Hey Fed, you’re steering the ship

TravisV sent me to the latest TIPS spreads, which are downright scary if you believe the Fed should actually try to hit its inflation target:

5 year TIPS spread = 1.34%

10 year TIPS spread = 1.66%

30 year TIPS spread = 1.82%

Keep in mind that even if the Fed were on target for 2% CPI inflation, the 30 year spread will usually be a bit over 2%, because long term there is more tail risk of high inflation than deflation.  The 1.82% figure is worse than it looks.

And it’s even worse.  The Fed is actually targeting PCE inflation, which tends to run about 0.3% below CPI inflation, so those spreads actually reflect about 1.04%. 1.36% and 1.52% PCE inflation expectations.  That’s dangerously close to a position where the Fed could lose credibility.

Why then are they planning on raising interest rates?  They seem to be relying on flawed NK models that suggest tight labor markets cause higher inflation.  And they notice that unemployment has recently fallen to 5.3%, and may decline further.

But these NK models are simply wrong; low unemployment does not cause inflation.  Rather unexpectedly high inflation (when caused by demand shocks) causes low unemployment. And monetary policy drives inflation.   The NK models have causation reversed.  The Fed is acting like a bystander waiting for the economy to bring inflation on line, whereas actually the Fed determines inflation.  But to do so they need to ease monetary policy when they are likely to fall short of their target.

In fact, the labor market will eventually adjust to any inflation rate, at least within reason.  If the Fed steers the economy towards 1.4% long run inflation, wages will adjust and unemployment will naturally fall to the natural rate.  There is nothing that will automatically move inflation up to 2%, unless the Fed does something to make it happen.  And raising interest rates in September or December is not the “something” that will get those TIPS spreads up where they need to be.  It won’t just happen; the Fed must make it happen.  They should cut the interest rate on bank reserves from 0.25% to zero.  Tomorrow. There’s your “normalization”, IOR was 0.00% for the first 95 years of the Fed, until October 2008.  How’s that positive IOR working out for you?

Is 1.3% or 1.5% inflation actually that bad?  Not necessarily, but what is bad is a monetary policy that is not steering nominal GDP in a direction consistent with the Fed’s announced goals.  If they can’t get this right, how will their policy have any credibility in the next recession?  Won’t we go back to the old failed policy of procyclical inflation during the next recession?  I hope not, but I’m seeing nothing out of the Fed that gives me any assurance they’ve learned their lessons from the past recession.

PS.  The Fed’s apparent willingness to raise rates in the next few months proves that market monetarists were right in the 2009-13 period.  It wasn’t that the Fed was out of ammo; they simply had an excessively conservative policy target.  If our critics were right (that the Fed wanted to do more, but was out of ammo) then the Fed would not be contemplating a rate increase with these appalling TIP spreads, which are similar to the bad old days of the Great Recession.

PPS.  Michael Darda sent me an excellent paper from the San Francisco Fed:

Slowing down a boom in house prices is likely to require a considerable increase in interest rates, probably by an amount that would be widely at odds with the dual mandate of full employment and price stability. Moreover, the Fed would need a crystal ball to foretell house price booms. In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable.

The Fed tried popping the stock bubble in 1929.  It “worked.”  Once is enough. Please, no more bubble popping.



63 Responses to “Hey Fed, you’re steering the ship”

  1. Gravatar of Kenneth Duda Kenneth Duda
    6. August 2015 at 12:13

    Nice post Scott.

    What I found frustrating about the Fed paper you linked to (on interest rates and house prices) is that the paper pre-supposes that there was a housing bubble. Kevin Erdmann (http://idiosyncraticwhisk.blogspot.com/search/label/Housing) argues that the behavior of house prices was entirely reasonable. House prices didn’t rise because of bogus sub-prime lending to people buying houses to sell them to a greater fool later! They rose because of the combination of supply constraints, expected rent inflation, and low interest rates. So there was no bubble. The Fed succeeded in reducing house prices all right, by killing the real economy. If that’s a victory, I’d hate to see a defeat.

    In my mind, one good argument against having the Fed pop bubbles is that most people have no idea, even ex post, which price movements are “bubbles” that ought to be “popped”.


    Kenneth Duda
    Menlo Park, CA

  2. Gravatar of Jason Smith Jason Smith
    6. August 2015 at 12:17

    1% PCE inflation 5 years out is *exactly* in line with the information equilibrium prediction:


  3. Gravatar of marcus nunes marcus nunes
    6. August 2015 at 12:31

    @ Ken Duda
    Another take on the house price “bubble”:

  4. Gravatar of E. Harding E. Harding
    6. August 2015 at 12:33

    “If our critics were right (that the Fed wanted to do more, but was out of ammo) then the Fed would not be contemplating a rate increase with these appalling TIP spreads, which are similar to the bad old days of the Great Recession.”
    TIPS spreads during the Great Recession fell under .5%. Not even close to today.

