[The Fed] has committed itself to an inflation target of just under 2 percent. Of course, none of that assures us that the Fed will hit the bull’s-eye. It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.
[...]
SKEPTICAL? Then let’s see what the bond market vigilantes really think.
The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6 percent and the 10-year expected rate was about 1.9 percent. Notice that the latter matches the Fed’s inflation target. I don’t think that’s a coincidence.
But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.
In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.
Monday, June 22, 2009
Alan Blinder on the Inflation Debate
In recent posts (e.g., this one) we noted the views of Paul Krugman, John Taylor, and others on whether the Fed's responses to the financial crisis might lead to high inflation in future. Yesterday, Alan Blinder, the Princeton economist, former Fed governor, and long-time Democratic policy adviser weighed in on the debate in his Sunday New York Times Business Section column, Economic View: "Why Inflation isn't a Danger"). Blinder's argument essentially boils down to this: The Fed is aware that if it doesn't rein in the money supply in a timely manner as the crisis abates, this will lead to inflation. The Fed has planned for this, and has the competence to pull this off. Further, bond market participants appear to support this view. Blinder wrote,
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The TIPS rate is set artificially low by using the government's [invalid] figure for inflation.
That makes TIPS a less than effective hedge against inflation.
Electricity rates are set to surge 20 - 50% starting in January even without Cap & Trade. Energy of all types has been rising greatly as have insurance and healthcare.
I think most people have experienced significantly higher expenses even as official numbers indicated little to no price inflation.
The BIG LIE, if told often enough, gets believed by the unknowing suckers.
There is a wild card I should mention that Blinder left out of his column: Bernanke's term expires next year. If I had to bet, I'd bet he'll be reappointed by Obama, given the recent praise Bernanke has received, including from some of his previous critics. But what if Obama nominates his own candidate -- Larry Summers, for example. Would an Obama appointee be as zealous an inflation hawk, considering the effect that Fed tightening could have on the economy heading into 2012?
Obama can't nominate his own candidate, if my memory serves he has to pick a presently sitting Fed Governor. The Fed is not like the Treasury Dept or other exec branch beaurocracy, it plays by its own rules. Summers has 0% chance.
We will get high inflation inevitably, imo. You can't increase the money supply like they have without getting it. The author of this short article is politically biased and his appeal to authority on the discriminating, prescient wisdom of the markets (and the Fed) flies in the face of history.
Paul,
I don't know if you remember this, but an argument that some conservatives used to make in the context of entitlement and federal pension spending (compellingly, I thought) was that government inflation measures overstated real inflation. Even if they understate it though, wouldn't the TIPS spread be significantly higher if the bond market anticipated inflation?
J.K.,
Looks like you're right about the Fed chairman needing to be appointed from among the current Fed governors, so Summers won't in the running. I was going by some erroneous media speculation I had read about Summers's current position being a stepping stone to a Fed chairmanship. He'd have to be nominated to the board of governors first.
Regarding Blinder being politically biased, he may be, which is why I mentioned his political affiliation, but it happens that Dr. Mark Perry, who is conservative, is leaning toward Blinder's position on this:
"Both the bond market data showing contained expectations of inflation at around 2%, and the commercial banking data showing declining loan volume, seem to support Blinder's position more than Laffer's. I'm leaning toward Blinder's position for now. Inflation is not any kind of "clear and present danger," at least not yet."
Paul Price: "The TIPS rate is set artificially low by using the government's [invalid] figure for inflation. That makes TIPS a less than effective hedge against inflation. "
Many look at TIPS because it is set by the market! It doesn't matter what the government sets for the rate. It will trade as the market determines it. Unless you don't believe there is a free market in TIPS bonds*, it is an important forecast for inflation. Of course, this doesn't mean it's always right but it is an independent indication of market expectations.
"I think most people have experienced significantly higher expenses even as official numbers indicated little to no price inflation. "
This was one of the big (erroneous) argument of commodity bulls over the last two years. Namely, inflation was far higher than what was reported. Some invested in commodities, not because of higher growth rates or increasing long-term demand, but as a hedge against inflation (I believe this is happening now to some degree as well). Needless to say, the inflationists were washed out badly and suffered massive losses. Investors like Peter Shiff, Jim Rogers, and so on, likely suffered massive losses (ignoring any short selling they did, which was unrelated to inflation.)
Healthcare and insurance may be rising but if wages stay flat; if housing drops (this should spill over into rents soon); if anything to do with technology drops; and if energy costs (particulary natural gas) drops, inflation may not materialize.
(* Some do argue that the bond markets are manipulated. As far as I'm concerned, anyone arguing that needs a huge burden of proof because the bond market is extremely large and hard to manipulate. TIPS is somewhat small but the Treasury market is very large. Some were claiming that the Treasury market was manipulated by foreign central bank buying a few years ago, and that's why the yield curve inverted. Of course, their argument turned out to be false and the yield curve inversion did portend to an economic slowdown. Anyone ignoring the signals of the bond market suffered. I would say the same thing about the TIPS market right now. If TIPS are signalling low inflation, one better be sure if they are betting against it (by taking an inflationist stance.))
