May 19, 2009
In Search of ... Hyperinflationary Expectations
With large budget deficits in place and projected going forward, as well as the expansion of the Fed's balance sheet, there's been some talk of inflationary pressures, and even hyper-inflation  McCain. I wondered if these fears were manifested in survey- and market-based expectations measures.
For certain, there is little pressure apparent in short term forecasts like the WSJ and Survey of Professional Forecasters. This makes sense (at least if one believes in the Keynesian conception of an output gap ) given the amount of slack displayed in Figure 1.
Figure 1: Median expected ten year inflation recorded as of second month of each quarter, from Survey of Professional Forecasters (blue, left scale), actual CBO-defined output gap (red line), and WSJ forecasted (purple triangle), in log percentage points. NBER defined recessions shaded gray; second recession assumed to end 2009Q3. Source: Cleveland Fed, BEA, GDP 2009Q1 advance release, and WSJ May survey [xls], and CBO potential GDP (9 January 2009).
I also plot the median expectation of ten-year inflation. Note that this measure has not budged much at all.
This data, of course, will not convince those skeptical of survey-based measures. What about market based measures? The standard approach is to subtract the TIPS yield from the Treasury yield. We know for a variety of reasons, this calculation can lead to misleading results. However, the Cleveland Fed has stopped publishing its adjusted series:
October 31, 2008
We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.
With that caveat in mind, Figure 2 displays the implied ten year expected inflation rate.
Figure 2: Difference between ten year constant maturity Treasury yields and ten year constant maturity TIPS, monthly data. Series GS10 and FII10. Source: St. Louis Fed FRED.
Some people are looking to commodity prices as indicators of expected inflation. I'd say that making inferences this way is fraught with difficulties, because changes in such commodity prices will incorporate both relative price and price level effects.
So, there's little evidence now of inflationary pressures. That being said, there's plenty to worry about as time goes on (as Jim recounts). And even if inflationary expectations remain well anchored, we do have to keep an eye on possible crowding out due to higher interest rates (all of us, except Dick Cheney, who didn't ever worry about deficits as the Bush Administration ran up trillions in debt ).
Posted by Menzie Chinn at May 19, 2009 09:00 AMdigg this | reddit
Not disagreeing with what you said, I think markets are underestimating the inflation threat, and I think when inflation risk finally gets people's attention, it will likely to play out as a dollar story -- and that, is probably the second shoe-drop everyone has been waiting.
Posted by: Yu'er at May 19, 2009 10:30 AM
I forgot to say that I also agree with Jim that the early signs of there being too much liquidity rushing around are likely to be in all sorts of commodity prices.
Posted by: Yu'er at May 19, 2009 10:38 AM
Given that these views have largely been expressed OTM payers or caps, looking for them in TIPs breakevens probably won't get you very far.
Posted by: Anon at May 19, 2009 10:45 AM
Menzie I think you must get a kick out of pushing the buttons of us conservatives. Nice post though. While I often use the TIPS spread, I wonder how accurate it or surveys are at actually predicting inflation.
Posted by: GWG at May 19, 2009 10:54 AM
"who didn't ever worry about deficits as the Bush Administration ran up trillions in debt "
Because Bush's deficits were miniscule compared to Obama's.
Posted by: Heterosexual at May 19, 2009 11:02 AM
But there's plenty of evidence NOW that uncertainty surrounding long term inflation forecasts is extremely elevated!
Check the individual forecasts for the Survey of Professional Forecasters during the second quarter of 2009!
Posted by: sigma at May 19, 2009 11:58 AM
Would love to know your opinion on this comment from John Hussman. He seems very concerned about inflation down the road.
I quote "The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade."
Posted by: Raph at May 19, 2009 01:11 PM
Historical Inflation from Wiki.
The chart shows that inflation tends to work itself out within five years or less. During the so called Great Moderation, one could reliably predict inflation will be less than 5%. Otherwise, predictions ten years out would be highly random, I would think.
Posted by: Mattyoung at May 19, 2009 01:23 PM
Very good quote. I agree completely and have been infuriated with the power of these bondholders to pass thier loss forward to taxpayers.
Posted by: don at May 19, 2009 03:38 PM
Why are you infuriated with the bondholders? It was the Bush/Obama administrations who had the power & did it. (Are you hinting at the huge contributions made by Goldman, Citi, etc leadership to Obama?)
Posted by: algernon at May 19, 2009 08:24 PM
The charts are a nice attempt at bringing data to the inflation vs deflation debate, but...
... shouldn't we expect that in the current cicumstances the inflationary expectations will be higly non-linear?
