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Deflationary expectations
The difference between yields on five-year Treasuries and five-year TIPS was a minus 0.46 percentage point at one point this week, a record. TIPS typically yield less than Treasuries because their principal payments rise at the rate of inflation. A shrinking yield gap indicates investors expect inflation to slow.
The market ``is pricing in deep deflation,'' said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc. one of the 17 primary dealers that trade directly with the Fed.
Here is the story.
Furthermore this market price indicator, in addition to showing deflationary expectations, has implications for the nature of our current crisis. The price of oil already has done lots of its falling. So you might say the market expects the broader monetary aggregates -- credit -- to be less than robust over coming periods. I should add (contra Alex) that a rising monetary base, without a robust credit market, won't get you much inflation. In fact the base has so risen because the Fed desperately has been trying to prevent...a credit crunch. Just imagine the credit boom that the observed recent path of the monetary base would have brought if we were not in...a credit crunch.
Posted by Tyler Cowen on October 27, 2008 at 08:59 AM in Economics | Permalink
Comments
Older readers (I am one) may feel that this debate reminds them of earlier downturns. That difficuties in raisng loans are reported before the loan statistics show a contraction is old news in more than one economy. However, this time the contrast looks more extreme. I fear that Alex is right about where we are and Tyler is right about where we are going. The route from one to the other begins to look precipitous.
Posted by: David Heigham at Oct 27, 2008 9:17:23 AM
Would someone please explain how the monetary base in this graph is calculated? Is it just cash, or cash plus checking deposits, or what?
Posted by: Richard Squire at Oct 27, 2008 9:28:34 AM
Would someone please explain how monetary base in this graph is calculated? Is it just cash, or cash plus checking accounts, or what?
Posted by: Richard Squire at Oct 27, 2008 9:29:44 AM
A careful reading makes it clear that the trader means "disinflation," a reduction in the inflation rate, not deflation. The trader expects disinflation because the economy is going into recession. Longer term expectations, which are relevant for interest rates on mortgages - such as I quoted earlier - are up.
"Inflation expectations, as measured by 10-year TIPS, climbed in March to the highest level since August 2006 as commodity prices surged."
http://www.bloomberg.com/apps/news?pid=20601213&refer=home&sid=atV9Ioht2Buo
Posted by: Alex Tabarrok at Oct 27, 2008 9:41:20 AM
"I should add (contra Alex) that a rising monetary base, without a robust credit market, won't get you much inflation."
Doesn't it work the other way too? If consumers get scared about their job, they save instead of using their credit cards or taking out new mortgages. A decrease in demand, as well as a decrease in supply, could limit the amount of money in circulation and thus inflation.
Posted by: mw at Oct 27, 2008 9:59:17 AM
Alex, the *minus* 0.46 spread in the TIPS market says it all. That's deflationary expectations. I'm not, by the way, saying that people expect the credit crunch to last for ten years. They don't. That is all your response is showing.
Posted by: Tyler Cowen at Oct 27, 2008 10:05:01 AM
5 year TIPS now indicating 0.53% deflation
10 years indicate 0.68% inflation
nominal yield curve is positive, TIPS is almost flat
Posted by: fusion at Oct 27, 2008 10:10:26 AM
Housing prices must deflate until they are inline with incomes. But that means that the value of financial assets tied to housing must drop in value. The Fed throwing money at financial institutions, who use the money to band-aid their rapidly declining assets, proves useless because incomes are falling. Unemployment doubles, triples in some area.
Looking forward, few good investments oportunities appear, people have no desire to borrow or lend. At first people borrow to meet short term needs, but they quickly adjust borrowing to meet projected future needs. The outlook looks bleak to most people. People who thought they were wealthy, discover their assets are worth little.
Inlation begins to appear in some areas. Food and transportation costs as a percentage of income increase dramatically. Some nations turn to military spending to spur growth. Conflicts over raw materials increase. Governments become less stable.
Medical costs escalate in the United States. Senior citizens in large numbers lack the resources to care for themselves, their savings are gone. Stress on a national level starts to have adverse outcomes on large groups of people.
Crime escalates. Increasing government control to control prices leads to black markets.
Is that our future?
Posted by: DanC at Oct 27, 2008 10:14:07 AM
You can find TIPS expected inflation estimates here
http://www.clevelandfed.org/research/data/tips/index.cfm?state1=1&state2=&state3=&state4=&startDate=01/01/2008&endDate=10/27/2008&freq=daily
Household expectations here
http://www.clevelandfed.org/research/data/tips/index.cfm?state1=3&state2=&state3=&state4=&startDate=01/01/2008&endDate=10/27/2008&freq=daily
and a variety of other forecasts here
http://www.actionforex.com/long-term/long-term-forecasts/global:-inflation-expectations-monitor-2008090358548/
None show deflation expectations.
Alex
Posted by: Alex Tabarrok at Oct 27, 2008 10:37:06 AM
Alex, 5-year TIPS show deflation as the expectation. You're citing the ten-year contract. That shows people expect the current problem to be over within ten years but not five. It's very supportive of my view.
