What should we make of current market signals?
For those foolish enough to pay attention to my predictions, here are a few thoughts on the current condition of the economy. First the data:
1. Stocks hitting all-time record levels.
2. The yield curve un-inverting, back to a normal slope.
3. But 2-year yields remain below 3-month yields.
4. Five-year TIPS spreads at 1.87% (implying PCE inflation closer to 1.62%.)
The TIPS spreads might be slightly biased by risk premia, etc., but overall I suspect that inflation expectations actually are below 2%, say in the 1.7% to 1.8% range, over the next 5 years.
The most interesting data point is:
5. A roughly 88% chance of a rate cut by January 2020, according to the fed funds futures.
Update: That seems to be an error on my part. CME Fedwatch lists a 70.7% chance of a rate cut.
Here I think it’s important not to obsess over a single data point, but look at the set of data as a picture that describes a complex scenario. Here’s my view:
The stock market clearly doesn’t expect a recession. That’s probably the least controversial thing I’ll say. Thus the strong expectation of a rate cut by 2020 is motivated by something other than recession fears. (At least I got that right back in December!) My best guess is that the fed funds futures market and the TIPS markets are seeing the same thing—“lowflation” is a real issue, under-appreciated by the Fed.
Now let’s go back to stocks—why isn’t lowflation a problem for stocks? Let’s start with the fact that while academic economists like me worry about the impact of lowflation on policy credibility, it doesn’t matter all that much to hard-headed investors, who don’t much care whether inflation averages 1.75% or 2.0%, as long as it’s associated with steady NGDP growth.
Then recall that most recent recessions were triggered by tight money policies aimed at restraining high inflation. And yes, that includes the 2008 recession. The markets now see the Fed in a long drawn out battle against lowflation, which means that we’ll likely go many years before the Fed would institute the sort of tight money policy that typically triggers a recession.
In other words, they see a sort of goldilocks economy, with the Fed consistently trying to nudge PCE inflation up from 1.75% to 2.0%. They see the rate cut that they anticipate in 2020 as being analogous to the 1995 rate cut, which paved the way for 5 golden years of growth.
Of course the markets may be wrong, but that’s my best guess as to what they anticipate. And since I’m a market monetarist, that’s also what I anticipate.
There are worse things than 5 more years of the Fed struggling to push inflation up from 1.75% to 2%, and I’ve lived through plenty of them. Cast your eyes over to Europe, described in this memorable line by Wolfgang Munchau:
It says a lot about the eurozone economy that it reached the top of its business cycle with short-term interest rate at -0.4 per cent.
File that under “very good sentences”.
To add insult to injury, the Fed is having a June conference aimed at improving its already fine performance, whereas the Europeans don’t seem to have a clue as to what went wrong with the euro. Sad!
PS. Hint: The problem with the euro is not the lack of a eurozone-wide fiscal policy, which would never work, it’s the failure of the ECB to maintain adequate growth in NGDP. In other words, the stubborn Germans and the enlightened European liberals are both wrong. I’m afraid there’s no hope for Europe.
PPS. I have a new 7-page policy brief at Mercatus that explains the basics of monetary policy. It’s basically for beginners.
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29. April 2019 at 11:35
Very good post. ECB is clueless.
29. April 2019 at 14:25
Nice policy brief, Scott.
Draghi surprised me in a positive way, at least now and then, considering Scott’s correct analysis: an extremely difficult political environment with extremely stubborn Germans and all those European liberals that are basically pretty extreme socialists.
Nevertheless you can read a hundred thousand TDS articles in the media but hardly any article that criticizes Merkel, Schäuble, Weidmann, and this whole bunch of European “liberals”, especially not at the same time. But Trump is the bad guy. Take Trump’s incompetence, multiply it with 100, and you get the European Union.
29. April 2019 at 16:04
I think Scott Sumner will have jinxed the US economy by using the word “Goldilocks.”
The use of the word “Goldilocks” is a certain reverse Midas Touch.
