Posts Tagged inflation expectations
I call on Paul Krugman: return his Nobel Prize in economics. My request is based on his article in the April 29 New York Times magazine. Titled “Earth to Ben Bernanke,” the article actually supports many of Dr. Bernanke’s actions, specifically the quantitative easing program. (Dr. Krugman, for some reason, does not like this name, calling it “This is the strategy that has come to be known, unhelpfully, as quantitative easing.” Really? Unhelpfully?
So what does Dr. Krugman believe the Fed should do? I can summarize his proposal in one phrase: announce a higher target for long-term inflation. Currently the Fed’s implicit inflation target is probably around two percent. Krugman believes, with some empirical support, that raising the inflation target would cause people and businesses to increase their spending because they will expect the purchasing power of their money holdings to depreciate faster. However, there is another point that Krugman overlooks that is at least as important as increasing velocity.
Higher inflation expectations mean higher nominal interest rates. Krugman seems to be following the lead of Dr. Olivier Blanchard, now “Economic Counsellor and Director, Research Department” at the IMF. Prof. Blanchard is currently on leave from M.I.T. He once proposed that increasing the inflation target would increase interest rates, giving the central bank more room to — get this — lower interest rates. Let me quote from my blog entry in March, 2010:
“Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher. This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.
Unfortunately, Prof. Blanchard has made an error that should make him blush. It is the real interest rate, not the nominal interest rate, that affects most economic activity. The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.”
Spending depends on real interest rates, not nominal rates. Increasing inflation expectations will indeed increase nominal interest rates and raise spending a bit by increasing the velocity of circulation of money. But the increase in spending won’t be very large because real interest rates have not changed.
Dr. Krugman has one Nobel Prize, while Dr. Blanchard has none. Krugman’s proposal today is no more valid than Blanchard’s was two years ago. I call on Dr. Krugman to return his Nobel prize in economics for failing to see a fundamental flaw in his proposal.
On January 18, real yields turned positive on 10-year TIPS. Markets are possibly getting a bit more optimistic. Here are a couple of representative real yield curves. Essentially, during the last week the real yield curve shifted up about 14 basis points. (To get the complete data in an Excel 2007 workbook, click here.)
Nominal yields shifted up about 19 basis points in the longer maturities. Thus there was an increase in inflation expectations of about 5 basis points.
We can easily construct an inflation expectations curve. Expected inflation is simply the difference between the nominal and real interest rate for each maturity. Here’s what it looks like:
Fed chairman Ben Bernanke and the FOMC announced a new round of “quantitative easing” on November 3. Some of us are old enough to remember when QE2 was the abbreviation for a luxury ocean liner (the Queen Elizabeth II, still owned and operated by Cunard). Today those initials have been co-opted by the Fed to stand for the second round of quantitative easing.
The idea here is simple enough. Banks are not lending their excess reserves. In fact, the Fed’s latest H3 report includes the following information:
So instead of just buying more short-term Treasury securities (and expanding the excess reserve base even more), the Fed has decided to make purchases of longer-term Treasury notes and bonds. In fact, $600 billion in new purchases, at a rate of $75 billion per month for eight months. The Fed has repeatedly stated that their concern is deflation. They are deliberately trying to create inflation. Here’s an excerpt from their November 3 press release: “Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.”
So what’s the problem? Apparently some folks don’t understand the yield curve. This is straight out of the Wall Street Journal article:
Since August 27, yields on T-notes (maturities between 1 and 10 years) have fallen. However, T-bond yields have risen. It seems clear to me that the Fed has pretty much succeeded. Long-term yields are higher because the Fed has managed to increase inflation expectations. Note, however, that inflation expectations have only risen beyond the 10 year horizon. Up to 10 years, yields have fallen, indicating that the market pretty much agrees with the Fed: inflation expectations are lower. (Of course, it’s possible that adding $600 billion in liquidity to this market has lowered relatively short-term yields simply because of expectations of more liquidity.)
What we don’t need is stuff like this:
“… David Ader, head of government-bond strategy at CRT Capital LLC, said … ‘I think the bulk of the move is a position unwind exacerbated by the timing of the year’ …” “Position unwind?” Great.