Be careful what you wish for

When the ECB was founded, it adopted inflation targeting with the implicit assumption that the purpose of the policy was to hold down inflation. In fact, the policy regime has mostly forced the ECB to try to raise inflation.

In 2020, the Fed adopted an average inflation targeting policy with the implicit assumption that it would be used to push inflation higher when at the zero bound. In fact, the policy may end up forcing the Fed to push inflation lower at the zero bound.

One commenter suggested that stocks were declining because of the fear that high inflation would lead to tight money. But the evidence doesn’t really support that view:

Notice that the rise in 10-year yields this year is all inflation premium, the real yield has not risen, and remains deeply negative. Nominal interest rates are rising due to the Fisher effect, not fear of tighter money. Admittedly, even real yields are not a foolproof indicator of changes in monetary policy (they can reflect growth expectations), but they are less unreliable than nominal yields. Whatever is causing the recent drop in stock prices, it is not a fear of tight money.

The real yield on 5-year bonds is even more sensitive to monetary policy than the 10-year yield, and it’s falling even more sharply:

And 5-year TIPS spreads have risen sharply, to 2.72%. That implies about 2.4% PCE inflation over 5 years, more than enough to make up for the recent shortfall.

Monetary policy is either about right or too easy; it’s certainly not too tight.

PS. Notice that people investing in 5-year TIPS are guaranteed a negative 2% annual return. But it’s even worse. They have to pays taxes on their nominal return, so the actual after-tax return is even lower. What happened to equalizing tax rates on wage and investment income?


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17 Responses to “Be careful what you wish for”

  1. Gravatar of Michael Sandifer Michael Sandifer
    13. May 2021 at 11:52

    Maybe I’m missing something, but I think the evidence you present supports my view that markets fear the Fed has put a cap on the recovery, and may even fear the Fed will overreact to these rising inflation expectations.

    Just because inflation expectations have risen enough to more than offset the most recent shortfall doesn’t mean money isn’t tight. I’ve argued it’s been tight since the beginning of the tech crash. Even if you think that’s extreme, what about the shortfall that began with the trade war?

    Also, monetary policy doesn’t even need to be tight for the markets to fear reaching the Fed’s inflation ceiling. It can even be loose, in which case it’s not necessarily bad to have such a ceiling.

    That said, unemployment is still high and inflation can only occur to the degree to which wages are flexible. Wages have to be in a position to increase to have substantial inflation, either because the economy is near at least a temporary full-employmebt level with rising AD, or because the expected inflation rate is high enough that employment is expected to blow past it’s sustainable level. We have a very temporary situation that is holding employment down for the next few months or so, after which more hiring will presumably occur.

  2. Gravatar of Michael Sandifer Michael Sandifer
    13. May 2021 at 11:58

    To clarify my last paragraph, high inflation typically begins with higher RGDP growth, even if the economy is at capacity, as wages are much stickier than output, but then wage inflation occurs and employment falls, as stickier prices rise. This is what we saw happen repeatedly during the Great Inflation.

  3. Gravatar of Michael Sandifer Michael Sandifer
    13. May 2021 at 12:04

    Oh, and I don’t define “loose”or “tight” within the Fed’s AIT regime. While it’s an improved regime, it’s still a dumb one, and it’s still vaguely defined. Average of 2% over what period, and how does it avoid being arbitrary?

  4. Gravatar of Split Rock Split Rock
    13. May 2021 at 13:09

    You say: “Monetary policy is either about right or too easy; it’s certainly not too tight.” yet hypermind is still showing below trend growth (though the gap has been closing).

    I might revise it to “Monetary policy is either about right or too tight”

    https://pbs.twimg.com/media/E1RmHw1XsAUOwa_?format=png&name=small

  5. Gravatar of ssumner ssumner
    13. May 2021 at 13:15

    Michael, The markets are forecasting that the inflation undershoot since 2017 will be more than made up within 5 years.

    Split, The Fed is not targeting NGDP growth; they have a 2% AIT. I’m judging policy in relation to their goal. That’s because if they overshoot they’ll have to tighten, perhaps causing a recession.

  6. Gravatar of Rajat Rajat
    13. May 2021 at 13:20

    Interesting – why would the real interest rate be lower over the next 5 years than the next 10, almost a whole percentage point lower? If that doesn’t reflect tighter money in the future, then it must be some sort of decline in net savings, perhaps a capital investment boom or China or other big savers moving into consumption mode? Am I interpreting that right?

    Off topic, but did you see Skanda Amarnath’s comment in the NY Times about how the recent drop in US jobs growth was not concentrated in low-wage employment, suggesting that the $300 UI supplement was not the reason? https://www.nytimes.com/2021/05/12/opinion/panicking-about-that-jobs-report-breathe-look-at-the-data.html

  7. Gravatar of Michael Sandifer Michael Sandifer
    13. May 2021 at 13:29

    Scott, catching up to a four year-old previous trend line within 5 additional years… Should the Fed expect a pat on the back for that?

  8. Gravatar of Dale Doback Dale Doback
    13. May 2021 at 13:51

    I was under the impression that the average target was going to be mostly forward looking and so based on the price level from just before the pandemic fallout, so Jan 2020. I don’t think this was explicitly stated, but sort of assumed. So, I see money as a little loose right now as the price level is back on target but expectations are too high.

  9. Gravatar of PG PG
    13. May 2021 at 18:08

    Which of the following is preferable under AIT in present circumstances:

    a year of 10% inflation followed by two years of 2% deflation

    Or

    Three years of 0% inflation?