  5. Gravatar of ssumner ssumner
    6. August 2015 at 12:49

    Ken, Yes, Kevin has done great stuff on that.

    In my view the first bit of the housing downturn was related to the crackdown on immigration. But after that it was tight money.

    Jason, Interesting!

    E. Harding, I should have been more specific. Yes, they actually went negative for a brief period in 2008. I meant they are the sorts of rates we typically saw during the lean years of 2009-13

  6. Gravatar of John Hall John Hall
    6. August 2015 at 12:53

    This is precisely why the presumed September rate hike doesn’t make any sense.

  7. Gravatar of Kevin Erdmann Kevin Erdmann
    6. August 2015 at 12:53

    I see Kenneth is spreading the word for me. Thanks, Kenneth.

    Kenneth is right. Isn’t it weird that they don’t mention rent? As if financial securities have value that is completely unrelated to cash flows? It’s crazy how common this is.

    Second, they treat home values as if they are a product of demand, managed through mortgage rates. As if assets don’t have some intrinsic value, which is itself a function of interest rates?

    Then, they treat long term interest rates as if they are a function of short term rates, moving in the same direction. This seems, to me, to ignore the very important distinction between short term rates that are following natural rate fluctuations vs. those that are active reflections of policy.

    Further, the idea that rates could even move that far seems to ignore the zero lower bound. In the 1970s, when inflation was nearly 10%, it was possible for the yield curve to invert by several percentage points, but in 2004, with “Core minus shelter” inflation around 1%, that was not possible.

    So, the result of this analysis is that they are assuming a linear, positive relationship between short term rates and long term rates, to create the supposed effect on home prices. But, the Fed could not have actually pushed long term rates to the 7-8% range that the paper seems to point to by raising short term rates. The premise of the paper is not in the set of possible outcomes.

    Using treasury rates instead of forward rates confuses this issue, because part of the increase in long term treasury yields comes from the portion of those bonds that are short term cash flows. If we look at forward rates, they have generally been falling for 30 years. Normally, the Fed is slightly behind the natural rate, and long term forward rates climb when short term rates begin to rise. But, in 2004, forward rates continued to fall. The flat 20 year treasury rate was a combination of rising short term discount rates and falling long term discount rates.

    Looking at this from a Fed-centric, demand-side lens, it looks like rates needed to be raised even higher in order to cut demand for housing. But, what it really was signaling was that the demand-side model with positively correlated yield curve movemements was not applicable.

    Here’s a post with some of those rates:
    The graph includes 3 rate hike periods. Look at the difference in long term yields in 2004-2006 compared to the others.

  8. Gravatar of LK Beland LK Beland
    6. August 2015 at 13:31

    Say that one believes that there is a housing “bubble”. If so, I would argue that this “bubble” is in large part caused by widespread government intervention in the mortgage debt market.

    Having one arm of the government (the Fed) use a policy that affects the whole economy to counteract a policy enacted by another arm of the government (e.g. the FHA) that targets a specific sector seems completely crazy to me. If one wants to pop “bubbles” one should ask the FHA to stop subsidizing loans, rather than ask the Fed to restrict the money supply to the whole economy.

  9. Gravatar of marcus nunes marcus nunes
    6. August 2015 at 13:47

    @LK Beland
    A good example of using a shot gun to kill a fly is given by the BoE in late 1999 when one of the reasons for hiking interest rate was an ongoing house price boom in the SE of England (London-Dover corridor). They never considered that local prices were rising due to a strong inflow of frenchmen ~running away~ from 60% MTER in France, compared to 40)% in the UK.

  10. Gravatar of foosion foosion
    6. August 2015 at 13:52

    Unemployment hit 3.7% in December 2000, without ensuing massive inflation. Why would anyone believe 5.3% represents tight labor markets, especially in light of employment compensation growth?

    The Fed will raise rates because the Fed wants higher rates. There’s nothing in the data that suggests raising rates makes any sense. There is pressure from the tight money crowd, the same group who have been predicting soaring inflation for years.

  11. Gravatar of Steve Steve
    6. August 2015 at 14:16

    I see Marcus already posted here, but for some reason didn’t like to the best explanation for the Fed’s desire to raise rates.


    A Tentative hypothesis is that of the 12 regional Fed presidents, 10 have never voted for an increase in rates! And some of them are voting members this season (which has three more meetings to go).

    What’s that saying? When you get the ball in the endzone, act like you’ve been there before!

  12. Gravatar of Major.Freedom Major.Freedom
    6. August 2015 at 15:22


    For the millionth time, the amount of the TIPS spread is not a forecast of future price inflation.

    As I pointed out last year or the year before, inflation index bonds like TIPS contain an implicitly option the value of which makes the present value higher.

