Tuesday, August 3, 2010

Inflation Expectations Are Not Stable!

Many observers, including myself, have been puzzled by the Fed's lack of urgency in recent months over the apparent slowing down of aggregate demand.  The one thing monetary policy is capable of doing is stabilizing total current dollar spending, but it isn't and this inaction effectively amounts to a tightening of monetary policy.  There have been many reasons given for this seeming complacency by the Fed: internal divisions over policy, fear of political backlash, opportunistic disinflation, fear of awakening bond vigilettentes, and sheer exhaustion.  Another potential reason is that the Fed simply doesn't see this aggregate demand slowdown in the data.  I actually considered this possibility some time ago but never put too much weight on it since this is the Federal Reserve after all.  It has far more resources than I do and  surely sees what I see in the data. However, after Fed Chairman Ben Bernanke's speech yesterday I am beginning to wonder if the Fed is actually missing something in the data.  In particular, I was stunned to read this sentence in the speech:
Meanwhile, measures of expected inflation generally have remained stable.
Uhm, unless I have been living in parallel universe and just got phased into a different one this  statement is completely wrong.  Inflation expectations, as I show below, have been persistently declining  since  the start of  2010.  Not only that, but Bernanke's claim that inflation expectations are stable has huge policy implications.  It is widely understood that expectations of future inflation are a key determinant of current aggregate demand.  If expectations of inflation are stable as Bernanke claims then aggregate demand growth should also be relatively stable.  On the other hand, if inflation expectations are falling and have been doing so for some time as I claim then it is likely that current aggregate demand growth also has been falling.*  

If Bernanke really believes inflation expectations are stable then one must give him credit for implementing monetary policy in a manner consistent with that understanding.  However, I simply cannot understand how he or anyone else at the Fed could hold such a view.  The best indicators of inflation expectations have been screaming red alert for some time now.  How the Fed could have missed this red alert is unfathomable to me, but on the off chance that they have and are reading this post I ask that they please take note of the following set of figures.

The first figure shows the term structure of expected inflation over the first half of 2010.  The plotted curves in the figure show the average expected inflation rate at various yearly horizons for the first six months of 2010.  The data comes from the Cleveland Fed. This figure makes clear that inflation expectations have been trending down across all horizons since the start of the year. Note that the 1-year horizon has seen inflation expectations drop by  about 100 basis points. (Click on figure to enlarge)

Now to put this figure into perspective let's look at the term structure of inflation expectations the last time expected inflation fell rapidly and caused aggregate demand to tank.  Yes, that would be the late 2008, early 2009 period.  Here is the figure for this time.  Notice any similarities? (Click on figure to enlarge.)

Here too we see a decline across all horizons with the 1-year having the sharpest decline.  Now current inflation expectations have not fallen as much as these above but they are persistently falling.  And we  know from the late 2008, early 2009 experience what happens to aggregate demand when inflation expectations are allowed to continue to fall: you get the greatest decline in nominal spending since the Great Depression.  

Now the dire picture painted by the Cleveland Fed data is wholly corroborated by the inflation expectations implied by the the difference between the nominal interest rates on regular treasury securities and the real interest rates on treasury inflation protected securities (TIPS).  This measure of inflation expectations is graphed below using daily data on 5-year treasuries for the period January 4, 2010 - July 29, 2010: (Click on figure to enlarge.)

Here again there is a clear downward trend. Inflation expectations are falling and there is currently no end in sight.  Given all of this evidence, how can Ben Bernanke assert that inflationary expectations are stable?  I am truly bewildered by that claim. I hope Fed officials who have read this far are also bewildered and are now reconsidering their views.  Let me be very clear what all of this implies: by failing to stabilize inflation expectations the Fed is effectively tightening monetary policy at a most inopportune time. I hope this is not how the Fed wants to be remembered. 


  1. TIPS gives us market expectations for the CPI, not market expectations for inflation in the prices of goods and services. A large part of the CPI reflects asset deflation in residential housing. The CPI also uses questionable methodology for measuring quality improvements. So expected inflation in the CPI of 1.3% might translate into expected inflation in goods and services of 3%. Even 1.3% inflation is far from the danger zone of deflation where stuffing mattresses with cash is more attractive than making longer term investments.

    So investor expectations of CPI inflation have fallen from 2.1% to 1.3% over 8 months. Two big things have happened. Obamacare passed and Europe has gone through a sovereign debt crisis. Both events are damaging to the economy and would be expected to slow inflation by reducing capacity utilization. The markets apparently do not expect the fed to buy enough bonds to offset the effect on the price level of slower recovery in the real economy.

    Should the fed buy bonds to restore inflationary expectations or should the fed take this opportunity to lower its inflation targets. Since we are nowhere near a level of deflation that is damaging to the economy, it doesn't much matter. I think the case is a little stronger for quantitative easing - if only to calm the fears of the people who are hysterical about a deflationary spiral.

  2. The problem is that the Fed seems to think that anything less than or equal to some implicit target (say 2% for core inflation) means that inflation expectations are stable.

  3. The administration (which of course includes the Chair) is looking past our current midsummer doldrums to an ever more robust recovery later in the year. Thus we saw Bernanke saying last week that rising wages will lift spending in the coming quarters, and Geithner's newspaper particle extolling the recovery.
    And the Fed sees rising commodity prices as evidence the economy is not at risk from deflation.

  4. I'm just a dumb businessman and not an economics professor, but I have noticed that wheat futures are up 92% since June and that corn,soybeans, rice and other food commodities are all looking like bubbles in the making.

    What do make of that? Think that might be something to add to the equation?

  5. The TIPS and the Cleveland Fed data impute inflation, in whole or in part, from the Treasury market. This relies on modeling Treasury prices as inflation expectations.

    Whether this is always a good model is debatable. Treasury prices may include non economic participants like central banks.

    So Bernanke and company may be looking at other measures not derived from Treasury markets. And I would guess they are not seeing deflation confirmation in those places.

  6. Chris of Stumpton:

    Inflation expectations created from TIPS may be contaminated by a liquidity premium, but the Cleveland data is not. But even if the TIPS data is contaminated by it, consider the implications. A liquidity premium means increase demand for liquid assets, of which money is the most liquid. In short, a heightened liquidity premium suggest increased money demand which, in turn, is deflationary and something that should be offset by the Fed to maintain monetary equilibrium.

    If the Fed is looking elsewhere I would like to know where it is. I find it hard to believe the Fed has a more precise measure of inflation expectations than those created by the market itself.

  7. A good time to revisit Mankiw, Reis and Wolfers paper on "Disagreement about inflation expectations" ?

    "Analyzing 50 years of inflation expectations data from several sources, we document substantial disagreement among both consumers and professional economists about expected future inflation"