29. April 2019 at 18:54
https://www.project-syndicate.org/commentary/stalling-growth-revives-monetary-finance-proposals-by-adair-turner-2019-03
worth reading
30. April 2019 at 02:29
“Fed explores another version of QE
Federal Reserve economists, like the respected St. Louis Fed’s David Andolfatto and Jane Ihrig, have floated the idea of a “standing repo facility” which would allow banks to exchange Treasuries for reserves.
The plan would get banks to hold fewer reserves, and thus would help the Fed in its quest to shrink its balance sheet.
There’s considerable support for the plan, but critics say it could represent more dangerous tinkering with financial markets.”
—30—
You know, we are talking about blips on computer chips being traded around. Is there a nexus between real output and hiring and this above operations? Where does the rubber hit the road?
30. April 2019 at 04:24
You’re quite right not to obsess over some of the recent data. The two most recent points of low inflation data aren’t statistically significant and might be revised anyway. The path of inflation is still well within any forecast model error range.
I do take the Fed Funds Futures seriously and do suspect money is still too tight, but not enough evidence to make an empirical case for that from a conventional perspective. A real GDP slowdown was widely expected. From a conventional macro perspective, nothing interesting is happening.
From the perspective of expectations-based, ZLB-related pseudo multiple equilibria, however, the next several months to few years could be very interesting. Falsifying evidence is possible, though because it’s an expectations-based hypothesis, it can be slippery.
30. April 2019 at 05:02
Apologies if this is a stupid question, but what is wrong with “lowflation”?
30. April 2019 at 09:27
I bet someone in the Trump apparatus would have nominated you for the FED eventually but you kinda blew it with your 1285 TDS posts. Sad!
30. April 2019 at 09:56
Ewan, The Fed chose a 2% inflation target because they felt that a lower rate would risk occasional deflation and a zero rate trap.
Christian, Why do you think I did all those posts? Mission accomplished!
30. April 2019 at 14:23
Too bad. Reference to a “Trump Appointee” would have made family gatherings more entertaining.
30. April 2019 at 21:08
Q1 Employment Cost Index up 2.8% y/y.
That means a even a mere 1% increase in productivity brings unit labor costs down below 2% up y/y.
As we speak, labor costs are a drag on the Fed’s putative 2% inflation target.
And the labor force is expanding—maybe even rapidly.
Out of four adults taking a job, three were not previously in the labor force!
Labor force participation rates are rising (and disability claims are falling). We can expect higher real pay and greater variety of jobs will continue to expand the labor force. After all, if most jobs are not manual labor, then retirement at age 65 is not mandatory. Higher pay will surely attract greater labor force participation.
What sort of econo-sadists would not embrace such results?
I mean, outside of the Fed?
1. May 2019 at 00:03
Do we think there is a zero rate trap?
I vaguely recall from decades ago an argument for a steady deflation target (when there is productivity growth). Is this a thing (or a figment) and has it been refuted?
1. May 2019 at 04:16
Great post
“In other words, the stubborn Germans and the enlightened European liberals are both wrong. I’m afraid there’s no hope for Europe.”
Would this colour you view on Brexit?
1. May 2019 at 07:41
Ewan, In a technical sense there is no zero rate trap. But under current Fed procedures it makes policy less effective.
Sales, No, because the UK is not a part of the Eurozone
1. May 2019 at 08:40
The UK is not part of the Eurozone, but the Eurozone is very much what the EU is about, and a template for how it operates. Why would anyone not want to reform the EU, which can only happen after a shake-up. Otherwise, it’s distinctly undemocratic ordo-liberalism versus throw-back nationalism, with no knowing which will win.
“Under current Fed procedures…” – so much the worse for current fed procedures.
2. May 2019 at 04:30
Scott writes very clearly, as the Policy Brief demonstrates. Very useful for interested amateurs such as myself.
2. May 2019 at 05:22
I understand that the UK is not part of the Eurozone but the ECB is far from being the most dysfunctional of EU institutions. Your (accurate) comments don’t seem to be a ringing endorsement for membership of the EU, let alone the Eurozone.
3. May 2019 at 08:09
5 years is the new transitory.
5. May 2019 at 08:08
I agree with critics who say the EU tries to do too much.