    The former has a CPI closer to the level target after three years, but the latter seems much more in line with the price stability mandate.

  10. Gravatar of Lizard Man Lizard Man
    13. May 2021 at 22:57

    “ they have a 2% AIT. I’m judging policy in relation to their goal. That’s because if they overshoot they’ll have to tighten, perhaps causing a recession.”

    So why not just redefine it to a 2.5% AIT? Is it better to have lower inflation? I would think that having a higher inflation target would the give the Fed more flexibility, and make it easier to smooth out shortfalls and overshoots over a number of years.

  11. Gravatar of John Hall John Hall
    14. May 2021 at 03:53

    You might find the Fed’s DKW model useful for correcting TIPs yields for term and liquidity premia.

    https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm

  12. Gravatar of Michael Rulle Michael Rulle
    14. May 2021 at 04:12

    I am glad you mentioned that holding TIPs to maturity locks in a negative real yield. It has become a good trading instrument. TIPs are very counterintuitive. As a buyer has made money being long Tips.

    It is very interesting reading your thought process in real time at a time of very real uncertainty (political and fiscal) which presumably the Fed must incorporate into its own tactics to achieve its target inflation. AIT seems required——maybe it’s just a mental trick to make sure you hit your target. He has not been very specific how AIT ideally should work. But my guess is his range is 1-3—I.e his ideal Max-min.

    The headlines seem attracted to inflation porn. I may be wrong, but I did believe Powell’s target is PCE ex food and energy. As far as I can tell PCE for April has not been released—-supposedly at end of this month. But CPI ex food and energy was 3%. Headline was 4.2%. I have not seen the 3% number printed anywhere except on bea.gov. And as I mentioned recently, Powell stated before the fact the number would be artificially high due to lower prices than normal last year. Maybe that,is wrong but he said it before the fact, not after.

    My point is he seems to be achieving his objectives so far. The forward 5 year breakeven should be 2.0 not the 2.51 if the market believed him. But frankly, a 50bp difference in 5 years within the framework of AIT does not seem like much.

    In other words, I believe Scott’s view is consistent with what we observe.

  13. Gravatar of Michael Rulle Michael Rulle
    14. May 2021 at 04:36

    One other point. Or rather a confusion. Why are markets willing to buy securities with a negative real yield? One answer, which is what I would have previously believed with almost certainty is they expect inflation to decline.

    But now I think my premise is wrong. The Fed appears to be a dominant buyer. But why? Why are they buying? Is this one of the tactics to keep inflation low? That does not make sense to me.

    My question is——why is the Fed a huge buyer? The Fed’s role is to maintain stable inflation and Max long term employment.

    The standard answer is they keep interest rates low and thus help economy grow. Have no idea if that is true——but it sure does feel like price supports.

    Yes, they went heavy on QE as an emergency device in 2020 and 2007-008. But is is necessary now?

  14. Gravatar of Daniel Daniel
    14. May 2021 at 05:44

    Scott, thanks for addressing the comment in a post.

    The “fear that high inflation would lead to tight money” is the gist of what you said in this comment thread: “Split, The Fed is not targeting NGDP growth; they have a 2% AIT. I’m judging policy in relation to their goal. That’s because if they overshoot they’ll have to tighten, perhaps causing a recession.”

    If you think monetary policy is maybe a bit too loose now, then you think there’s a higher probability of overshoot-tighten-recession than those who think policy is just right now. Discounted future cash flows would do okay in an inflationary environment, but poorly in a recession (hence looking at equity prices).

    Or maybe it’s not all inflation premium (http://econbrowser.com/archives/2021/05/diverging-market-based-inflation-expectations-at-5-year-horizon).

  15. Gravatar of ssumner ssumner
    14. May 2021 at 09:25

    Rajat, I am not sure about the real interest rates. Yes, I saw the UI piece; there’s overwhelming evidence that UI is depressing labor force participation, even Matt Yglesias accepts the claim.

    Michael, Why pat them on the back for something they aren’t trying to do? You were the one who mentioned 4 years, not the Fed.

    Dale, That was also my assumption, but TIPS spreads must be viewed with caution. They are a lagging indicator.

    PG, Both would be horrible, not sure which is worse.

    Lizard, Yes, 2.5% (as in Australia) might be better, but that has no bearing on judging the current stance of policy, as they’ve opted for 2%.

    John, I’m not saying they are wrong, but I’ve never understood those models.

    Daniel, Good points.

  16. Gravatar of Michael Sandifer Michael Sandifer
    14. May 2021 at 17:52

    Scott,

    Yes, of course, I realize the FOMC may not think money’s been too tight since the trade wars began, but then it’s not exactly an institution that can be characterized as competent, now, or especially historically.

    I think looking back on this era people will be amazed that even the best countries on earth had committees that had monetary policy discretion, esspecially with such crude models and data. And to make things worse, they have Rube Goldberg policy transmission mechanisms that offer nothing, but distraction and confusion.

    We really should experiment with private money and deregulated, non-moral hazard banking. But, short of that, central banks should just use software to make subtle, real-time adjustments to the growth of the money supply in future years. In fact, abolish the “bank” aspects of what monetary authorities do. The very existence of lenders of last resort represents moral hazard.

  17. Gravatar of Nick S Nick S
    19. May 2021 at 19:42

    “ PS. Notice that people investing in 5-year TIPS are guaranteed a negative 2% annual return.”

    That ain’t true. Someone needs to review their understanding of TIPS…

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