Scott Sumner Back to Normal
By Arnold Kling
That is, he is saying things I disagree with.
1. Between July and November 2008 the Fed adopted an ultra-tight monetary policy.
2. Real interest rates on indexed 5 year T-bonds rose from 0.5% to 4.2%
3. The tight money caused NGDP growth to plunge from its usual 5% to negative 3%.
4. The AS/AD model predicts you’d get about 1% inflation and negative 4% real growth.
5. That’s what we got, therefore modern macro nicely explains the recent recession.
According to Sumner, we know that the Fed tightened because we know that real interest rates on TIPS rose. The real rate is the nominal rate minus the expected rate of inflation. Because the nominal rate did not rise, the increase in the real rate came from a big drop in expected inflation. So we know that the Fed tightened because expectation inflation dropped, and we know that expected inflation dropped because the Fed tightened. That’s too circular for my taste.
I’m also not convinced that we can read expected inflation in the TIPS market. Take right now, for instance. The TIPS market is saying that inflation is going to be low. But is that what the people who are buying gold believe? I don’t think so.
I dare you to try to tease inflation expectations out of financial markets right now. It is as if the people who believe in low inflation are buying nominal U.S. treasuries, the people who believe in high inflation are buying gold, and the two markets are not talking to one another. Why aren’t the inflation bulls shorting treasuries, and why aren’t the inflation bears shorting gold?
One explanation for financial markets is that short-term nominal interest rates are low, so that speculators are willing to try a “carry trade” in anything–gold, long-term bonds, stocks, whatever. If that’s the story, then folks, we’re really living in BubbleWorld, and you can’t read rational inflation expectations into any asset prices.