Either the financial system will go bust in which case a lot of people will be selling a lot of assets and we need not worry about inflation.
Or the financial system will get enough subsidy/money making opportunities and consequently high inflation will be a problem the MOMENT enough people coalesce around this view?
Posted by: Pawel at May 20, 2009 01:41 AM
After more than 200 years, the US gov't had about $5 trillion in debt. 8 years later, in January 2009, that debt had more than doubled to about $11 trillion. And you think the reason that Bush and Cheney didn't worry about it was that they could foresee that Obama was going to have a bigger deficit? Wow! Just foreseeing that a Democrat would be the successor is amazing enough, but they knew it would be Obama? That's pretty magical. In case you are interested in facts, only about $300 billion of the projected $1.8 trillion of deficit for this year (which is a budget year that started in October of 2008 - that Obama is one powerful guy, passing budgets before he was even elected) has been added by Obama. The rest is a result of the financial situation and pre-existing laws.
Posted by: bill at May 20, 2009 05:44 AM
Many do not understand the difference between economic contraction and deflation just as they do not understand the difference between economic expansion and inflation. Currently the US is in a massive contraction that followed the inflationary real estate boom. The money cranks believe that somehow massive injections of money will magically create real assets but we have a great real world example this fallacy. Since the late 1980s Japan has engaged in the most massive Keynesian pump priming of any country in the history of the world and it has not subsided. The result can be seen in last quarter's numbers. The Japanese economy declined 15.2%. http://www.bloomberg.com/apps/news?pid=20601080&sid=aESruA91JsS4&refer=asia
The contraction in the US is real and no amount of pump priming is going to create growth. Commodities are reflecting the injections of liquidity but in a contracting economy higher prices are offset by declining sales volumn and total revenue and profits continue to fall. Just ask the Japanese.
Posted by: DickF at May 20, 2009 06:23 AM
Why trifle with who was worse Cheney or Obama. A man killed by a kitchen knife is just as dead and on killed by a sword.
Posted by: DickF at May 20, 2009 06:27 AM
To me the real question in the the inflation or no inflation debate is how is the fed going to get the toothpaste back into the tube. Could the fed not crank up the reserve requirements for banks and let them do all the heavy lifting. Going from a reserve requirement of 10% to 50% would have a major effect on the money multiplier thus possibly letting them avoid inflation for the time being. With all the negative press on banks it also appears that this would be the path of least resistance. Politically speaking other than bankers who would balk at the fed for lifting the bank’s reserve requirements??? I am not saying it is the right thing to do but it does look like the easiest thing for them to do. Arguments??
Posted by: William at May 20, 2009 07:20 AM
wouldn't increasing the reserve requirement tighten lending even more? that sounds like the opposite of what the gov is trying to do. but i am definitely all for increasing reserve requirements in the long term; just not right now.
Posted by: ryan at May 20, 2009 09:29 AM
C'mon, Professor; be a gracious winner. Your candidate won, and today's jaw-dropping deficits are his creation, now.
Good to see someone in government/academia finally talking about household debt-to-income (saw on Mish):
Actually, it is about four-to-ten years too late, as it will now be terribly difficult for hoi polloi to aggressively save for the future lean times, given cratering employment.
Posted by: jg at May 20, 2009 09:47 AM
OT: CNN reports that
"Japan's gross domestic product fell 4% last quarter -- the fastest pace on record for the country, the government said Wednesday. GDP in the world's second largest economy was 15.4% lower than the same time period last year, according to figures released by the Cabinet Office."
15.4%? What is happening over there?
Posted by: Steve Kopits at May 20, 2009 10:29 AM
No, sorry I did not make that clear. I am not talking about doing it now. I am talking about down the road when/if inflation starts to become a problem. We all know what they have done to the monetary base; my question is how are they going to undo it without undoing our economy? Printing money is a cake walk; it is the taking back in that is the problem.
Posted by: William at May 20, 2009 01:38 PM
What the central bank should be doing and what it can do are two different things. When gas prices started up, becoming more price inelastic, then the banks should have been decreasing interest rates, making money more elastic. When the consumer restores price elasticity in oil, the central bank should increase elasticity of money, raising interest rates. Lower rates on the way down, raise them on the way up. Unfortunately we do not know yet if we are on the way up or down. Taylor, of the Taylor rule was quoted (if I remember) that the Fed should start to raise rates by a smidgen.
Posted by: Mattyoung at May 20, 2009 02:12 PM
Steve wrote: "15.4%? What is happening over there?"
Don't know -- but it's above expectation of -16.1%! Given that IP fell 34% yoy, this is not too surprising. The truly astonishing number is machine tool orders: in April, relative to a year ago, it actually fell
... but wait, that was an improvement from March, which was -85.2% yoy ... so ...
