Economic Models, the Bond Market, and Monetary Policy
By Arnold Kling
In a comment on this post, Bryan asked whether I should not be betting on treasury-indexed securities. I’ll answer that one below the fold.
What I have been thinking about is this.
1. In general, I do not think that monetary policy matters much. Instead, I think that the bond market matters, and the Fed plays a relatively small role there.
2. In practice, the Fed’s approach to forecasting inflation and bond investors’ approach to forecasting inflation will be similar. “Great minds think alike,” so to speak. Thus, the Fed and the bond market are likely to start worrying about inflation at about the same time. So, in 1980 we say that Paul Volcker made a difference. In fact, it could be that no matter what he did, bond investors had gotten tired of low real yields and were going to sell bonds, causing long term rates to rise. In other words, bond investors made the same mistake as the Fed in the 1970’s–they assumed that economic slack would keep inflation low. By 1980, both investors and the Fed decided that they had to change how they thought about the economy. As a result, interest rates soared.
3. Because “great minds think alike,” it may be hard to distinguish the marginal effect of monetary policy from a change in the way the “great minds” view the economic outlook.
4. Right now, a lot of “great minds” are back to 1970’s thinking, namely that economic slack means we will see low inflation. That model may not turn out to be true.I am in fact betting on inflation. Before the financial crisis, I would have described my portfolio as consisting of U.S. and international stock index funds, plus TIPS (inflation-indexed Treasuries). I have a very different portfolio now.
1. I have a very large investment in commodities. I bought oil through the exchange-traded fund USO, but I was not happy with that. That fund way underperforms actual oil, and I made only a small profit when I should have nearly doubled my money, based on the price of oil when I bought and sold. As of now, my main commodity investment is PCRIX, a mutual fund offered by PIMCO.
2. My largest stock market investment is in the Vanguard materials index fund. I call this the “anti-green” portfolio, since it seems to include a lot of chemical companies and such. However, in the last month, I have hedged this by buying the “anti-anti-green” portfolio, an exchange-traded fund, SMN, which goes up when materials stocks go down, and vice-versa. I have decided that stocks have come back plenty, and at this point I would rather have a net exposure close to zero in the U.S. market. If I miss out on a further rally, then so be it.
3. I still have some international stock mutual funds, mostly Asian.
4. I have bought some TBT, the exchange-traded fund that is short the 10-year Treasury. If you think of this in combination with the fact that I still hold some TIPS, then I am doing exactly what Bryan would dare me to do. That is, I am “long” the inflation-index bond and “short” the regular bond, which leaves me net long on inflation.
Each of these is an inflation play. Commodities are an inflation play. The “anti-green” portfolio was an inflation play, although now I am hedged out of it. The Asian stocks are a bet against the dollar, which is something of an inflation play. And TIPS plus TBT equals a pure inflation play.
If anything, I may be betting too much on my own economic views. I probably should be a little more deferential to mainstream thinking.