Thursday, June 30, 2011

Inflation expectations are heating up (cont.)

This chart compares my calculation of the 5-yr, 5-yr forward inflation expectations embedded in the pricing of Treasuries and TIPS (i.e., the market's expectation of what the 5-yr forward average rate of CPI inflation will be five years in the future) with the actual, year-over-year rate of inflation according to the CPI. By this measure, inflation expectations were only briefly higher than they are today in August 1997. (Note that forward inflation expectations have naturally been much less volatile than actual inflation, since the forward measure is based on what the market expects inflation to average over a 5-yr period.)

While it's clear that inflation expectations have been heating up considerably in the past few years (from almost zero at the end of 2008 to now almost 3%), it's also true that inflation expectations might still be considered to be "anchored" in the sense that they are not outside the range of what actual inflation has been over the past few decades.

So far, the market data support both those who worry that inflation is heating up, and those who believe that inflation is still firmly under control. Thus, reasonable men can continue to disagree on this subject.

As one of those who worries that inflation is likely to continue to heat up, and potentially sustain a higher level than what we have seen in recent decades, I cite the evidence of a very weak dollar, very strong gold and commodity prices, a very steep yield curve, and a super-abundance of bank reserves which have the potential to create a significant expansion in the money supply. Those who are not worried about inflation cite the economy's weak growth and large output gap (which according to Phillips Curve theory creates significant deflationary pressures), the relatively subdued 6% growth in the M2 money supply, and the significant decline in real estate prices.

I would add that on the margin, the evidence lends more support to those who worry than to those who don't. Both actual and expected inflation have been rising this year, much as the market-based evidence (e.g., the dollar, gold, commodities, yield curve) has been predicting, and contrary to what the Phillips Curve theory of inflation has been predicting.


Benjamin Cole said...

Also, remember, that unit labor costs have been falling to flat in last three years. If memory serves, something like 65 percent of business costs are labor.

Commercial rents are flat to dead.

Commodities had a speculative run, but there is a ceiling on commodities--buyers start buying less. Not like stock speculation, where the ceiling is the moon (as we saw in 1990s). Gold may be a loonie exception.

Anyway, I am not afraid of any inflation rate you can count on one hand. we need huge monetary stimulus to get us out of the recession.

Phillips Curve? I actually believe in something else: That when output goes up, unit costs go down (many businesses have heavy overhead). So for several years into a recovery, you get declining unit costs.

Pour it on, Bernanke, pout it on, print money until the plates melt, and then start issuing scrip. Let the good times roll, baby.

Public Library said...

Very good post. The genie is out of the bag.

The Fed has a terrible record of preventing calamity. Lets not forget a fews years back the Fed mantra was to clean up messes, not lean against them. So we find ourselves here again with the Fed ignoring market signals.

There can only be a general rise in the prices of all goods via the printing of paper money. In a fixed quantity of money regime, other prices would need to decrease.

We are no longer in a world where China can continue paying their labor force pennies. That party is over and soon prices will head North all around us.

If the government denies it, it must be true. Hence the usage of strategic oil reserves without much of a reason to communicate.

This party is just getting started.

Benjamin Cole said...

Public Library: I keep waiting, waiting, waiting for this inflation tidal wave. Waiting some more.

Frankly, even some strong inflation would help me out, and my country. How much longer do I have to wait?

Does it happen in next 10 years?

McKibbinUSA said...

Benjamin, the coming inflation will definitely happen within the next ten years, which is no time at all in the big picture of things...

honestcreditguy said...

inflation in the things you need, deflation in the things you dont...

thanks to the fed, treasury and peak stupidity in congress...

if they couldn't see the subprime threat, they surely are blind to inflation...

stagflation sucks...were there..

Jeff said...

The last time I was sitting in Interlaken Switzerland was 1985. I could get over 2 Francs for every dollar. Good thing too. The dollars were scarce. I stayed at Balmers Youth Hostel and had a wonderful time.

Today I am sitting at the Victoria Jungfrau hotel in Interlaken having more dollars in my pocket. But those dollars are only getting me .85 CHFs. Still having a wonderful time.

But it's a shame we've had 10 years of weak dollar policies. Ten years from now I might not be able to afford Balmers!

Dave said...

The only correct statement you make in this post is your acknowledgment that the conclusions you made about this graph are entirely misleading. The rest of your argument, "well, ok, maybe government spending doesnt cause downturns but it still doesnt do anything," has no basis in fact, and certainly cant be found in your graph. How come you didnt choose statistics that were relevant, as opposed to misleading? Like for instance the fact that 4 separate economic surveys estimated that the ARRA actually created or saved between 1 and 3.5 million jobs? Note that none of those surveys found that stimulus spending, in that instance, "did nothing or even hurt." Note that even this data doesnt mean that federal spending would always improve the long term health of the economy. The reality is much more subtle and thats why we should be careful about saying stupid things and adhering to poorly substantiated viewpoints.

Dave said...

Woops that comment was intended for the post about the correlation between government spendi ng and unemployment. Sorry