Sivaram, I'm no expert on the intricacies of high finance, but do you think that the secondary TIPS market takes most of its cues from the auctioning done by our big banks, which opens the door for manipulation by those players, whom by the way are now all owned in essence by the Fed and executive branch bureaucrats with an agenda? Also, isn't hte secondary market dominated by the same players, supposedly acting on behalf of their clients?
The "too big to manipulate" argument is also made by forex academics (forex has the largest markets in the world) who don't do any actual trading, yet every forex trader I've known says manipulation occurs there. Who knows though.. Manipulation doesn't have to mean that the bulk of trades are fudged, just that some of them are and/or the information they trade on is. I felt the way the stock market traded in 08 with the bailout debates sometimes smacked of manipulation by those financial institutions lobbying for it.
Dave,
Well I hope those two are right, but I'm doubtful. It may not be an immediate danger but remember it is much harder to combat inflation than it is to fight deflation. Not to mention our currency has secular inflation built into it even without any massive bailouts. Raising interest rates carries a lot of consequences and the negative effects are felt a lot sooner (and by everyday people) than the negative effects of combatting deflation by printing money. So while Blinder is confident the Fed will be "fast on its feet" to combat inflation, I think his argument ignores the difference in process. Still looks like a glib PR piece meant to comfort readers, to me.
Siv,
One more thing, for when you respond, I'm aware of Sagan's exdraordinary proof maxim...I am more asking if you see how TIPS manipulation is possible as a thought experiment instead of definitively asserting that it exists.
JK,
I would share your view that the market can be manipulated. This is definitely true in the short-term. I mean, a big chunk of the Treasury buyers in the last few years used to be so-called Carribean buyers (basically shadow banking system player and various other entities) and it's easy to funnel money to those entities and get them to buy the bonds. Short selling could be more difficult but maybe they can manipulate derivatives such as the CDS on those bonds.
I just don't think it is likely or that it is easily doable for any period of time. Even if some market can be manipulated, the bond market would be one of the most difficult given its size.
Even though the Treasury buyers are only handful of investment banks, what you are saying requires collusion on a grand level. Basically a conspiracy. It's possible but the more complicated your speculation gets, the more difficulty you will have with finding burden of proof to support it.
Ultimately, it comes down to whether you believe we have a free market (for the most part) or not. If the market is manipulated, it's best not to participate in it.
"Even though the Treasury buyers are only handful of investment banks, what you are saying requires collusion on a grand level. Basically a conspiracy."
I'd be interested in hearing what you think about, if you ever get to read it, Quigley's formerly suppressed tome Tragedy and Hope where he spends some time discussing the cartel history and nature of Western central banking systems...this is one of the books that basically gave much of the ammunition for G Edward Griffin's libertarian bible "The Creature from Jekyll Island". (unlike Griffin, however, Quigley supported the establishment). I personally think there's been plenty of conspiracy in the banking industry. Things work out so well, so consistently, for the same people time and time again.
"If the market is manipulated, it's best not to participate in it."
Not necessarily, you can recognize that the money must flow somewhere, and invest accordingly, for the short term. Also shareholder friendly, dividend paying stocks can exist within a framework of market manipulation. Where you get into trouble as a long term investor (IMO) is buying shares of companies where the shares don't really represent ownership of the company, and those shares, being merely free print-on-demand money for insiders, are most open to manipulaton and abuse. I personally favor small cap stocks with high insider ownership that pay a portion of net income out as dividends. But I guess I'm getting into stocks here which is a tangent.
Here's a better link, since you'd probably need the unabridged (uncensored) 1st printing, but it'd cost you a pretty penny. $975 in that link is probably the cheapest I've seen it though.
Or you can just torrent it. :)
Sivaram,
Paul Price was referring to the CPI, which what the government uses to adjust the principal of the TIPS. He's not the first to suggest that the CPI understates inflation, though, as I noted, others have made the opposite claim.
As far as your and J.K.'s speculation about a conspiracy to manipulate TIPS yields (and, by extension, the TIPS spread over non-inflation adjusted Treasuries), what does Occam's Razor suggest? The simplest explanation seems to be that bond investors don't expect high inflation right now.
"what does Occam's Razor suggest? The simplest explanation seems to be that bond investors don't expect high inflation right now."
That is true Dave, which is why I made it clear to Siv when bringing up the issue that it was a thought experiment. Occam's Razor is just a guideline, and more suited to observation of the natural world than the behavior of man, who can design and carry out complex plans for the future. It has not deterred you or others from speculating on the closeness of Goldman Sachs alumni, for instance.
Fair points, J.K.
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