What do we know about expected inflation? According to Arnold Kling not much if we look to financial markets:
Both series show a sudden change in expected inflation beginning in 2008:Q3. The survey measure of expected inflation, however, drops far less than the TIPs measure. Still, there is (so far) a permanent drop in expected inflation that is hovering around 1.5%. This implies a rise in real rates. How much is not clear. While this leaves some ambiguity as to what happened to real interest rates, I am still convinced that monetary policy was effectively tight late last year based on other measures.
I'm also not convinced that we can read expected inflation in the TIPS market. Take right now, for instance. The TIPS market is saying that inflation is going to be low. But is that what the people who are buying gold believe? I don't think so...I dare you to try to tease inflation expectations out of financial markets right now.Kling's bigger point here is that Scott Sumner's claim that real interest rates shot up late last year--and hence, monetary policy tightened--cannot be verified since we cannot properly tease out a correct measure of expected inflation from financial markets. In the case of TIPs this is because there was an increased liquidity premium at the time and, as a result, the difference between the treasury nominal yield and the TIPs real yield may have been reflecting more than just expected inflation. I always like an empirical dare so let me respond to Kling's challenge this way: instead of turning to financial markets let's look to the Philadelphia Fed's Survey of Professional Forecasters. This survey of economic forecasters looks at inflation forecasts and should provide a robustness check against the TIPs implied expected inflation. The big drawback to this approach is it only has quarterly data. With that said, below is the average 1-year ahead inflation forecast for the GDP deflator plotted along with the 5-year inflation forecast from TIPs (click on figure to enlarge):
Both series show a sudden change in expected inflation beginning in 2008:Q3. The survey measure of expected inflation, however, drops far less than the TIPs measure. Still, there is (so far) a permanent drop in expected inflation that is hovering around 1.5%. This implies a rise in real rates. How much is not clear. While this leaves some ambiguity as to what happened to real interest rates, I am still convinced that monetary policy was effectively tight late last year based on other measures.
What about going forward? The real yield on 5-yr TIPS looks like it wants to go negative (it trades at .12% today). So if it does decline to sub-zero levels, would you say the Fed is tight or easy? And why is the real rate close to zero when the inflation spread and yield curve steepness both point to a recovery in AD? At the same time gold is rising?
ReplyDeleteAll of the above point to a Fed that is stimulating nominal AD and having absolutely no effect on real AD. For those that believe nominal and real AD have some sort of causal link (declining real wages?), this is problematic.