Wednesday, October 19, 2011

Inflation and bond yields


Consumer price inflation came in a little higher than expected in September, and both the core and headline measures registered some acceleration. Inflation is alive and well, but not terribly high.


Subtracting energy, the CPI is up at a 2.9% annualized rate in the past six months, and that is almost the fastest pace in the past decade. As I've argued repeatedly, the fact that non-energy inflation is up despite the huge amount of economic slack prevailing in the economy is prima facie evidence that monetary policy has been and continues to be quite accommodative. There is no shortage of money out there, and that negates the deflationary concerns that have contributed to the market's malaise. Things could be a lot worse if we had not only a weak economy but also a general decline in the price level.


If you believe that core measures of inflation (ex-food and energy) are the appropriate ones by which to judge monetary policy (I don't necessarily agree, but the Fed pays more attention to core inflation than to headline inflation), then the chart above suggests that the bond market in the past three months has zigged when it should have zagged. Long bond yields are now only about 1% above the year-over-year rate of core inflation, when they typically exceed core inflation by at least 2% (note how the y-axes in the chart above offsets yields and inflation by 2%). The last time this happened (at the end of 2008), the decline in yields proved very fleeting, and already we have seen 30-yr bond yields jump by almost 50 bps from their lows earlier this month.


This last chart compares 10-yr Treasury yields to the core CPI over a shorter time frame, and it too shows that yields have fallen to very low levels relative to inflation. Bond market vigilantes have been lulled into complacency by the events in Europe—the threat of sovereign defaults seems to have created mass panic over the prospects of another recession and a return of deflation. But the longer we go without these fears being confirmed by terrible events in Europe—not just a Greek default, but also a wave of bank failures and a collapse of economic activity—the more upward pressure there will be on bond yields. More and more, I'm coming around to the idea that a Eurozone collapse has been so widely feared for so long that when Greece finally does default, the aftermath won't be nearly as ugly as the expectations.

8 comments:

William said...

As you have been predicting, much to one of your most "vocal" reader's denial and dismay ;~)

Bill said...

Scott,

Didn't the pundits say that the S&P downgrade of the US was "priced" into the market only to find that stocks started their severe correction after it actually happened? Don't you think an actual Greek default will cause a much more severe correction if not an outright bear market?

Dr William J McKibbin said...

To hope that a Greek default can be contained is wishful, if not wreckless thinking -- as soon as Greece defaults, Spain, Portugal, and Italy will follow in earnest -- then there's California -- a Greek default would be a cascading disaster for the global economy -- better to bite the bullet and initiate monetary expansion globally -- global austerity will lead to global revolutions and horrors beyond words -- monetary expansion will lead to inflation, which can be managed, even at 30,000% annually -- only fools will bet on default or austerity -- but eventually, default and austerity lead to monetary expansion and inflation -- that's history -- that's the way of fiat currencies -- that's the future -- it's time to get on with it...

PS: Buy high quality equities and real estate now before it's too late...

William said...

McKibbin - have any of your predictions actually proven to be correct? Back in July / August, you wrote that the USA would default - not just be downgraded. And if you truly believe that the USA will still default, why do you own equities? Gold would be the only conceivable asset to own in that event.

AAA said...

Scott,

If you currently own TIPS, then inflation gets to 7%, and yields get to 10%, would that be good or bad for the TIPS owners?

Benjamin said...

Core inflation is dead. If there are prospects for core inflation, then real estate investors and TIPS buyers are brain dead.

I know there are nations with bad economic policies, and some of those nations have experienced bad inflation. I am not in favor of inflation in double digits, almost no one is.

I heartily recommend we drop federal outlays as sliver of GDP to 16 percent, by cutting federal agency outlays (largely defense and USDA) and entitlements.

But on monetary policy, I advise all readers and the always insightful Scott Grannis to bone up on the Market Monetarists. It is a rules-based system for targeting nominal GDP through monetary policy.

Goldman Sachs, Brad DeLong and even Paul Krugman recently have come on board, quite a victory for the Market Monetarists, who have been arguing for the supremacy of monetary policy over fiscal policy.

If market Monetarsim is adopted, the arguments for stimulus through fiscal policy will evaporate to the eternal benefit of the United States.

I welcome all to join the market Monetarism bandwagon!

Scott Grannis said...

AAA: in your scenario, which I assume has nominal 10-yr yields rising to 10%, 10-yr TIPS yields would probably rise from the current zero to, say, 1.5%. Rising real yields would thus push the price of 10-yr TIPS down by about 13%.. But TIPS owners would also receive a 7% coupon because of rising inflation. So for the first year, total returns would be negative, but then returns would be turn positive if inflation continued at 7% per year.

AAA said...

Scott,

Thanks so much for answering. I really appreciate your educational insights. I continually use your information to better equip people so they can make informed decisions.