Deflation risk

by on July 26, 2013 at 3:27 am in Data Source, Economics, Uncategorized | Permalink

There is a new paper by Matthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig which serves up some very useful data, here is the abstract:

We study the nature of deflation risk by extracting the objective distribution of inflation from the market prices of inflation swaps and options. We find that the market expects inflation to average about 2.5 percent over the next 30 years. Despite this, the market places substantial probability weight on deflation scenarios in which prices decline by more than 10 to 20 percent over extended horizons. We find that the market prices the economic tail risk of deflation very similarly to other types of tail risks such as catastrophic insurance losses. In contrast, inflation tail risk has only a relatively small premium. Deflation risk is also significantly linked to measures of financial tail risk such as swap spreads, corporate credit spreads, and the pricing of super senior tranches. These results indicate that systemic financial risk and deflation risk are closely related.

The NBER link is here.  An ungated SSRN version is here.  Here is a Krugman post on high inflation becoming increasingly rare.

Ray Lopez July 26, 2013 at 3:55 am

Ah, so there’s a Great Moderation in inflation. I’ve heard that phrase somewhere before…

Andrew' July 26, 2013 at 6:45 am

Well, what about the part where we just assume that 2.5% is good?

mulp July 26, 2013 at 2:25 pm

Do you question Milton Friedman?

He is the one who made ~2% annual inflation the ideal monetary policy as the means of eliminating wage and price stickiness.

He was the one who made TIPS the companion policy to protect the unsophisticated individual saver so this inflation policy targets only wage and price stickiness.

Along with indexing tax tables, benefits.

He made me a believer back in the early 70s.

FE July 26, 2013 at 8:00 am

You could plot Krugman’s graphs with growth rates, and show them declining and converging in the 2% range. Then say that economics textbooks probably talk too much about high growth, which does not seem to be an issue in the real world.

Brian Donohue July 26, 2013 at 8:58 am

No no no no no. Potential GDP, based on 3% growth until eternity, is the Axiom upon which the Whole Edifice is built.

T. Shaw July 26, 2013 at 10:45 am

If there occurs a material degree and period of deflation, the “Whole Edifice” comes crashing down.

I have no use for Krugman’s ether-net contributions. But, I use his print stuff instead of cat litter.

Anyhow, you can’t allow the market to “pull the levers”, that’s the function of that MIT/Fed man behind the green curtain.

George Doehner July 26, 2013 at 8:18 am

Artificially inflated asset prices will eventually deflate. Almost three decades of credit emissions from central banks is not a small thing. All of that accrued growth will reverse out eventually. It either happens quickly or slowly.

Yancey Ward July 26, 2013 at 12:58 pm

I agree. All asset prices are stored consumer purchasing power. Either they deflate, or consumer prices rise to absorb it.

Ray Lopez July 26, 2013 at 8:32 am

Another factor to consider: world populations are still growing (from 7B to 10B in another 25 years) and with the US dollar the ‘de facto’ reserve currency, most of these people will essentially be buying dollars. Hence the US can afford ‘deficits without tears’ and essentially printing money is deflationary, unless the US Fed Reserve printing presses go crazy, which so far they have not. As for Krugman, he is quite wrong that inflation is due to big shocks like war. Witness for example the 70s inflation due to a simple supply shock of about 5% of GDP due to petroleum (I think it’s 2.5% now). Let’s say it was 10% just to be safe–that’s still less than the 15% the financial sector comprises of the GDP. Yet still inflation took off in the 1970s due to a spike in oil. So ‘mass hysteria’ is as important in inflation as ‘supply shocks’. Hence, as long as the US dollar is king, we’ll not have inflation, but when and if the US government tries to pay off all the Baby Boomers pensions with inflated dollars, and the world loses confidence in the dollar, it will result in hyperinflation.

Alexei Sadeski July 26, 2013 at 10:23 am

People actually believe that the ’70s inflation was caused by an oil shock???

derek July 26, 2013 at 9:16 am

Does the paper show how these swaps and option prices are calculated? My understanding is that they are backwards looking. Low inflation over the last decade or two means that there will be none for the next three decades. The computer says so. And we will sell you an option for a few basis points.

JWatts July 26, 2013 at 9:34 am

As for Krugman, he is quite wrong that inflation is due to big shocks like war. Witness for example the 70s inflation

Yes, Krugman’s post is a little odd and seems to ignore some obvious facts:

There’s a brief spike around 2008; if you look at it, it turns out to be mainly small commodity-exporting countries pushed into big devaluations by the crisis, leading to one-time jumps in consumer prices.

Followed by:
One is that economics textbooks probably talk too much about high inflation; it’s a nice pedagogical set-piece, but not something that’s a real issue in today’s world. Another is that high inflation doesn’t happen just because a country’s rulers are spendthrifts or don’t know about the Emperor Diocletian or something; it is always associated with severe political and social disruption.

His examples contradict his own following statement. Commodity exporting countries facing high inflation from a recession are not suffering from severe political and social disruption. They are suffering from the financial disruption of plunging commodity demand resulting from the recession.

Furthermore, Iceland’s problem weren’t caused by political and social issues, they were caused by monetary issue and Iceland was not a commodity-exporting country..

Dave Coyle July 26, 2013 at 9:42 am

Why would we expect the inflation risk premium to be as high as the deflation risk premium. Asset traders can easily ride inflation waves to higher values, decreasing the risk in that event. That is much more difficult in a deflationary period meaning that the price should be the higher of the two.

Sisyphus July 26, 2013 at 2:04 pm

To what extent is this difference in risk premia potentially driven by knowledge of solutions to high inflation and deflation?

For moderately high inflation, we know that the Fed can raise interest rates and otherwise slow money creation, as was done in 1979-1980, until inflationary expectations are broken. As long as the government isn’t trying to use seignorage to fund itself, which isn’t really possible for a developed economy, the impacts are big in the short term, but manageable. In any event, the solution is largely known and understood.

Based on the Japanese Lost Decade, and to a lesser extent the US experience in the Great Depression and the 1870s-1880s, we are not nearly as good at dealing with deflation as a policy matter. Throwing a lot of money into the system, as the Fed did in late 2008-early 2009, seems to stave off the worst of it, but it’s not nearly as clear how to get out of a moderate deflationary expectations path. We seem to be be able to stop the deflation with sufficient central bank intervention, but not recover the jobs and return to the prior trendline for growth afterward.

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