    An investor who expects say 5% or 10% price inflation could very well accept a TIPS bond that is priced to yield 2%. And that additional demand itself slightly raises the price, lowering the yield somewhat further.

    The fact that the 10 year TIPS spread is presently less than 2% does not, contrary to Summer’s confusions, imply “low price inflation as far as the eyes can see.” It could very well imply the exact opposite.

    Never reason from a price change, bwahahaha!

  13. Gravatar of Rajat Rajat
    6. August 2015 at 15:55

    Scott, could you please step through your argument a little slower for me..

    Are you saying that if NGDP continues at (say) 4% pa, UnN will eventually fall to its natural rate (say 4.5%) and inflation will not rise. Then UnN should stay at the natural rate unless there is a demand shock (ie change in NGDP growth). If there is a positive demand shock which causes unanticipated inflation, that could push UnN down below the natural rate; and the reverse applies. If this is right, it is consistent with your comment that prices can rise even with a slack labour market (such as in 1933-4). But I thought you also said that how a given NGDP increase is shared between real growth and inflation is a function of the slope of the AS curve? How can both ideas be true? I need some concrete steppes here.

    I’m also interested in what happens at the natural rate of UnN if NGDP continues at 4%. Would the tightness of the labour market lead to wages growth rising from 1-2% to around 4% (assuming a stable wage share)? If that’s right, are you then saying that such a rise in wages growth would not lead to or ’cause’ higher inflation unless there is subsequently a positive demand shock? If that’s right, I think that what’s going on is that most people use the difference between the actual UnN rate and the natural rate as a proxy for the likely slope of the AS curve. When you’re at a point on the AS where it becomes very steep, even a small increase in NGDP (say from 4% to 4.5%) could simultaneously cause a rise in inflation and fall in UnN, which is what they want to avoid. On this view, while it’s wrong to attribute causation of inflation to the labour market, the labour market acts as a proxy or coincident indicator of the sensitivity of inflation to changes in NGDP. If that’s right, isn’t it understandable that people start to fear inflation when the labour market tightens?

  14. Gravatar of benjamin cole benjamin cole
    6. August 2015 at 15:59

    My guess is that the criminalization of robust housing construction in the exact places where there is housing demand plays a much larger role in house prices and inflation then generally recognized.

    Not much housing inflation between the coasts – – – does that mean the Fed is too tight?

  15. Gravatar of bill bill
    6. August 2015 at 16:32

    Normalize IOR ASAP!

  16. Gravatar of Kevin Kevin
    6. August 2015 at 16:48

    @Major.Freedom ???

    You are confusing spreads and yields.

    Treasuries are currently priced to higher yields than TIPS, meaning that any demand that pushes down TIPS yields will actually raise spreads, holding Treasury yields constant.

    They’re about as good as it gets for inflation expectations

  17. Gravatar of Ray Lopez Ray Lopez
    6. August 2015 at 17:22

    The man funding Sumner believes there was no bubble (all evidence to the contrary), like Erdmann says. Then again a ratex type once wrote the Dutch Tulip Mania was rational (since the tulips were rare at the time). Sumner politely demurs, saying Erdmann has ‘great stuff’ (dog, bite, hand, feeds, theme). Sumner then implausibly PS-es that the Fed’s popping of a bubble in 1929 led to the Great Depression (most historians feel not, that other factors played into this, and arguably the GD was the result of structural changes and 1929 was the camel straw). Sumner also believes in an Austrian-type ‘natural interest rate’, which of course cannot be empirically tested and, like velocity in the quantity theory of money, can change over time, making it meaningless. Can you imagine entrusting 17.4T+ economy to these people? Luckily money is neutral so all their crazy schemes are likely to result in nothing much.

  18. Gravatar of ssumner ssumner
    6. August 2015 at 18:34

    Kevin, Excellent post, but one question. How do you calculate those equity returns, which run a bit over 10%?

    LK. Good point.

    Foosion, Agreed.

    Steve, Excellent!

    Rajat, You asked:

    “Are you saying that if NGDP continues at (say) 4% pa, UnN will eventually fall to its natural rate (say 4.5%) and inflation will not rise.”

    Nope, I’m saying that the TIPS markets are telling us that the Fed will fall well short of 4% NGDP growth over the next decade. If they do get 4% NGDP growth, I think they will hit their 2% inflation target, indeed they’ll exceed it.

    On 1933, I’d say that you can have inflation with high unemployment, but the unemployment rate will probably be falling, as was the case in 1933–it’s a level/growth rate distinction.

    I can sort of accept using the unemployment rate/natural rate gap as a proxy for the slope of the AS curve, (although it’s tricky to get this right), but my point is different. You start the analysis with monetary policy, which leads to inflation and NGDP growth (which will be 3% in my view.) Then from that you go to the labor market, where unemployment gradually falls to the natural rate, at any stable inflation rate. So there’s no reason to expect the unemployment hovering around the natural rate to lead to higher inflation over time.

