inflation expectations

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Is There a “Policy”?

I read this morning that the Federal Reserve had bought, at the peak of the recent crisis, about 40% of all US government bonds being issued.

This may, to some of you, be something of no concern.

Think again

The illusion that there are separate spaces for monetary and fiscal policy is belied by this fact.  Which one was it?  Was it the Fed flooding the economy with money?  Or was it the government issuing debt to finance economic activity? I suppose it was both.  But it wasn’t fiscal policy.  The effect of all that money was simply to support asset prices.  Whether that was the intention is irrelevant.  The flood found its way into the financial system and relatively little found its way into the economy in the form of an expansion of productive activity.  We could go further: a great deal of what expansion of capacity actually occurred went abroad to build fragile supply chains and take advantage of low wages in distant parts.

What also happened was that households sat on the portion of the flood that they received as a hedge against further economic mayhem.  And when, as now, they began to feel more confident they started to spend the money on goods rather than services.  Remember that the economy is heavily skewed towards consumption, and within that, towards services.  The problem with services is that they tend to be in-person.  And being in-person is something a lot of people are avoiding right now.  So they decided to switch and buy goods instead.

This, being the twenty-first century, those goods usually contain some sort of a computer chip.  Quite why we need our refrigerators to talk to each other is beyond me, but someone decided it has great value to us.  So everything nowadays is packed with the ability to communicate.  Which puts pressure on the chip manufacturers.

It also, coincidentally, puts enormous pressure on the people who move the chips around the globe because, this also being the twenty-first century, chip production is concentrated in far corners of the globe rather than near to where they might be incorporated into the final product.  This is the way of efficient supply chains.  Which, as we now know, is something of an oxymoron.

With the supply side of the economy so battered by both unexpected money-induced demand and the corporate delusion of efficient supply chains, we are now being bombarded by price increases.  This has given rise to the specter of inflation.

I hope you have noticed that inflation is always a specter.  It is a ghost that haunts the minds of serious people who, once they see workers demanding more wages, seek to damp such demands as being insidious.

But insidious to whom?

Asset holders of course!

The long term value of assets is eroded by inflation.  Those pesky workers demanding higher wages works to undermine that value by inducing a cycle of “inflationary expectations”.  That wages have been suppressed for eons in order to boost the profits earned by asset holders is left out of the discussion.  We must, at all costs, preserve those asset values.

So, in the face of a collapsed economy in, say, 2008, we pump in trillions of dollars of money.  This has the primary effect of ensuring asset holders don’t get taken completely to the cleaners.  Job well done.  The problem then becomes how to wean ourselves off the flood of money.  That’s easy: we wait for the economy to return to its long term trajectory and then ease off.  The presumed recovery in earnings prospects will offset any downside implied by removing the monetary life support.  Rising interest rates will prevent the specter of inflation undermining asset prices.  Wages will be contained within sensible bounds.  Profits will recover.  Asset values will flourish.

Phew.

Except.

What happens if the economy doesn’t return to its long term trajectory?  What happens if it wallows along sub-optimally, starved of investment, with low productivity and perpetually on the brink of a renewed downturn?

Well, in that case you keep flooding it with money.  Just like we did between the Great Crash and the Pandemic Crisis which provide bookends for a period of pretty awful economic policy.  Too little reliance of fiscal policy at one end and relentless floods of money throughout.  It was called quantitative easing.  In fact it was an addiction.

In the absence of an economic policy that put government expenditure of real activity at its heart, think of the bridges that could have been built with all that money, we monetized the debt instead.  We flooded the financial system with cheap money.  Indeed we ended up making money so cheap it has become incredibly difficult to increase its price.  It has made credit so widely available that even the most perverse investment opportunity is grasped as a possibility worth thinking about.  The search for returns has overwhelmed any sense of risk aversion.  Everything goes.  And like all addictions this will end badly.

We have produced an economy awash with debt and with asset prices higher than the underlying cash flows justify.  This is what happens when you ignore history and imagine that you don’t need proper fiscal policy.  Or, at the very least, that you distinguish between monetary and fiscal policies.

So now the central banks are stuck.  Having created an addiction they need to offset the inevitable withdrawal symptoms.  If they raise interest rates they might deflate asset values from their addiction riddled levels.  If they don’t raise interest rates they might abet the onset of an inflationary cycle that might deflate asset values from their addiction riddled values.

Whoops.

