Deflationary expectations

by on October 27, 2008 at 8:59 am in Economics | Permalink

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.

1 David Heigham October 27, 2008 at 9:17 am

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.

2 Richard Squire October 27, 2008 at 9:29 am

Would someone please explain how monetary base in this graph is calculated? Is it just cash, or cash plus checking accounts, or what?

3 mw October 27, 2008 at 9:59 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.

4 fusion October 27, 2008 at 10:10 am

5 year TIPS now indicating 0.53% deflation
10 years indicate 0.68% inflation
nominal yield curve is positive, TIPS is almost flat

5 Alex Tabarrok October 27, 2008 at 10:37 am
6 Bob Murphy October 27, 2008 at 11:04 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…”

7 Eliezer Yudkowsky October 27, 2008 at 12:23 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.

8 Jorge Landivar October 27, 2008 at 12:57 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.

9 Bob Murphy October 27, 2008 at 1:23 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.

10 Tom Grey October 27, 2008 at 2:33 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.

11 guy in the veal calf office October 27, 2008 at 2:43 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)?

12 larry glenn October 27, 2008 at 3:50 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.

13 BR October 27, 2008 at 4:24 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/

14 BeerHere October 27, 2008 at 6:55 pm

BR,

The market is looking at a scenario where the United States fully engages in a world war?

15 Unit October 27, 2008 at 10:42 pm

What if the prices of housing all of a sudden start going up again? After all, we just saw oil go way up a few months ago and now go way down. Question: have we now reacted in such ways that even if the prices of houses start going up again it won’t help at all?

16 Andrew October 28, 2008 at 5:15 am

http://globaleconomicanalysis.blogspot.com/2008/06/2-trillion-reduction-in-credit-card.html
FDIC Bank Examiner Audits
From a source I consider reliable, I received this email the other day: A good friend of mine has a friend who is a Bank Examiner(BE) for the FDIC. The BE says the message he takes into every exam is “You must raise your loan loss reserves”. This is delivered directly to the Chairman, President and CFO of every bank visit, every time. No Exceptions!

This de-leveraging crisis proves that the free market is dead! hahaha (that’s my sarcasm indicator for those who don’t get it)

Question: How is recapitalization different from easing capital reserve requirements, of which relaxing mark-to-market on an interim basis a subset? I say again, these rules are intended to keep banks from getting in trouble, but the banks are already in trouble and the rules are threatening their business and the economy.

17 David Heigham October 28, 2008 at 8:12 am

Market expectations are not very consistent at a turning point? Surely it would be a surprise if they were.
Expectations inconsistent with possible outcomes are a necessary condition of booms and busts, I think. The expectations change at turning points, and this is a process which takes time. In general the more swiftly expectations return to the realm of possibility, the more swiftly the turning point disturbance passes.

Andrew
Cycle after cycle, bank examiners (in such countries as I know about) deliver this message at the downturn; even those who said as much earlier and therefore prevented some of the trouble are saying it now. It means cut your dividend; and does little damage because it does not distort earnings.

18 Tom November 20, 2008 at 11:10 pm

An alternative explanation for the TIPS to nominal Treasuries yield is that there is a currently very high liquidity premium and TIPS aren’t as liquid as nominal treasuries. In this context it is interesting to note that the Cleveland Fed has decided to stop reporting its liquidity adjusted break even inflation forecasts http://www.clevelandfed.org/Research/data/TIPS/index.cfm

19 Sword of the New World money January 1, 2009 at 9:18 pm

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