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.