Is inflation coming? Maybe, but probably a lot less than you assume
Since the election, there’s been a lot of speculation that we are transitioning to a more inflationary environment. That’s certainly possible, but I’d encourage everyone to take a deep breath. There are three arguments I’ve seen for this claim, and two are extremely weak, while the third is mixed. Let me start with the strongest of the three, rising TIPS spreads.
As a believe in the EMH, I am not going to discount the importance of TIPS spreads, I’ve cited them in the past. Rather, I’d like to put that evidence in perspective with a few observations:
1. As of today, 5 and 10 year T-bond yields are up 50 and 54 basis points from a month ago. That’s pretty significant. But that’s mostly real rates, which are up 32 and 33 basis points. That means TIPS spreads are up 18 to 21 basis points. That’s not trivial, but it’s also not a dramatic game changer. We’ve seen similar moves at times over the past 5 years, and not much happened.
2. In addition, the level of inflation expectations remains well under 2%, especially when you subtract 30 basis points to reflect the fact that PCE inflation (the Fed’s target) runs about that much below CPI inflation (reflected in TIPS.) This is important, because TIPS spreads (as we’ll see) are basically the ONLY evidence we have for the inflation story. And even they are not predicting that the Fed will abandon its 2% inflation target (or ceiling, as some of you would claim.)
3. While I often cite TIPS spreads, I’ve also acknowledged in the past that experts believe these spreads are somewhat distorted by shifts in risk premia. They aren’t perfect. The Cleveland Fed, among others, attempts to come up with adjusted spreads to better reflect true inflation expectations. Of course these estimates are model based, and hence are not perfect either. Please send me any recent ones you come across.
Update: JP Koning directed me to the Cleveland Fed. Their model adjusts TIPS spreads to account for risk premia. Yesterday they updated their 10-year inflation expectations estiamtes to 1.75%. Last month it was 1.69%, and two months ago it was 1.72%.
4. With some uncertainty about the accuracy of small moves in the TIPS spreads, where else can we look for inflation signals? Well, the big story since the election has been the dramatic appreciation of the US dollar. If we are to believe that Trump plans to debase the dollar through higher inflation, would you expect the forex value of the dollar to be surging higher on that information? That’s not the macroeconomics I studied in school. Indeed doesn’t the recent upswing in the dollar suggest we might get a bit lower inflation, as import prices drop?
5. In contrast, there is an alternative explanation for these events. Maybe the markets expect a dose of supply-side Reaganomics, and this is driving up expected RGDP growth (modestly to be sure, as rates are still low in absolute terms) and also driving up real bond yields and the value of the dollar. That makes more sense than the inflation story, although I’m also willing to accept a mixed claim of “0.3% more trend RGDP growth and 0.2% more inflation” as being consistent with the various markets.
The other two arguments cited for higher inflation are especially weak. One claim is that fiscal stimulus will drive up inflation. But Yellen recently shot that down—the Fed fully intends to do monetary offset, and is recommending that Trump not do fiscal stimulus. I have a post on that at Econlog. (BTW, people frustrated with my Trump derangement over here should keep in mind that I always try to put my most important posts at Econlog.)
The other reason cited is that Trump might pack the Fed with compliant pro-growth, low interest rates doves like Arthur Burns. But there are many problems with that claim. Trump would not be able to get a change in the Fed’s official mandate through the Senate. It would be highly controversial, and there are more than enough GOP mavericks and inflation hawks in the Senate to stop it. Ditto for a choice of an obvious lackey for chair of the Fed. He needs to put up a respectable name. The press has discussed two groups of possible Fed appointments. One is traditional conservatives like John Taylor and Martin Feldstein. And the other group is more heterodox thinkers like David Malpass and Judy Shelton. Neither group includes a single person who can be described as a “dove”. Does anyone seriously think that John Taylor would switch the Fed to a 4% inflation target just to please Trump?
For better or worse we are locked into a world of low inflation. Get used to it, it’s not going away. And that means that artificial attempts to generate higher wages will do nothing but slow growth and reduce employment.
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18. November 2016 at 12:37
“The Cleveland Fed, among others, attempts to come up with adjusted spreads to better reflect true inflation expectations. Of course these estimates are model based, and hence are not perfect either. Please send me any recent ones you come across.”
Here you go:
https://www.clevelandfed.org/our-research/indicators-and-data/inflation-expectations.aspx
18. November 2016 at 13:47
This “real risk premium” doesn’t make any sense to mr. The Cleveland Fed explains:
“Similarly, the real risk premium is a measure of the compensation investors require for holding real (inflation-protected) bonds over some period, given the fact that future short-term rates might be different from what they expect.”
TIPS spreads are the difference between TIPS yields and nominal Treasury yields. It seems to me that the same “real risk premium”, as described above, is embedded in both securities.
My gut says this Cleveland Fed adjustment is a step backwards.
18. November 2016 at 13:52
..or is it something like this: If inflation hits expectations exactly, holders of nominal Treasuries should enjoy a greater return than holders of TIPS, since they were exposed to an additional risk (CPI fluctuations) that TIPS holders didn’t face.
On this view, holders of nominal Treasuries should expect a slightly higher return for bearing additional risk, like Bill Sharpe would say.
Is that what people are talking about here? And the idea is that this premium changes over time?
I’m skeptical that the Cleveland Fed or anyone else can divine movements in this spread, although in a higher inflation environment, I would expect this premium on nominal bonds to increase, because the range of actual CPI changes would increase.
