I have supported the various QEs from the beginning, while seeing them as limited in their efficacy. At the time, and still, I feared deflationary pressures more than high inflation. Still, recently the question has arisen whether those QEs boosted the risk of high inflation. Ashok Rao looks at options data to pull out the best answer I have seen so far:
…did the risk of high inflation increase after the Fed engaged in QE2? (Note this establishes a correlation, not causation)…
And you see two very interesting trends: the probability of high inflation (that above 6%, which is the largest traded strike) sharply increased over the latter half of 2010 and early 2011, the time period over which the effects of QE2 were priced in. This is a general trend across all maturities. While the 3, 5, and 10 year option follow a similar path afterwards, the 1-year cap is much more volatile (largely because immediate sentiments are more acute). Still, you see the probability of high inflation pic up through 2012, as QE3 is expanded.
The takeaway message from this is hard to parse. This market doesn’t exist in the United States before 2008, and isn’t liquid till a bit after that, so it’s tough to compare this with normal times. While the sharp increase in the probability of high inflation would seem to corroborate the Hoover Institution letter, that wouldn’t mean much if it simply implied a return to normalcy. That’s just a question we’ll have to leave for a later day.
What about the probability of deflation? We’ll the interesting point is that for the three higher maturity options, the probability for high inflation and probability of deflation were increasing at the same time. This was a time of relatively anchored 5 year implied inflation, but the underlying dynamics were much more explosive, as can be seen in the above charts.
There are some very useful pictures in the post, and do note the variety of caveats which Ashok wisely (and characteristically) offers. He notes also that for the United States deflationary risk was never seen as very likely, but the QEs lowered that risk even further.