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What about the TIPS spread?

I’ve recently been asked about why I don’t put more weight on the TIPS spread, as compared to 3 to 5 years ago.  I still consider the TIPS spread a useful indicator, but there are a bunch of reasons why I talk about it less frequently:

1.  The TIPS spread does have a few biases, which need to be taken into account.  One is the lag in the adjustment of inflation-indexed bonds to CPI inflation.  In the short run, fluctuations in CPI inflation are caused by oil price fluctuations.  This causes the TIPS spread to change in the same direction as the level of oil prices, without changing the actual expected rate of inflation at all.  It’s an artifact of the lags, and this phenomenon has recently depressed the spread.

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2. I’ve known about the preceding issue for quite some time, and always took it into account when making comments.  But I’ve more recently become convinced that the risk premium is also an issue.  It seems likely that the TIPS spread slightly understates the expected rate of CPI inflation, due to the fact that conventional bonds are viewed as more liquid, and thus offer a slighter lower expected yield.  I don’t think this is a big issue, but it might bias the result by a couple tenths of a percent.

3.  On the other hand, the Fed is targeting PCE inflation, which runs about 0.3% below the CPI inflation used to adjust TIPS returns.  So the biases cut both ways.

A few years ago the problem with monetary policy was obvious.  Actual PCE inflation had been running substantially below target, and the TIP spreads were also well below the target.  In addition, unemployment was too high.

Today, unemployment is below the estimated natural rate, actual inflation has run roughly on target, and the TIPS spreads show only a small problem (at least when you adjust for the recent plunge in oil prices.)  Furthermore, wage inflation is up to 3%, as compared to 2% a few years ago, indicating increased long run support for a core inflation rate at close to 2%.  I suspect wage inflation will rise a bit more.

That’s not to say I’m completely sanguine about the situation.  While the consensus of private sectors forecasters is for 2.1% PCE inflation going forward, I believe that there’s at least a 25% chance that we still haven’t gotten inflation up to 2%, and that the TIPS spreads are correct.  So it’s something I’ll be watching.  But don’t put too much weight on the next few months inflation numbers, as the recent oil price plunge will surely lower the rate for a while.  (Back in July, the 12-month PCE inflation rate was running at 2.36%, whereas the actual underlying rate of PCE inflation was never that high–it was due to rising oil prices.)

Overall, I still believe monetary policy is roughly on target regarding inflation.  But if the data proves otherwise over the next 24 months, I’ll change my view.


A follow-up post on nationalism

A quick point about my previous post.  I regret saying this:

Perhaps Brooks is not familiar with how the term ‘nationalism’ has actually been used over the past 100 years.  It’s all about zero-sum thinking, us vs. them.

Obviously David Brooks knows more history than I do.  I should have said something like:

I wish Brooks had put more weight on how the term ‘nationalism’ has actually been used over the past 100 years.  It’s all about zero-sum thinking, us vs. them.

I really hate nationalism.  And yet while I don’t agree with what I see as his attempt to put a positive spin on the term, it was clearly well-intentioned on his part.  So I apologize for the dismissive way I made my point.

HT:  Christian List


Are the tax cuts affecting growth?

Probably, but it’s too soon to say.  Here is some (annualized) data on RGDP and NGDP growth:

2009:Q4 to 2016:Q4:  NGDP growth averaged 3.8%, RGDP growth averaged 2.1%

2016:Q4 to 2018:Q1:  NGDP growth averaged 4.5%, RGDP growth averaged 2.4%

2018:Q1 to 2018:Q2:  NGDP growth was 7.4%, RGDP growth was 4.1%


1.  Monetary policy has recently become more expansionary, especially in 2018:Q2.  This would be expected to modestly boost RGDP growth, and it did.  But NGDP growth has no effect on long-term trend RGDP growth.

2. There is a small amount of evidence that RGDP growth picked up after 2016, but it’s really only in the last three months where we seem to see significant effects from Trump policies—especially the corporate tax cut.  (I’m not interested in the demand side effects of other tax cuts, which are offset by monetary policy over any significant period of time.) But it’s still not completely clear if this growth surge is any different from 2014-15.

In my view, about 1/2 of the 0.3% initial boost to growth was due to deregulation, and the rest was due to easier monetary policy.

This year I expect a bigger growth surge due to the tax cut.  I predict an extra 1% of RGDP growth, and I also predict this growth burst will fall off sharply in subsequent years, so that the long run effect will be RGDP about 2% higher than otherwise, at most. But 2% more RGDP is a lot–well worth doing. (Here I’m referring to actual RGDP, the tax bill might slightly distort the figures by changing the way corporations report the location of economic activity.  We’ll know that occurred if Ireland’s GDP takes a hit.)

I have not factored in a major (and persistent) international trade war, as I still consider that outcome to be unlikely.

BTW, the 7.4% NGDP growth in Q2 is not likely to be sustained, according to the Hypermind prediction market (which shows 4.6%).   Ditto for real GDP growth.  I recall that RGDP growth averaged over 5% during the second and third quarters of 2014, but that was not sustained.

PS.  Earlier GDP figures were revised downwards, so the NGDP growth under the previous year’s Hypermind market was actually 4.6%, not 4.8%.  Of course the payoffs depend solely on the initial announcement.

PPS.  The employment situation is of course much less impressive.  Job growth has not increased under Trump, despite the fantastic claims of some in the media:

Trump’s policies have produced the best of all economic worlds — surging growth and employment, with little inflation and a rising dollar.

That’s simply not true:

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Love this tweet

Vaidas Urba directed me to this tweet from Vitor Constâncio, who’s term as the Vice President of the ECB just ended. Also recall Bernanke’s recent advocacy of level targeting.

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PS.  Here is the link embedded in the tweet:

The only real solution to Too Big To Fail

In a recent post I suggested that higher capital requirements might be called for if policymakers were unwilling to bite the bullet and remove moral hazard from our financial system.

The FT has a new article discussing a Treasury proposal to end Too Big To Fail, by setting up a new type of bankruptcy for big banks.  I wish them well, but remain skeptical.  In my view, the only way we’ll ever be able to remove moral hazard is with monetary policy reform.  If we can get to a policy of NGDPLT, then policymakers will no longer have to worry about the consequences of the failure of a big bank.  Unfortunately, that’s likely to take many decades, as we first need to implement the policy, and then see how it does during a period of financial distress.  Only then would policymakers begin to feel comfortable rolling back TBTF.  (And even then, special interest groups will try to keep it in place.)

PS.  The NYT has a new post showing that historians view Trump as being the worst President in American history.  That’s also my view.  Some people judge presidential performance by how the country is doing.  That’s about like judging my blogging based on how monetary policy is doing.  A couple posts I’d recommend are Yuval Levin explaining why Trump is not actually the President, in the conventional sense of the term.  He’s not qualified to be President, so day-to-day decisions are made by others.  Thus the GOP “deep state” wisely vetoed his recent attempt at crony capitalism, which would have re-regulated the coal and nuclear industry as a backdoor way of bailing them out.  The outcome was good, but Trump’s specific input into the process was destructive.  Matt Yglesias also has a good post, explaining why Trump is much more corrupt that even lots of left-of-center reporters assume.

PPS.  I have a new post on budget and trade deficits, over at Econlog.