18. November 2016 at 14:16
Thanks JP, I added an update.
Brian, I don’t know enough about their model to comment. I certainly don’t accept it uncritically, I just put it out there as one more data point.
18. November 2016 at 15:08
Scott, if by some fantastically unlikely sequence of events, an evil version of you could be installed in the White House, and via some sort of magical powers (maybe Master Persuasion?), Evil Scott was able to get everyone at every level of Federal power to do what he wanted, which basically involved using the levers of the Presidency to enrich and empower himself, would that be inflationary? And if so, would the market predict inflation, and increasingly so, as evidence of Evil Scott’s plan became more evident?
18. November 2016 at 16:36
Good post and largely agree.
John Taylor? Gentleman, scholar…and very partisan. If Fed chair, and election 2020 looks like a toughie for GOP….maybe a little monetary looseness is in order.
Don’t forget, Taylor gushed about the effects of QE in Japan, before the topic became politicized. In his 2012 position papers for then-candidate Romney, the tight-money talk was noticeably absent. The Taylor rule can be adjusted after all.
And poor old punching-bag Arthur Burns.
Still, if Burns gets the blame…then should he also get credit for the 20% expansion of the GDP in just four years coming out of the 1975-6 recession? I remember no dramatic structural improvements in the economy in those years, which leaves monetary policy as the reason for such a robust expansion.
Remember, Burns was contending with oil spikes.
Is there a lesson in that 20% expansion in just four years?
Looking for such a lesson today might be a better angle to take on Burns than a simple bashing.
18. November 2016 at 17:00
Dr. Sumner,
I agree with the .2% inflation + .3% RGDP conclusion. Trump’s perceived disregard for environmental constraints for mining/drilling was probably worth an extra .3% in expected RGDP. Have you read up on his rumored EPA chief?
18. November 2016 at 17:46
Brian:
“TIPS spreads are the difference between TIPS yields and nominal Treasury yields. It seems to me that the same “real risk premium”, as described above, is embedded in both securities.”
There is an embedded inflation option in TIPS. This is valued, which affects the price and the yield.
It is quite possible for increased inflation expectations to affect TIPS by way of pricing the embedded option higher which reduces the yield and make it superficially appear as though expected inflation has decreased.
18. November 2016 at 18:22
On why Trump’s infrastructure plan is but a bump on a log:
http://ngdp-advisers.com/2016/11/17/orthodox-macroeconomists-prove-innumerate-bond-traders/
18. November 2016 at 20:42
So on the one hand we are told to worry about strongman authoritarian enabling act Trumpler…
But on the other hand this authoritarian is too wimpy to even remake the Fed Board of Governors?
18. November 2016 at 20:44
Randomize, I can imagine how bad he is.
And you’d need a lot more than a new energy policy to get another 0.3% of RGDP growth per year. That sounds small, but it’s Yuuuge! Currently, productivity growth’s running about 0.5%, so that’s a 60% rise in the growth rate—requiring lots of reforms in many areas.
18. November 2016 at 21:09
Steve, Yup, it’s a lot easier for a President to spy on Americans than to change the Fed.
19. November 2016 at 11:00
Speaking of David Malpass… Occasionally, I hear him on various media. I have genuinely attempted to understand his arguments. But, one of his memes is “the Fed coerced low-rate environment funnels credit disproportionately to government and big business and thus starves small business of access to credit” or some such. I really struggle to understand his reasoning. Can any one enlighten me ?
20. November 2016 at 07:36
Regarding printing money leadint to inflation, is the below logic true?
There remains the possibility that helicopter money, could in theory cause ZERO inflation. The theoretical idea behind this is that if all the new helicopter money (let’s assume about 80% of GDP) is used to pay down the total debt from 330% of GDP to 250% of GDP, then no new money is actually entering the system on net. While helicopter money is entering the system, there is (at least theoretically) a corresponding removal of money of the same magnitude as a result of debt/GDP being paid down. Stated another way, reducing leverage actually reduces total credit money in the system which offsets any new helicopter money that is printed. It is the total net change in money that matters, and in this case the net change is zero despite the massive amount of new money entering the system.
22. November 2016 at 08:21
Prof Sumner,
You wrote: “Well, the big story since the election has been the dramatic appreciation of the US dollar. If we are to believe that Trump plans to debase the dollar through higher inflation, would you expect the forex value of the dollar to be surging higher on that information?”
I think the story here is that the dollar is appreciating on expectations of tighter money (monetary offset) resulting from Trump’s plans for fiscal expansion. Perhaps financial markets either don’t buy that his supply-side reforms will reduce inflation or doubt that he’ll actually implement them.
22. November 2016 at 11:11
Fred, I agree.
22. November 2016 at 12:07
Still, if Burns gets the blame…then should he also get credit for the 20% expansion of the GDP in just four years coming out of the 1975-6 recession? I remember no dramatic structural improvements in the economy in those years, which leaves monetary policy as the reason for such a robust expansion.
Burns left office in 1978. His stewardship was poor, but the real explosion in inflation was contemporary with the tenure of his successor, Wm. Miller. There was a brief squib about Burns in The Wilson Quarterly some years back. The thesis offered by the article (which was itself a discussion of a book on the inflation of the era) was that Burns had bought into the idea that inflation was not derived from monetary policy and that monetary policy could do little about it.
Growth rates in per capita product were higher during the 1970-91 business cycles than subsequently, but they weren’t exceptional (about 2.06% per year). The most rapid advances post-dated Burns.