It's the economy, stupid
By Scott Sumner
Here are some things that seem very likely:
1. The global stock/oil/bond yield plunge is at least partly due to expectations of slower nominal GDP growth. I know of no other economic news could explain a sudden decline of this magnitude. One plausible theory is that investors are losing confidence in the ECB, and/or the slowdown in China.
2. With the S&P now trading around 1800, a recession in the US next year seems very unlikely, albeit slightly more likely than a month ago. More likely the Fed will once again be wrong about its 3% growth forecast for “next year” for the umpteenth consecutive time.
3. Global policymakers like Janet Yellen and Mario Draghi would be able to make far more informed decisions if we knew what was happened to expectations of future aggregate demand. But because they are not willing to spend 2 million dollars setting up a highly liquid NGDP futures market, we do not have that information.
4. Monetary policy in all the major economies has tightened somewhat in the past month. However the degree of tightening may well be less than many people assume. Again, we simply don’t know, but could easily find out if we wanted to. Nobody (including the economics profession) seems to care.
Last year I was sharply criticized by many individuals for my belief that QE had not significantly depressed interest rates. They pointed to evidence that rumors of ending QE had raised bond yields. We now have pretty conclusive evidence that I was right and they were wrong. Here’s one common mistake they made:
a. We did have some pretty clear evidence that at least some of the rate increases were due to rumors of tapering. But only a small portion, not a significant portion. The rate increases occurred gradually throughout the year. Late in the year tapering was unexpectedly delayed, and bond yields fell only modestly. That was the first piece of evidence that I was right. They should have fallen sharply (if my critics were right), as the Fed restored the previous market expectations about tapering. Then German yields fell to levels far below American yields, without QE in Europe. Another piece of evidence my critics were wrong.
b. My critics missed the fact that while tapering rumors were clearly raising bond yields on a few specific days, most of the increase during 2013 was spread gradually throughout the year, and was reflecting much stronger than expected growth in the US (and elsewhere) in the second half of 2013.
c. Who was right? We now have a pretty definitive answer. Bond yields have plunged dramatically lower this year despite no “news” on tapering. Instead it reflects slowing expected global growth, just as market monetarists claimed. Most of the so-called “tapering” increases in bond yields during 2013 have been unwound.
The mistake people made was a common one, and had two parts. They forgot that more than one factor can explain a price change, and that a price change in a given day that is clearly linked to a particular news item does not imply that all the price changes that year are also linked to that news. We now know what we should have know all along, macroeconomic expectations are the dominant factor driving nominal bond yields. And keep in mind that global band markets are closely linked, so real interest rates in the US reflect not just US economic activity, but global growth as well.
The common (right wing) argument that QE was “artificially” holding down interest rates has now been blown out of the water, although anyone who looked at David Beckworth’s posts on this topic would have reached that realization several years ago.
PS. Thirty year TIPS spreads are at 2.03%. That sounds well anchored, but the Fed is actually targeting 2% PCE inflation, which is equivalent to about 2.4% CPI inflation. (The TIPS are based on the CPI, and hence TIPS spreads are usually significantly above 2%.) So long term inflation expectations do seem to be falling, and are now well below the Fed’s target. I think this reflects a modest loss of credibility, due to fear the Fed can’t handle a low rate environment with their interest targeting tools. But in fairness, they still have much more credibility than the ECB, at least for the next few years.
Ten year TIPS spreads are at 1.88%
PPS. People who have been hawkish since 2008, warning that QE would cause high inflation, really need to throw in the towel. Always remember; good economists don’t make forecasts, they infer market forecasts.