Meanwhile the bond market, in its current addicted state, prefers to believe that the central banks will continue to drip feed it sufficiently to prevent a decline in values.  How else can we interpret the contradiction between the constant refrain of the inflation specter being raised by bankers and their concurrent willingness not to bid up long term interest rates?

Interesting times.

So the Fed’s avowed intention to taper its asset purchases down to zero by mid 2022 looks like an exercise in hope and belief that something will turn up.  Which doesn’t sound much like “policy” to me.

But it will have to do.

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Modern monetary theorists will chortle at the above.  The constraint they prefer to rely on with respect to the flood of money is inflation.  Great.  Question: is the exchange of Fed-created money for Treasury-issued debt not a form of MMT?  After all it ends up as money.  And the debt becomes an issue only for those who talk about debt ceilings and “affordability”.  We talk flippantly about low interest environments being comfortable for the issuance of debt to finance government spending.  So we ought not concern ourselves about etc debt per se, only the cost of carrying it?  But who made interest rates so low?  Did we not manufacture the exact conditions within which debt is so cheap?  It sounds so circular.  Meanwhile why don’t we simply dispense with the illusion of debt to begin with?  Why don’t we recognize it as money at the source?  Why don’t we simply fund government with money?  If Fed-created money and Treasury-issued debt are so fungible why bother with the distinction?  In whose interest is it to maintain the difference?  Asset holders.  Now we know who policy is maintained for.  Surprise.

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And Now For Something Completely Different …

My summer of research is almost over.  The season here in Vermont is changing and the view from our window will soon be dominated by the brilliant autumnal colors our region is famous for.  All is both regular and well.

Sort of.

Perhaps there’s something in the water down there in New York.  There are rumblings of life in economics.  The long sclerosis inhibiting the emergence of theories that explain rather than re-invent reality might just be close to loosening its grip.

I hope so.

In case you are unaware, there has been a paper published that has emerged as something of a viral hit.  We all need to add to its fame.  It begins thus:

“Mainstream economics is replete with ideas that “everyone knows” to be true, but that are actu- ally arrant nonsense. For example, “everyone knows” that:

  • Aggregate production functions (and aggregate measures of the capital stock) provide a good way to characterize the economy’s supply side;
  • Over a sufficiently long span—specifically, one that allows necessary price adjustments to be made—the economy will return to a state of full market clearing; and,
  • The theory of household choice provides a solid justification for downward-sloping market demand curves.

    None of these propositions has any sort of empirical foundation; moreover, each one turns out to be seriously deficient on theoretical grounds.  Nevertheless, economists continue to rely on these and similar ideas to organize their thinking about real-world economic phenomena. No doubt, one reason why this situation arises is because the economy is a complicated system that is inherently difficult to understand, so propositions like these—even though wrong—are all that saves us from intellectual nihilism. Another, more prosaic reason is Stigler’s (1982) equally nihilistic observation that “it takes a theory to beat a theory.”

    Is this state of affairs ever harmful or dangerous? One natural source of concern is if dubious but widely held ideas serve as the basis for consequential policy decisions.  In this note, I examine one such idea, namely, that expected inflation is a key determinant of actual inflation. Many economists view expectations as central to the inflation process; similarly, many central banks consider “anchoring” or “managing” the public’s inflation expectations to be an important policy goal or instrument.  Here, I argue that using inflation expectations to explain observed inflation dynamics is unnecessary and unsound: unnecessary because an alternative explanation exists that is equally if not more plausible, and unsound because invoking an expectations channel has no compelling theoretical or empirical basis and could potentially result in serious policy errors.”

So starts Jeremy Rudd an economist at the Federal Reserve Board in his discussion of inflationary expectations and their role in determining inflation.  He seems to think they aren’t as important as some theorists might imagine.  Oh dear.

The entire paper is designed to puncture the delusions that surround central bank policy making.  Which is, of course, an excellent and worthy goal.  The problem is that, at the end of the day, central bankers need to be able to attach their policy decisions to some theory or another in order to provide themselves with intellectual rigor.  Otherwise they would be reduced to telling the public that the recession they just induced in order to eliminate expectations of inflation was simply based on guesswork or reading the tea leaves.

Which is, perhaps, what they’ve been doing anyway given that most of the edifice of economics is simply jargon infested language describing just that.  Well, maybe not guesswork.  More like ideology.