  19. Gravatar of Rajat Rajat
    6. August 2015 at 20:02

    Thanks, Scott, that helps.

  20. Gravatar of Bonnie Bonnie
    6. August 2015 at 20:26

    I’d like to see which NK models these might be before blaming them for absurd monetary conduct. Though I was criticized for labeling the current monetary regime as arbitrary and capricious, at least you’ve shown here that it certainly isn’t about inflation (which certainly is no surprise to this reader) or that sometime holy grail of central bank credibility that we heard so much about during the Great Recession. Those things obviously only apply on the upside of the CPI. If the current monetary conduct isn’t arbitrary or capricious, or both, then it certainly is baffling.

  21. Gravatar of Kevin Erdmann Kevin Erdmann
    6. August 2015 at 20:34

    Scott, thanks.

    First, I begin with the Flow of Funds report. I use nonfinancial corporate profits after tax, divided by nonfinancial corporate equity values. Then, I divide nf corp. interest expense into an inflation portion and a real portion. The principal on fixed interest nominal debt declines in real terms over time, so the inflation portion of the interest payment is really a debt repayment, if we think about it in real terms. So, I add the inflation portion of interest payments to the profit.

    Aswath Damodaran at NYU publishes expected corporate growth rates back to 1960. Part of the real expected yield of equities comes from expected real growth. So, I add Damodaran’s growth estimates, adjusted for inflation to that.

    If 10%+ seems a little high, it could be for several reasons, including:

    1) forecast growth rates might tend to be slightly optimistic, so realized yields over time may be slightly lower than this.

    2) this includes all nonfinancial corporations, so there is probably a bit of a liquidity premium on the valuations for small firms that are included in the data. This would make the returns slightly higher than, say, the S&P 500. This seems to be a persistent effect among publicly traded small caps. To the extent that there are private firms and micro-firms in the FoF data, this added return would be even higher than we see among public small caps. So, some of that return may not be available through public stock markets.

  22. Gravatar of ssumner ssumner
    7. August 2015 at 04:57

    Thanks Kevin.

  23. Gravatar of Brian Donohue Brian Donohue
    7. August 2015 at 06:19

    Good post, good comments.

  24. Gravatar of Benny Lava Benny Lava
    7. August 2015 at 07:21

    Scott, is this suggesting that money is tightening and we are setting ourselves up for a contraction?

  25. Gravatar of Neil Neil
    7. August 2015 at 07:42

    There appears to be some cross currents in the data. The labor market data are consistent with 5% nominal GDP. Aggregate hours are up 2.7% over the last year while hourly earnings are slightly above 2%. Income growth is flowing to the private sector.

  26. Gravatar of Pras Pras
    7. August 2015 at 08:23

    Prof. Sumner….what are your thoughts on Jeb Bush’s claim that he can get us to 4% real growth on structural changes alone?. I think it’s pure fantasy for a developed nation.

  27. Gravatar of Liberal Roman Liberal Roman
    7. August 2015 at 08:53

    Yellen has been a huge disappointment in my opinion. I was really hoping that she would breakthrough against the FedBorg and strongly indicate that there is going to be no rate rises until inflation picks up. I guess that was too much to hope for.

    Now we most hope that she is at least as strong as Bernanke and changes the Fed tone when the markets start dropping. At least Bernanke was humble enough to listen to the markets.

  28. Gravatar of Liberal Roman Liberal Roman
    7. August 2015 at 09:06

    Scott, you haven’t done a post in Japan in awhile. Would like your thoughts on the lack of any sustained improvement in their economic situation particularly as pointed out in this article:


    The best quote:

    “As noted consistently when discussing Japan, the effect of QQE is actually enormous but in the “wrong” direction; making Japan quite relevant and important as an almost pure dissuasion against monetarism.”

    As a devoted monetarist, I must say that Japan, at the very least, shows the enormous difficulty in changing inflation expectations after 20 years of 0% inflation.

  29. Gravatar of What´s wrong with macro (and the Fed) in two short sentences | Historinhas What´s wrong with macro (and the Fed) in two short sentences | Historinhas
    7. August 2015 at 09:34

    […] From Scott Sumner: […]

  30. Gravatar of Ariza Andres Ariza Andres
    7. August 2015 at 09:40

    Investors require higher yield for holding relatively less liquid TIPS, so the breakeven inflation may be low relative the inflation expectation. Your whole story start on a point easily debatable.