Posted by: Tyler Cowen at Oct 27, 2008 10:46:28 AM
Wow, I have never seen so many Tyler and Alex posts in one thread, especially with them arguing. This is cooler than Superman II.
Seriously, I would encourage anyone who is really into this stuff, to check out this blog post, where I make two important points. First, if you had used this forecasting method five years ago, it would have been way off. (I show the graphs.)
Second, the reason the "expected inflation rate" has collapsed, is NOT that nominal yields have come down to the real yields. Rather, much of it has been an increase in "real yields" since January, when TIPS were almost zero and came back up to 2 and change.
So Tyler, do you really think that the market expected very low growth (over the next 5 years) in January, and then became gradually much more optimistic up to today?
I offer my own explanation, which is that traders do not trust the government to honor the principal adjustments in the TIPS contracts. I.e. they insist on a higher contractual TIPS yield, because they think the gov't will fudge the CPI and/or say, "In this year of a $800 billion budget deficit, we will do a modified principal increase in the principal, especially because of unusual volatile in energy prices blah blah..."
Posted by: Bob Murphy at Oct 27, 2008 11:04:38 AM
Along the lines of what Bob_Murphy mentioned, I'm expecting to see something like, "Well, *normally* gasoline prices increase 20% between
April and May, but this year they just increased 15%, so by our ultra-complicated but ultra-correct method
you can't understand, gas price fell 5% between the two months. That gives us an annualized change of -45%.
Let's see, factor in the weighting, add in the other goods and, inflation's at -4%! Please believe us. :-D"
And yet somehow your grocery bill doubled and the cereal boxes don't even wait for your grip
to buckle...
Hey, anyone need a structural engineer? :-)
Posted by: Person at Oct 27, 2008 12:20:27 PM
The government routinely fudges the CPI. If it were calculated in a constant way a la "shadow government statistics" then the TIPS price would be different, no?
What you're showing isn't expected inflation/deflation, it's the expected way that the future government will elect to calculate the CPI - a quite different forecast.
Posted by: Eliezer Yudkowsky at Oct 27, 2008 12:23:57 PM
Given that the dollar is not tied to any particular standard, isn't it more or less impossible for there to be any deflation that the government doesn't want? I mean, if we start deflating, why can't the government turn on the printing presses and start handing people money? Thus, I don't understand why there would be any real deflationary fears, rather than fears of TIPS cheating as mentioned by Bob Murphy.
Posted by: Alex R at Oct 27, 2008 12:25:54 PM
Deflation?
Absolutely!
Prices at the grocery store are, and have been dropping immediately and immensely, as are prices at the pump.
Just today I saw gas for $2.27 down the street from me.
However I am not horribly worried.
It seems we are contemplating this with half our brains tied behind out back.
We are talking about the money in terms of the money supply. I think in this case its far better to talk about it in terms of the exchange rates. Because of the newish global economy and ease of world trade, we can no longer look at the dollar in absence of other currencies. When the dollar was very low valued earlier this year, prices on commodities and internationally tradable goods were absurdly high. As the dollar rose, the prices began to fall.
If we looked at monthly US GDP in terms of other currencies' exchange rates we would see what appeared to be a recession in the US earlier this year. This also fits the behavior for job losses and increased layoffs as part of a post recession jobless recovery. I know this sounds strange, but I think, we may have had a recession that was masked by a quickly increasing money supply due to the banks' over-leveraging, increased exports due to a weak dollar, and other sources of inflation.
In short, because of how much trade goes on globally, we can no longer think of economies isolated in single currencies as a good approximation. For the future, we need some sort of global GDP-currency-sortof-average-baseline-thingy to compare against for growth.
Posted by: Jorge Landivar at Oct 27, 2008 12:57:59 PM
If I am write about what "Monetary Base" is, it looks to me like a hoarding of cash as well as injections by the Fed.
Anyone have a view? As asset prices tumble, someone is selling. Whoever is selling is obviously not buying something else, so that money is going somewhere. It looks like its going under the mattress, so to speak.
Tyler or Alex, if you go to the St Louis Fed's research site, you'll see many other adjusted Monetary Base graphs that show considerably less sharp upturns. Any opinions?
Posted by: Jason at Oct 27, 2008 1:04:03 PM
I think this graph from FRED illustrates my point. Since 2003, the 5-year nominal and TIPS have moved almost in lockstep, with the gap between them (presumably) due to inflation expectations. However, that relationship has completely broken down starting in about June 2008, where the gap steadily shrank until now it is reversed.
Now if Tyler is right, and this is because the world is forecasting major recession and falling prices (over the next 5 years), this disappearance of the gap would manifest itself in a falling TIPS yield and a much faller collapse in nominal yields.
Yet we see the opposite. The nominal yields fell a little since June, but the TIPS yields shot way up. To interpret this as a sign that the market expects zero price increases over the next five years, you would have to say that the market is expecting much stronger real growth now, than it was back in January.
