chart that to my mind illustrated the "smoking gun" leading to the present crisis. It charted the close relationship between inflation and home prices up through the nineties until 1995. At that point, with the revised CRA, Rubin's pressure on the banks to expand the "ninja" loans, the home prices made a significant break to the upside which led to the Fan and Fred debacle and the rest of the story. I can't recall where I saw that chart. Would you have any recollection of seeing one with that content?

Tory Conservative said...

Scott,

I read that Citigroup is forcasting a national unemployment rate of over 8 percent for 2009. While not exactly "depression" levels of unemployment, it does seem that Citigroup is predicting a significant recession.

Does this seem like a credible forcast in your opinion?

I guess the optimists today are only predicting a "slowdown" in the economy, not a contraction. Still, I imagine that slow GDP growth would result in higher unemployment rates than the current 6.1 percent.

I guess if I had to put a prediction out there I would say that an unemployment rate of 7.5 percent for next year, 2009, is likely. What say you on this? Or is it better not to make any prediction, given that we are in unchartered waters?

Scott Grannis said...

thudbear: thanks for your kind words. I am pursuing your idea as I think it may pay dividends. Look for a post on the subject of real estate.

Scott Grannis said...

tory: things could get worse and the unemployment rate could rise to 8%, but so far I don't see the signs of a significant deterioration. Exports are incredibly strong, and residential construction activity can't contract much more than it already has. The main problem is fear, which has caused consumers to cancel some spending. That's a temporary thing, but if it continues it could exacerbate things.

egp said...

Scott,
great post, clear as fountainwater. Thank you.

Thudbear,
I think that the CRA story should be elaborated and toutetd as loud as possible. Here in Germany nobody knows about it and all media and governments draw the wrong conclusions.

egp said...

I forgot to mention that I don't see any connetction between CPI and expectations.
Is there any possibility to measure velocity? Is there any connection between velocity and anything/something else?

Dead Cat Bounce said...

Scott, I greatly appreciate the blog as well. I am going through it and finding it very interesting and educational.

I was wondering if you are implying in your article that in the near-to-medium term, low exchange rates along with the recent and trending growth in money supply will eventually lead to an increase in velocity, resulting in inflation? If an increase in velocity means increased investment and spending, wouldn't we also have to assume wage and business growth? I ask because I don't know how to discount the imminent socialism and mis-regulation that will be coming out of Washington into my expectations of economic growth (even if it is inflationary growth) should fear ever subside. Higher taxes and irrational regulations would seem to translate into depressed wages and uncertain/unprofitable investing, and given current market conditions, stagflation would then be the enemy (and a far worse one, made worse by the politicians I'm sure).

Dead Cat Bounce said...

I meant to say 1st line 2nd P:

...low INTEREST rates along with the recent and trending growth in money supply...

Scott Grannis said...

Don't get too excited about velocity. It's always hard to observe until way after the fact, to begin with. But if you understand velocity as being the inverse of money demand, then you may see that changes in velocity can give monetary policymakers a hard time. If velocity increases (money demand drops), then any given policy stance will become less tight/more inflationary.

Dead Cat Bounce said...

Thanks for the response, I am awed by the clarity of your explanation. Inflation is such a fluid concept to me, at least in terms of measurement and leading indicators (which as you point out have their own measurement problems), so I appreciate the timely lesson in pragmatism. I have to echo much of the sentiment I see on these blogs that I feel I should be paying you for this -- but obviously am very grateful I am not. Cheers to you, Mr. Grannis.