Friday, July 15, 2011

Bond market on the horns of a dilemma

Inflation and expected inflation are arguably the major determinants of interest rates. If the bond market appears to react to signs of growth, as it often does, then that is because the bond market—and the Fed—continue to think that growth and inflation are linked: i.e., more growth increases inflation risk, while less growth reduces it. We are now living in interesting times, however, because growth has been unusually weak and the so-called "output gap" (the amount of excess capacity, or the amount by which the economy is operating below its potential) has been huge—currently about 10% according to my calculations. Yet inflation by all measures has been rising. The bond market wants to rally, given how weak the economy is, but it is bumping up against the reality of higher inflation, as the chart above suggests.

Core inflation over the past six months is running at a 2.5% annualized rate. That doesn't sound like much, but as the top chart suggests, when core CPI is 2.5%, 10-yr Treasury yields tend to be in the neighborhood of 4.5%, and a 2% spread between inflation and bond yields is close to the long-term average. If long-term trends reassert themselves, Treasury yields could rise significantly. So the bond market is essentially caught on the horns of a dilemma: the lure of weak growth (perhaps made weaker by sovereign defaults) vs. the reality of rising inflation. We haven't seen a test of the Phillips Curve theory of inflation like this for a long time. The last time I remember such a test was in the late 1990s, when the economy was booming, and the Fed was fearful that the economy was "overheating" and inflation would rise. By the time the dust had settled, around 2002-2003, we realized that inflation had almost fallen enough to produce deflation. I think that when the dust finally settles on the current environment, we will see inflation rising some more, and Treasury yields rising by a lot more. 

In the meantime, there are two clear facts about inflation: 1) it has been extraordinarily volatile over the past 10 years, and 2) by all measures inflation has moved higher in the past year. At the very least, the volatility of inflation is a problem since it leaves the world uncertain as to what is really going on. The fact that inflation has risen, despite the very sluggish recovery and the existence of tons of excess capacity, is also problematic, because it directly challenges the theory that says inflation should be very low because the economy is so weak. Both of these realities weigh heavily on Treasury note and bond prices.


Bill said...

What's your take on the rating agencies threats to downgrade US debt even if the debt ceiling is raised?

Scott Grannis said...

Ratings agencies are not known for their ability to outguess or be smarter than markets. Markets have know for a long time that the fiscal situation in the U.S. has deteriorated significantly, so a downgrade wouldn't be surprising. But still, it is inconceivable that the U.S. would ever seriously default on its obligations, so that makes an agency rating rather moot.

McKibbinUSA said...

Interest rates will soon be rising -- dramatically...

piefarmer said...

I agree with your comment here that the market is paying attention and thus won't be surprised if a downgrade of US debt occurs. What then can be made of the fact that yields are flat to falling amid this debt ceiling debate? The bond market apparently shows no fear of a default or failure to extend the debt ceiling.

Rob said...

How can you not see that the old rules re. Inflation no longer apply ? They are from an era when countries like the US were much more insulated from outside forces. In a globalized economy, if China wants to pay more for stuff that it needs then the US pays more too, whether or not its economy is strong or weak. And I have never taken a single class of economics.

Scott Grannis said...

piefarmer: the bond market is not reacting to the threat of default because a true default (as opposed to a temporary one that might occur as the result of political squabbling) is inconceivable. In a worst-case scenario the U.S. can print all the money it needs to avoid default.

Benjamin Cole said...

Let me get this straight: We have an output gap of 10 percent, and nine percent unemployment, and the CPI-U, released today shows a 0.2 percent decline (deflation) for June.

The CPI-U is falling.

The CPI core rate for the last 12 months is 1.6 percent--in a series many conservative economists contend (in the past) over-measures inflation by about one percent.

If you look at the CPI survey the only serious bulge is in energy--and oil prices are dictated by a cartel, thug states and soaring Chinese demand.

And some are worried about USA inflation? Why? Of course bond markets are not worried about inflation-there isn't any to be worried about.

I just can't understand the current inflation-fetish, prevalent on the right-wing. We are at inflation rates that are actually below rates the Fed wants--central banker wet dream rates. And we all know that central bankers worship low inflation a lot more than some truck driver who needs a job.

These are puzzling times.

I can only hope a GOP president wins in 2012, and the right-wing comes to embrace a Fed that does not put a monetary noose around the economy's neck.

If history is a guide, we will hear "deficits don't matter" and "the Fed is too tight" if Michelle Bachmann gets into the White House.

Benjamin Cole said...

The Cleveland Fed, which puts out an interesting smoothed CPI, says inflation dead again.

"Median CPI Up 0.1% in June
According to the Federal Reserve Bank of Cleveland, the median Consumer Price Index rose 0.1% (1.7% annualized rate) in June. The 16% trimmed-mean Consumer Price Index increased 0.1% (1.7% annualized rate) during the month. The median CPI and 16% trimmed-mean CPI are measures of core inflation calculated by the Federal Reserve Bank of Cleveland based on data released in the Bureau of Labor Statistics' (BLS) monthly CPI report.

Earlier today, the BLS reported that the seasonally adjusted CPI for all urban consumers fell 0.2% (-2.6% annualized rate) in June. The CPI less food and energy increased 0.3% (3.1% annualized rate) on a seasonally adjusted basis.

Over the last 12 months, the median CPI rose 1.6%, the trimmed-mean CPI rose 2.0%, the CPI rose 3.6%, and the CPI less food and energy rose 1.6% .

We are talking a CPI, over the last 12 months, rising under 2 percent. This is inflation?

Stone Glasgow said...

How can the US "print all the money it needs to avoid default," if the Fed is only half-government run? About half the board is government appointed and the other is privately controlled. Why do you assume they are a government agency?