Even as there appears to be an overwhelming consensus that the FOMC will commence a second round of quantitative easing following next month's meeting, the evidence is mounting that this is not a good idea. As this chart shows, the bond market is getting more and more worried about inflation. 10-yr Treasury yields are anchored by the Fed's pledge to keep short rates low for a long time, and by the evidence that suggests that economic growth is not accelerating and unemployment will thus remain high for a long time. But 30-yr Treasury bonds have no such constraints. They have risen 35 bps since the end of August, while 10-yr yields are essentially unchanged. Meanwhile, 10-yr real TIPS yields have fallen almost 70 bps over the same period as demand for inflation protection has increased. All this adds up to an 80 bps rise in 5-yr, 5-yr forward inflation expectations (as shown above in red), the Fed's preferred indicator of the market's inflation expectations.
This one chart should be held up at the FOMC table, with the following admonition: "Gentlemen, the market is clearly telling us that to move ahead with QE2 would increase inflation expectations beyond what is consistent with our mandate to seek relative price stability. Meanwhile there is little or no evidence that economic growth has been constrained by a lack of liquidity. I vote to tell the world that we remain disposed to avoid deflation at all costs, but to make no changes to monetary policy for the time being." What would be very exciting to hear—but highly unlikely, unfortunately—is at least a few words to the effect that fiscal policy (e.g., extending the Bush tax cuts) is the more appropriate policy lever to be pulling at this juncture.
Love the blog but I'm curious. What is the "correct" expectation for inflation? 0% (Japan for the last 20 years) or 2% (kind of the unofficial estimate of the Fed's targeting).
ReplyDeleteI think the market is correct in increasing inflation expectations, but we were waaay below the Fed target with rates at the zero bound. Milton Friedman would say that indicates tight monetary policy (as he did in assessing Japan's woes in the 90's)
QE prevented a catastrophe and is necessary now just to get in the right direction toward the Fed target.
My inflation ideal would be zero, but I can live with the Fed's official target of 1-2%. Inflation is sinister, as it steals from the poor and the uneducated, and gives to the rich and the government.
ReplyDeleteScott Grannis-
ReplyDeleteMost economists feel we need minimum 2 percent inflation due to wage stickiness and other problems. I also think we need some inflation to give "dutch courage" to people who invest through borrowing, especially real estate.
Japan's experiment with zero inflation has been a disaster, and wipe-out for investors: Property and equity values fell 75 percent in the last 20 years. I don't think it was Japan's poor who got nailed, but those in stocks and real estate.
And everybody, rich or poor, loses in a sluggish economy.
That said, anything in the 2-4 percent range is fine with me. Jeez, Don Regan, Reagan's Treasury Secy, publicly lambasted Volcker for being too tight when inflation was 4 percent, and we were just leaving an inflationary era (1983, I think).
Zero inflation is a dangerous utopian pipe dream.
I have yet to see evidence that shows that Japan's allegedly sluggish growth rate was caused by zero inflation. I think it is far more likely that Japan's huge and growing public sector (and it's attendant deficits) is the cause of disappointing growth. I could be persuaded that the yen's long-term rising trend against virtually all other currencies is a factor behind disappointing growth. To the extent that's true, however, then there is no parallel to be drawn between Japan and the US today, since the dollar is at it's lowest level ever relative to a broad basket of securities (inflation-adjusted).
ReplyDeleteTLT and LQD are down hard today.
ReplyDeleteMight this be the beginning of the end of the 30 year bond bull market? Has the threat of QE2 cracked the negative psychology? What happens when the torrent of money force fed into bond funds starts LOSING value? How long will the average retail investor tolerate declining values in his bond portfolios? If he sells, where will he go with the cash?
If the dam breaks, the Fed may not have to do anything.
Scott,
ReplyDeleteDo you believe that the most effective form of fiscal stimulus is to extend the Bush tax cuts?
How much do you estimate this will add to GDP for 2011? I hear that tax cuts aren't too productive when it comes to boosting aggregate demand. Interested in your take.
By the way, I noticed the large drop in overall continuing unemployment claims across the aggregate state and federal programs. It was a drop of about 450,000 beneficiaries.
Do you have an explanation for this? Are people running out of benefits? I haven't seen much commentary on this.
Also, the NSA initial claims figure showed a 75,000 spike last week. Since you like the NSA data over the SA data, is 75,000 considered good or bad for this time of year?
Lots of question...interested in your take obviously.
Thanks,
Jason
Thoughts on how the foreclosure investigations will impact housing prices and hence the housing recovery? It seems like this will delay market clearing of prices and prolong the housing recession.
ReplyDeleteBill,
ReplyDeleteFWIW I am taking it as a temporary setback for the banks. It will probably delay their share price recovery until next year (not that far away now). It will take a few weeks but it will pass.
Jamie Dimon addressed it in JPM's conference call. He said, "..the underlying stuff is accurate, so that's the key substance. We don't think there are cases with people who have been evicted out of their homes that shouldn't have been."
Obviously, this is just one bank but its probably pretty close to that industrywide. The banks are not popular with the government now and AGs love their names in the papers. There are certainly many people who are being foreclosed on that are in difficult circumstances but just as certainly there are also many deadbeats gaming the situation for free housing for as long as they can. It will get worked out.
I'll defer to Scott on its GDP impact. Probably not too severe. JMCO
Keynesian government deficit spending and QE are theories that were developed in low or no debt environments. Simultaneous deployment of each exclusive theory was not something either theory took into major account.
ReplyDeleteSimultaneous deployment of both theories, in an advanced economy with moderate to high debt, was Japan in the early 2000’s. Japan remains in a 20 year recession.
The Fed’s theory is that QE was deployed incorrectly by Japan’s central banking authorities. Reminds one of the miserable track record of the series of Keynesian deficit spending deployments over these many decades (1930‘s to present)……it will work “this time” because all the other attempts were incorrectly deployed. That somehow , someway, it will work this time.
Sure!