Posted by: Yu'er at May 20, 2009 03:00 PM
Not furious with the bondholders, who are merely acting in their own interst, but with their power to influence, i.e, with the parties you mention, in part, as well as inattention of the lectorate.
Posted by: don at May 20, 2009 03:45 PM
Make of it what you will.
The U.S. dollar slid against most major currencies Wednesday, hitting a five-month low of US$1.3775 against the euro and pushing the Canadian dollar up US1.21˘ to a seven-month high of US87.69˘.
Posted by: DickF at May 21, 2009 05:31 AM
Well, when the Fed is systematically holding the nominal rate down by buying Treasuries, the breakeven inflation spread is going to be systematically understated (since it's the Tsy yield minus the TIPS yield). I would even say irrelevant. Inflation swaps yields are higher, and well off their lows, although still pretty tepid (forward inflation measures, though, are looking a bit chippy).
Another problem with the breakeven inflation measure is that it will systematically understate inflation expectations even in normal-liquidity environments, since Treasuries often can be financed cheaply in repo and TIPS are almost never "special"...I explain that in more detail here: http://inflationinfo.com/yahoo_site_admin/assets/docs/DRM_27-36_Natixis.35672847.pdf
As an anecdote, I can tell you that I have never seen the level of interest from institutional investors in inflation-linked solutions (my company provides specialized inflation hedges). Whatever the market measures say, and whatever the survey measures say (we know, anyway, that surveys are basically lagged versions of what inflation actually was), institutional money is terrified.
Posted by: Mike at May 21, 2009 10:03 AM
The dollar continues sliding amid talk that S&P could put a negative rating watch on Treasuries. I'm sure such talk is premature, but I do see reasons to be worried about the dollar.
- During the peak of the financial panic, from last September through March, foreign official purchases of Treasuries were elevated but focused on bills (less than or equal to 1 year). Total foreign official holdings of bonds & notes (greater than 1 year) were practically flat from end-August to end-March at ~$1.7 trillion, while holdings of bills more than doubled, from $540 billion. Since China and Japan each account for ~1/3 of all foreign official holdings, they must be driving this trend. This implies a greater capacity of China and Japan to reduce their Treasury holdings without selling, by simply redeeming. China and Japan are notoriously wary of selling because of the potential damage to their holdings should the news be leaked.
- It seems increasingly evident that some of the large reserves held at the Fed (which reached $950 billion on May 20) are entering the economy. Remember that this is money that has been newly created by the Fed as part of its various anti-crisis programs that involve purchasing or lending against mortgage-backed securities, Treasuries, "toxic" derivates, etc. To the extent this newly created money sits in reserve accounts doing nothing but earning the 0.25% annual interest that the Fed now pays on such accounts, it is not inflationary. To the extent it is utilized in the economy, it is inflationary, and potentially highly inflationary - $950 billion is greater than the total amount of currency in circulation. The recent rapid decline of Libor rates, the surge in stock prices, the renewed appetite for stock and bond issues, and the surge in purchases of commodity futures, against the background of continued economic weakness, growing commodity stockpiles and continued aversion to investment in the real economy suggests that the financial system has received a major boost to its liquidity that the real economy is not able to absorb.
Posted by: Tom at May 22, 2009 01:08 AM
Tom: Please note that you have to write out "less than". If you instead use the symbol, subsequent text is interpreted by our system as an unrecognized (and therefore ignored) html code.
Use the "preview" option if unsure how it will appear.
I've corrected your entry to read as I believe you intended it.
Posted by: JDH at May 22, 2009 02:08 PM
Thanks. I get that now.
There are many reasons why surveys and markets are bad predictors beyond the short term. But anyway, "hyperinflation" is a straw man. What we should be concerned about is asset and commodity price inflation (and counter-deflation), which is one of the many things the Fed and government are doing to delay recovery. Instead of the natural shake-out and renewal process that normally accompanies recessions, we've had a broad bailout and regular injections of operating capital into lame behemoths. Instead of real "green shoots" - investment-based productivity gains - we are left hoping that we might get some re-utilization of recently idled capacity as deficit spending temporarily cushions the nonetheless inevitable decline in consumption.
Posted by: Tom at May 23, 2009 01:43 AM
"you have to write out 'less than'"
Or you can use "& lt" (without the space and the quotes); the HTML interpreter will treat the ampersand as an escape and replace the two letter code with the desired symbol: lt for <, gt for >, et al.
Posted by: Charles at May 27, 2009 01:02 PM