    TIPS spreads probably arent downright scary…

  31. Gravatar of TravisV TravisV
    7. August 2015 at 09:44

    I think George Selgin might have said something about this recently……

    Mark Calabria: “Rules versus Discretion: Insights from Behavioral Economics”


  32. Gravatar of LK Beland LK Beland
    7. August 2015 at 09:57

    In Canada, long-term inflation expectations are at 1.62%, the lowest in at least 60 months. Monetary policy is (too) tight.

  33. Gravatar of Kevin Erdmann Kevin Erdmann
    7. August 2015 at 10:13

    Scott, I don’t know if you looked at the post I linked to in my comment on forward rates. I think treasury rates can be tricky because they include both short term and long term rates. Forward rates give a more pure picture of far-forward market expectations about monetary policy, I think.

    Part of my argument that monetary policy was too tight for the entire period of the 2000s is that forward rates were level until 2004, then declined when the Fed began raising short term rates. This is unusual. In the graph I link to below, notice how forward rates were rising in the previous periods where the Fed Funds rate was rising. But forward rates fell in 2004 and 2005.

    They have also risen and fallen with each QE. Now, they are lower than ever. Forward 10 year, 10 year rates are about 3%. They were nearly as low as 2% in January. Note that the Fed was signaling a summer 2015 rate hike then, so the main change in practical policy since then has been a push back in time of the expected first rate hike. Now that the expected rate hike is starting to stabilize, it looks like forward rates are starting to pull back.

    After today’s labor report, short term rates went up a little and forward rates collapsed by about 10 basis points. If the Fed pushes through rate hikes and forward rates fall in response, and the Fed doesn’t change their policy as a result, we could be in for a shit storm.

    I am cheating in the graph by treating treasury rates as zero coupon rates, to make the computation reasonable, but I think this is still a decent approximation of trends in forward 10 year, 10 year rates.


  34. Gravatar of ssumner ssumner
    7. August 2015 at 12:43

    Benny, My guess is that we’ll have slow growth.

    Pras, As dictator he could do it (mostly via immigration), but not as President.

    Liberal Roman, That article’s all wrong. Falling real wages is exactly what you’d expect from easy money, if wages are sticky. And of course Abenomics has led to higher inflation and lower unemployment than before. So I don’t see how anyone can claim it failed. The yen went from 78 to 125 to the dollar, that’s a pretty big move.

    The Japanese government is not committed to 2% inflation. It’s much easier to achieve your target if you are committed to doing so. Top officials in the Abe government are talking about reducing the target to 1%. Any country serious about 2% inflation would do level targeting. So I don’t think it’s hard to do, just that Japan isn’t trying very hard.

    Ariza, Yes, that’s possible, but the TIPS spreads have been falling rapidly, and the 30 year bond yield is under 3%. Clearly the markets do not expect 2% inflation going forward. But why would they, when wage growth is only 2%?

    Thanks Travis,

    LK, Where is money not too tight? I suppose South America perhaps.

    Kevin, I agree that money is currently too tight, but I think it was pretty good from 2000-07, when NGDP growth was close to trend.

  35. Gravatar of Dustin Dustin
    7. August 2015 at 14:48

    The paper is a good read. Surely you enjoyed this line in particular “house prices reflect the interaction of demand and supply rather than just one or the other.”Before reading this blog, and even kinda’ still, I would’ve though it strange that we need to be reminded so often of this very basic concept.

    RE: inflation, TIPS, etc… Depending on adjustments and methodology, PCE may be near or in excess of 2%. http://www.dallasfed.org/research/pce/

    Frankly, I’ve no idea which of the umpteen inflation variants is most appropriate. Sometimes it seems like some folks will take the measure that validates their opinion.

  36. Gravatar of Kevin Erdmann Kevin Erdmann
    7. August 2015 at 16:21

    GDI started collapsing in mid 2006. 1Q 2006 was the last quarter with annualized GDI growth above 4.5%.

    I agree that policy was fairly neutral in 2003-2004. But it seems to me that those forward rate movements in 2004 and 2005 suggest that forward NGDP markets would have been signaling to loosen by late 2005 or at least mid 2006.

  37. Gravatar of Major.Freedom Major.Freedom
    7. August 2015 at 16:56


    “You are confusing spreads and yields.”

    No, I am not confusing TIPS spreads and yields.

    TIPS spreads decreasing implies TIPS yields decreasing. We can take a low TIPS spread as interchangeable with low TIPS yields.

    “Treasuries are currently priced to higher yields than TIPS, meaning that any demand that pushes down TIPS yields will actually raise spreads, holding Treasury yields constant.”

    But Treasury yields are not constant with respect to what affects TIPS bonds. If TIPS yields change then so do Treasury yields, since Treasuries prices are also influenced by inflation expectations, although less so than TIPS bonds because unlike TIPS bonds, treasury coupons do not rise and fall with inflation. They are fixed.

    “They’re about as good as it gets for inflation expectations.”