I can’t resist.  Here’s the final few paragraphs:

“Say you had never heard of Phelps or Friedman, and only knew that the stochastic trend for in- flation (and labor costs) last shifted noticeably following a recession that occurred after a period when actual inflation had been running at four percent. You then came across some survey mea- sures of long-run expected inflation that roughly showed the same one-time level shift. Would you be convinced enough by this evidence to conclude that long-run inflation expectations were an important factor driving inflation dynamics? Or would you be skeptical of this conclusion because it is basically derived from a single observation (with later observations providing no evidence at all), and because one could just as easily explain these facts with an appeal to the notion that agents were simply making forecasts of inflation that were roughly correct on aver- age? How would you also explain that a recession permanently reduced trend inflation when actual inflation was four percent, but never did so thereafter?

Or would you justify the view that expectations “matter” by pointing to the inflation experience of the 1960s and 1970s, even though that period provides no actual evidence that workers or firms tried to boost their wages or raise their prices in anticipation of future price or cost changes? After all, history really only tells us that lags of actual inflation seem to enter inflation equations to a greater or lesser degree over time, not that expectations do or did; thinking that these lags of inflation are present because they are a proxy for some kind of forecast is more a habit of mind than anything solidly grounded in fact.

Alternatively, if you view the theoretical arguments as dispositive, exactly how would you explain to a fellow economist why it is that you see an important role for expected inflation in inflation dynamics? Would you make a halfhearted appeal to Phelps and Friedman? Would you feel a little guilty doing so, knowing that these authors either assumed such a role for expectations (Phelps) or motivated it with a theoretical mechanism whose basic predictions are clearly wrong (Friedman)? If not, then how would you explain that, in reality, only long-run inflation expectations seem even vaguely related to actual inflation? And if you tied your explanation to some sort of “wage bargaining” mechanism, what existing institutional feature of the economy would you point to in order to justify it? Would you instead try to fall back on the new-Keynesian Phillips curve, whose theoretical derivation is even harder to take seriously and whose empirical justification is close to nonexistent?

And would you feel the slightest bit nervous (or chagrined) about any of it?”

Go on.  Read the whole paper.  I know you want to.

 

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Consumers Swoon; Inflation Flat; Weak Weekend

The flow of weak data continued this morning and leaves us all with plenty to ponder over the weekend: the economy may well be headed out of recession as inventories are adjusted, but beyond that the horizon is murky to say the least.

The theme all week has been the abrupt ebbing of forward momentum and today’s news that consumer confidence fell in July – the index dropped to 63.2 from 66.0 – merely reinforces a worrying trend. The consensus prediction among analysts had been that the index would rise to 69.0, so obviously plenty of people have been carried away by the hoopla over recovery rather than getting a solid read on the underlying factors affecting consumers.

Wall Street analysts are perennially optimistic and tend to see a bright future on the basis of the slightest break in the clouds. This is what has happened over the past two months. As all the data started to suggest that the economy was no longer in free fall Wall Street immediately rushed to the conclusion that it would adjust back to normal quite quickly. Hence the run up in stock prices that seem to be based upon profit projections unrelated to where business is today.

I would urge caution.

While it is very clear that the economy has started to level off and is no longer imploding at the rate it was last year, we remain very far from a sustainable recovery. On the contrary the turn around has all the makings of being a ‘technicality’ rather than a ‘reality’.

Consumers seem to agree.

Dark clouds are hanging heavily over consumers: unemployment is the leading issue, and there seems to be no prospect of job generation in the next few months. Home prices are devastated which has destroyed many people’s savings – home equity is a false measure of ‘savings’ but many families fell into the trap of believing it was secure. And even those who are still employed are facing shorter work weeks, lost benefits, and reduced wages. This is not a recipe for rapid recovery. Indeed it may not support recovery at all.

Prices reflect this weak activity.

The Consumer Price Index was flat month on month in July, which was about what everyone had expected. Food and energy prices fell sufficiently to offset increases elsewhere, especially in health care costs. Unfortunately the CPI has now fallen 2.1% since this time last year, which, while not unusual in a recession, is not a trend we want sustained for long: the threat of prolonged deflation is too damaging to be viewed without alarm.

The enormous slack in the economy provides businesses with no room for price increases; commodities are generally in good supply relative to the now low levels of demand and so their prices are not under great pressure; and labor costs are still falling. All of which suggests that prices will be quiescent for a while longer.