In fact, the chart I link above shows that right now the yield on 5-year TIPS is the highest it has ever been. In other words, traders are apparently more optimistic now about "five year growth" than they have been at any time going back to 2003.
C'mon Tyler, that is crazy. Something else is going on here.
My suggestion is that people are thinking the BLS will be pressured to understate the CPI, even relative to all the BS it already does. I.e. using the current methods, if CPI increases 8% from 2008 to 2009, instead the BLS will come up with some bogus way to report it as a 6% increase. And so the buyers of TIPS insist on another 2 percentage points in the yield, to compensate.
Posted by: Bob Murphy at Oct 27, 2008 1:23:13 PM
and now for the meta question: obviously tyler and alex disagree (politely), very interesting to watch the debate. but what does it say for econ (or other policy analysis) that there's no definitive answer? is it lack of info? unlikely. so it's some definitional dispute? probably part of it. but how's a normal person supposed to reach any conclusion with any sort of certainty where the two rocket scientists can't even sort things out? and what good's a "science" that can only get things "right" in retrospect, if then, and still not gird us against next blowup? and how can tyler and alex have such strong opinions when someone they know, respect, trust believes almost the oppposite? shouldn't that cause each to reassess rather than defend own position?
Posted by: dj superflat at Oct 27, 2008 2:26:12 PM
Wow, yes, this is more exciting than Cato Unbound in terms of good blog post arguments!
What a Yes/No Credit Crunch death match!
I think Alex is right on the numbers but Tyler is right about a credit crunch -- the Baltic Index difficulty in getting letters of credit for trade is a huge issue.
I also think there are too many banks, and bankers, and that there is less and less need for any Big Banks. The gov't should give cash / loans / capital injections based on q2 & q3 leandings by small banks w/o derivatives or MBS exposure.
There will be far fewer Big Banks in a few years, unless the gov't wastes another trillion to save big bonuses. I don't think so.
While house prices ARE in deflation (free-fall?), they might have hit bottom. It would be nice if the gov't was buying more, in fact all, houses at 50% of the prior mortgage, to put a floor under the worst mortgages. Buy houses, not paper -- and then use those houses for 'affordable housing' programs.
Posted by: Tom Grey at Oct 27, 2008 2:33:06 PM
Sure, the BLS could mess with the CPI, but it wouldn't be a one time thing. There is almost nothing to be gained from a short term manipulation.
In the long term, the only reason to do this would be to control liabilities such as inflation adjusted government outlays.
This would imply a systematic under-shoot over a long period of time, hence changes in the CPI would be consistent, and we could track the actual inflation rate.
Actually, I've confused myself, but if anyone could help clear this up that would be helpful. Maybe at least the second derivative of the CPI would be consistent over time????
Posted by: stanfo at Oct 27, 2008 2:36:38 PM
How do the symptoms differ with respect to (1) a credit crunch and (2) retrenching consumer and business sentiment borne from recession fears (e.g., no appetite for expansion, investment, or heavy expenditures)?
Posted by: guy in the veal calf office at Oct 27, 2008 2:43:00 PM
The graph that Bob Murphy shows is misleading. He compares the expected average annual inflation for five years against the annual inflation rate calculated monthly. To do a correct comparison for checking the performance of the expected inflation based off of the 5 year TIPS you would have to compute the running average of five years worth of inflation data. This means that the last possible comparison that can be done would be up through five years ago.
Posted by: John Turner at Oct 27, 2008 3:21:18 PM
I find this debate fascinating but I think everybody is missing the elephant in the room - the real world - the commodity and ocean freight markets. Some folks are deleveraging because their notes are being called. Some folks are deleveraging because they got short Yen and long something else, which isn't worth what it was (probably, both the money they bought with the Yen and the stuff they bought with that money). Others are deleveraging because they "Texas hedged" the funds paid into them by the fools they sold commodity index funds to. Some folks are develeraging simply because they got long and wrong. When this rubbish is unraveled, the pundits worried about deflation will once again be talking bullish fundamentals. Keep your seatbelts fastened.
Posted by: larry glenn at Oct 27, 2008 3:50:43 PM
The market is taking a stance similar to Hussman here:
The Strategic Total Return Fund moved the bulk of its assets from short-term Treasury securities to Treasury inflation protected securities as real yields on these securities surged well over 3%. We have avoided TIPS of short maturity that are selling at significant premiums to par. Despite their high real yields, the premiums over face value would erode in the event of deflation (though the securities do not mature at less than par in any event).
http://www.hussmanfunds.com/wmc/wmc081027.htm
Posted by: BR at Oct 27, 2008 4:15:09 PM
And I think the market is looking at scenarios such as these:
What cost $100 in 1938 would cost $104.57 in 1941.
What cost $100 in 1938 would cost $122.81 in 1943.
http://www.westegg.com/inflation/
Posted by: BR at Oct 27, 2008 4:24:11 PM