    Yes but my point is not that they are not useful or not the best for inflation expectations. My point is that the nominal yields (or spreads) cannot be theoretically interpreted as direct inflation expectations. Since TIPs bond coupon payments rise when (measured) price inflation rises, an investor who expects price inflation to rise to 5% or 10% may very well agree to pay such a high price now that that the calculated yield in the present, with the coupons set with present inflation of less than 2%, is only 2%.

    Imagine a particular job in 1920 Weimar, just before the hyperinflation, that will give raises in exact accordance price inflation.

    Imagine in 1920 your inflation expectations for the next 5 years were bang on correct, that annual price inflation within a few years will reach hundreds of millions of percent inflation per year.

    What is your incentive here in terms of what wage rate you are willing to accept NOW, given other workers are vying for the same job?

    You might very well bid such a low price that you live in poverty in the next year. But then after that, your wages will skyrocket.

    But if we take the wage rate you accept NOW, the supremely low wage rate, a cursory observation of the superficial aspects of your wages rates may lead you to say that whoever bids and wins the lowest wage rate, expects price inflation to be very low in the future. After all, normal orthodox theory tells us that higher inflation should cause higher prices in the present.

    But because the wage rate for this job is linked to inflation, the price that exists could very well be set by people who expect runaway inflation.

    The same principle exists in the pricing of TIPS bonds. Low TIPS yields do NOT necessarily suggest low expected inflation. Now the investors might very well expect low price inflation, but we can’t know this by reasoning from prices of TIPS bonds.

    Never reason from a price change!

  38. Gravatar of Major.Freedom Major.Freedom
    7. August 2015 at 17:06

    Kevin, sorry I meant to say the TIPS yield and Treasury yields can be interchangeable, not the spread, which you are right are inversely proportional.

    This is what I had in mind:


    The yields move roughly in tandem.

    Lower spreads and lower yields do not imply low price inflation.

  39. Gravatar of TravisV TravisV
    7. August 2015 at 20:21

    Lars Christensen’s latest has some awesome graphs:


  40. Gravatar of TravisV TravisV
    7. August 2015 at 20:24

    But David Beckworth’s latest might be even better!

    To read it, google “The Monetary Superpower Strikes Again”

  41. Gravatar of TallDave TallDave
    7. August 2015 at 21:05

    The Fed can now read in the TIPS that the Fed is expected to miss the Fed’s target.

    I feel like no one would believe this as fiction.

  42. Gravatar of Kevin Erdmann Kevin Erdmann
    7. August 2015 at 22:25

    TallDave, what’s crazy is that, as far as I can tell, they are doing what most economists, financial traders and analysts, and regular citizens from the left and the right want them to do.

  43. Gravatar of Derivs Derivs
    8. August 2015 at 03:33

    “Treasuries prices are also influenced by inflation expectations, although less so than TIPS bonds because unlike TIPS bonds, treasury coupons do not rise and fall with inflation. They are fixed.”

    I think you got that backwards. A long 3% fixed 30yr, if we went to 10%inf would be a bloody disaster. The TIP at 1% would now price like an 11% coupon, when you could probably be getting no better than 13%. Not fun, but not the burial that the fixed 3% would have taken against a now 13% 30yr.

    I remember someone here once asking about a TIPS model. I made a rough and dirty arb model that day, and that model currently shows 30yr TIPS spds about 6bps from Fair Value. Model average diff from FV over last 5 yrs was only 17bps and almost always was inside of 30bps. That is with me knowing that if I built in the inherent 0 strike option, it would be more stable and even closer.

    All looks fine to me.

  44. Gravatar of TravisV TravisV
    8. August 2015 at 06:22

    Have any market monetarists addressed this recent Cochrane post in detail yet? Nick Rowe, maybe? I’d love to read Glasner’s take on it……

  45. Gravatar of TravisV TravisV
    8. August 2015 at 06:23

    Sorry, here’s the link to that Cochrane post:

    “Mankiw and Conventional Wisdom on Europe”


  46. Gravatar of ssumner ssumner
    8. August 2015 at 07:02

    Dustin, Yes, that’s good.

    Kevin. “Collapsing” is too strong, NGDP growth was still decent up through 2007.

    Travis, I strongly disagree with Cochrane on Europe. In a world of sticky wages the meter analogy is misleading. The disaster is exactly what Milton Friedman predicted.

  47. Gravatar of Major.Freedom Major.Freedom
    8. August 2015 at 07:10


    “A long 3% fixed 30yr, if we went to 10%inf would be a bloody disaster. The TIP at 1% would now price like an 11% coupon, when you could probably be getting no better than 13%.”

    Right, but how would a TIPS currently at 1% be priced if inflation actually goes to 11%? Given the coupons are going to skyrocket, the price would have to fall.

    But what I am saying is that before that happens, they will fall less on average because of the tacit option.