Overall I doubt inflation is a concern any time soon – until well into next year. This is despite the huge flood of money that the Fed has pumped into the economy over the past year. Most of that extra cash is now sitting as excess reserves held by banks at the Fed – it hasn’t found its way into the economy by way of credit growth. As long as that cash sits in the vault it represents no threat of inflation. But nor does it help us re-ignite growth. The Fed’s dilemma next year, or maybe in 2011, will be how to suck that cash out of the economy so as to prevent sudden uptick in prices.

You will read plenty of panicky stories in the financial press about the risk of inflation stemming from the enormously lax Fed monetary policies of the last year – pay them little or no heed. The people who are now worried about inflationary expectations driving up long term interest rates are ‘fiscal hawks’ – they are not focused on the depth to which the economy has plunged and the gap that has now opened up between actual activity and potential activity. My advice is to focus on that gap: until we have worked off the slack in the economy, that is until factories are humming, jobs are abundant, and workers are hard to find because they are all employed, inflation will be a theoretical rather than actual threat. Over a five year horizon I see rising inflation along with rising taxes to rein in fiscal deficits. Over the next two years though I don’t see inflation as much of an issue – not yet anyway.

So the week ends on a weak note. The optimists still cling to a vision of a recovery sufficiently robust that it self-sustains and thence accelerates. My view is that the recovery is less secure: until consumers are a firm footing with debts well covered, jobs safe, and wages growing, the economic engine will continue to sputter. As I reported yesterday: the entire GDP growth later this year can be attributed to the effects of the stimulus and an inventory correction. This means that the private sector is falling well short of the kinds of activity we need for a sustainable recovery to emerge.

This really does have all the makings of a jobless recoveryso we may well need more stimulus this fall.

The prospect for that is not good. Let’s hope that the next few weeks brings a turn about in consumer sentiment. Then we can look forward to 2010 with more optimism.

Addendum:

A brighter note:

Today’s release of real incomes shows a slight uptick in weekly wages from June to July. The growth came entirely from longer work hours as factories increased output to restore inventories. This is exactly the kind of impetus that the more optimistic analysts use when they forecast a self-sustaining recovery taking hold later this year. This evidence supports their case, let’s hope it continues.

More interesting in today’s report is the fact that wages increased 0.1% from July 2008 to July 2009. This looks very poor until we factor in the drop in CPI I mentioned above. Take the two together in order to arrive at inflation adjusted incomes, and real wages – which in theory are the measure we should be looking at – rose a decent 3.5% [ don’t add the CPI to the wage growth number: there is a separate CPI-W for wages, which deflated a little more than the overall number!] . This provides some extra hope that consumers will start to feel better about the future.

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Inflation: Not!

I don’t want to spend much time on this, but we should take a quick look at the inflation figures that came out this morning. Inflation doesn’t exist. The Consumer Price Index rose a paltry 0.1% in May after having been flat in April. Over the past year prices have actually declined 1.3%. That’s not inflation, that’s deflation. Duh. While I admit that the entire decline is due to the 27.3% drop in energy prices, even if we back that effect out inflation is only 1.8% for the last year. Let me repeat: inflation is not a problem.

Consider this: the Federal Reserve Board is currently targeting inflation to stay in the 1.5% – 2.0% range. So the 1.8%, ex-energy, since last May is right in line with where we want to be.

Also: the spread between inflation adjusted and non-inflation adjusted yields on government bonds is currently running at around … 1.8%. That means the market is anticipating the Fed’s ability to keep inflation within it’s desired range.

So all the recent blather about the ‘potentially devastating’ inflationary impact of all that government debt we are printing in order to save ourselves from slipping into depression is just that. Blather.

Yes bond rates have risen. They are now back closer to a more normal range. They were previously in an extraordinarily dire and unsustainably low range. Getting back to ‘normal’ is a good thing. We should reserve our panic mode for when they rattle on up. If they do. Which, given the extremely depressed nature of demand in the economy, I highly doubt we’ll see this year. I feel that I am compelled to repeat myself: pumping gobs of money into an economy operating miles from capacity, as is the case with the US circa 2008/2009 does not automatically translate into inflation. I realize that standard macroeconomic text books warn otherwise. But they are wrong. You can pump the monetary base from here to the moon and back and inflation won’t budge. We are stuck in a liquidity trap. The folks getting agitated about the inflationary consequences of current monetary and fiscal policy are totally off-base. These are not normal times. I wish they were, but they are not.

Did I make that clear?

And we should keep our critical powder dry for the big things. Like lambasting half hearted and lame bank reform.

I’ll get to that later today.