    Investors still have expectations about inflation, and so if investors expect 10% inflation, and they know the coupons on the TIPS will correspondibly increase to 10%, they would be willing to pay a premium for that privilege. But this is in the present, when inflation is currently sub 2% and thus lower coupon payments.

    You are talking about after the fact, which I agree.

  48. Gravatar of flow5 flow5
    8. August 2015 at 08:45

    The price level collapses in Dec. And the Fed won’t stop it as it would skew R-gDp’s growth.

  49. Gravatar of Kevin Erdmann Kevin Erdmann
    8. August 2015 at 09:29

    Maybe it’s a little strong. But, my point is that GDI gives an earlier signal than NGDP. By the end of 2006, cumulative declines in relative GDI growth were below any previous non-recessionary periods.


    Did you look at the Fred graph where I estimate forward rates, which dropped, anomalously, during the first year of Fed Funds rate hikes in 2004-2005? Aren’t forward interest rates an indicator of monetary policy stance?


  50. Gravatar of Kevin Erdmann Kevin Erdmann
    8. August 2015 at 09:34

    I suggest looking at that GDI graph with the end date set at the end of 2006. Then imagine the question in real time: Here is what GDI growth looks like. Given that the yield curve has been inverted for a year, does this look like a recession indicator?

  51. Gravatar of Dan W. Dan W.
    8. August 2015 at 09:45

    Scott, you observe that NGDP growth was still decent up through 2007. Not only that but through August 2008 the annual inflation rate was above 5%.

    “The July level of 219.964 (1982-84=100) was 5.6 percent higher
    than in July 2007.” – http://www.bls.gov/cpi/cpid0807.pdf

    “The August level of 219.086 (1982-84=100) was 5.4 percent higher than in August 2007.” – http://www.bls.gov/cpi/cpid0808.pdf

    What would have been the inflation rate in late summer 2008 if NGDP had not slowed? 6% 8% 10% Would such a report have been politically acceptable? How would the bond market have responded to such a report? What would have happened to the rates on adjustable loans?

    It appears to me the Fed failed at navigating a “safe landing”. You have every right to criticize what they did but there is no way you or anyone can claim to have done better. I assume you are familiar with the term “Monday morning quarterback”? It applies to more than just water cooler talk about Sunday’s football game.

  52. Gravatar of Jim Glass Jim Glass
    8. August 2015 at 12:08

    but through August 2008 the annual inflation rate was above 5%.


    month/ CPI/ % change over three months/ % at annual rate.

    2008-07-01 219.016
    2008-08-01 218.690
    2008-09-01 218.877
    2008-10-01 216.995 -0.93 -3.78
    2008-11-01 213.153 -2.60 -10.80
    2008-12-01 211.398 -3.54 -14.92

    The five-month decline from from 7/1 thru 12/1 projects to deflation at annual rate of 8.8%.

    Note that the Lehman bankruptcy occurred on 9/15/2008, two months after the deflation started, and still after that the Fed declined to cut rates citing risk of inflation.

    What would have been the inflation rate in late summer 2008 if NGDP had not slowed? 6% 8% 10%. Would such a report have been politically acceptable?

    Well, if NGDP hadn’t slowed then clearly real GDP would have slowed much less — the basic point of NGDP targeting, the cost of the ‘sticky wages and prices effects’ would have been much mitigated — and the inflation rate in the fourth quarter presumably would have been significantly higher than actual deflation of -3.5% (over -14% at an annual rate) while the inflation rate for the last half of the year would have been higher than deflation of -8% at an annual rate.

    I imagine less-negative, if not non-negative, inflation rates probably would have been as acceptable as ever — certainly more acceptable than the worst shot of deflation that has occurred since the 1929-31 period.

    It appears to me the Fed failed at navigating a “safe landing”.


  53. Gravatar of Jim Glass Jim Glass
    8. August 2015 at 12:12

    Damn formatting. I wrote that through an html editor, tested it, just ran the text copy I saved through another html page, it worked again, but it didn’t work here.

    Sorry. But the substantive point remains, no matter how confused the presentation.

  54. Gravatar of Dan W. Dan W.
    8. August 2015 at 16:44


    You infer that the Fed ought to be pulling monetary levers based on monthly fluctuations. But is that a reasonable way to make policy? How does the Fed know if a number is a trend or an aberration?

    Given the lag in economic collection, analysis and reporting and given the lag in monetary changes flowing through the system the Fed will always risk being behind the curve. The idea that the Fed can always plug the monetary leak and prevent a drip from becoming a flood is a fantasy. Concerning the lag between measuring demand and supplying it the classic “beer distribution” business school game comes to mind.

    Although government has found a solution. Permanently privatize gains and socialize losses. This way banks will lend and profit and trust along the way that when the wheels fall off the bus the government will be there to make them whole. Of course one must ask, is such a system still capitalism? If not then what is it and what are the ramifications?

  55. Gravatar of ThomasH ThomasH
    8. August 2015 at 18:49

    It has been apparent for some time that the Fed does not have a 2% inflation target; it has a 2% inflation rate ceiling. (It may have a 0% inflation floor.) In between, who knows?

  56. Gravatar of James Alexander James Alexander
    8. August 2015 at 23:13

    July 2008 “Excluding food and energy, the CPI-U has advanced at a 2.5 percent SAAR following a 2.4 percent increase in 2007.”
    August 2008 “Excluding food and energy, the CPI-U has advanced at a 2.5 percent SAAR in 2008 following a 2.4 percent increase in 2007.”

    The Board were panicking badly about the wrong thing. Energy prices. If all the highly paid experts at the Fed can’t see through a headline blip then we are lost. We were lost back then. They should have been looking at financial markets and correctly panicking about something they could do something about, the horrendous liquidity squeeze/surging demand for money.

  57. Gravatar of derivs derivs
    9. August 2015 at 03:12

    “Right, but how would a TIPS currently at 1% be priced if inflation actually goes to 11%? Given the coupons are going to skyrocket, the price would have to fall.”

    I have Fair Market Value on that at about 5% for AAA paper. Current spreads between highest and lowest investment grade is about 150bps and I would expect that to widen considerably. I’d guess around 6-7% for those TIPS at that level. It wouldn’t be fun for the guy who bought the TIPS either,

    As for pricing in the instantaneous, it would not make a difference as to opinions, it just requires, for position management purposes, that one understands the difference in convexities between TIPS and regular bonds, but again, this does not effect current price as statistically ‘next’ tick remains 50% up/50% down.

  58. Gravatar of ssumner ssumner
    9. August 2015 at 07:09

    Kevin, My mistake, I looked at NGDP, not NGDI.

    The drop in forward rates was Greenspan’s “conundrum”, wasn’t it?

    Dan, Inflation doesn’t matter, and in any case a bit faster NGDP growth would have been mostly reflected in RGDP, not inflation. And the Fed should have been looking forward at inflation forecasts, not in the rear view mirror. There’s no Monday morning quarterbacking here, I was highly critical at the time. (In the late summer and fall, not early 2008)

  59. Gravatar of Pras Pras
    9. August 2015 at 07:55

    Let me know if this statement is correct: if the Feds goal is to pop any sort of bubble, housing or equities, then raising rates in this environment will be counter productive. By raising rates, they will further suppress inflation, and thus further suppress mid to long term rates, leading to lower mortgage rates and less risky equities (by comparison to returns from treasury bills).

  60. Gravatar of GF GF
    10. August 2015 at 01:49


    Inflation expectations don’t actually look too bad in models that adjust for some of the shortcomings in TIPS breakevens. See for example, the Cleveland Fed model which has 10y inflation expectations at 1.88%, 30y at 2.2%. https://www.clevelandfed.org/en/Our%20Research/Indicators%20and%20Data/Estimates%20of%20Inflation%20Expectations.aspx

  61. Gravatar of ssumner ssumner
    10. August 2015 at 07:15

    Pras, No, if their goal is to pop bubbles then I’d suggest raising rates sharply.

    GF, I don’t have a lot of confidence in the Cleveland Fed model, in any case 1.88% (which is 1.58% PCE inflation over 10 years) is still too tight.

  62. Gravatar of GF GF
    10. August 2015 at 08:29

    Hi Scott, thanks for the reply.

    Why don’t you have a lot of confidence in it?
    The steepening of its inflation expectation term structure during commodity price routs is more consistent with what you have said about the effect of oil price falls on inflation. Short term expectations crash with longer term staying stable -whereas TIPS breakevens 5-10 years out have tanked almost one-for-one with the oil price.

    Also on what do you base your confidence of a stable 0.3% gap? It has only been 0.1% since Jan 09.

  63. Gravatar of ssumner ssumner
    10. August 2015 at 11:13

    GF, In case I forget to follow up, let me acknowledge that you might be right. I had not known about the recent drop in the gap to 0.1%. I wonder if the CPI is now doing more hedonic adjustments?

    I was frustrated when I read the Cleveland Fed’s article a few years back, as they did a poor job of explaining the intuition behind their procedure. I do understand the problem with lags and energy prices, but there were other adjustments that I found poorly explained. Maybe it’s just me.

    And of course there are other things as well, such as 2% trend wage growth and 2.9% 30 year bonds. It just feels like a sub 2% inflation environment to me, but perhaps that’s subjective.

    And btw, in the 3 1/2 years since the target was adopted explicitly, the PCE is up around 4.5%, whereas it should be up 7%.

    And again, I’m far more concerned about the Fed’s lack of preparation for the next recession, than I am by 1.5% inflation.

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