We never seem to learn
By Scott Sumner
At the beginning of 2015, we were told that growth would pick up, because plunging oil prices were “like a tax cut.” Well, they are like a tax cut, but of course demand-side tax cuts also fail to boost growth, as we saw in 2008. Growth in 2015 did not pick up, if anything it slowed.
Now we are being told that plunging oil prices are dragging down the stock market:
Stock markets around the world fell heavily Friday as investors reacted to new 12-year lows for oil prices, auto sector woes and China’s struggling economy.
Bond yields are also plummeting, as are TIPS spreads. The 5-year TIPS spread is now around 1.2%, indicating only about 0.9% for the PCE inflation rate that the Fed targets. If we had a NGDP futures market for 2016, it would almost certainly be sinking as well. And yet the Fed plans to raise rates 4 times this year, to prevent high inflation.
In fact, plunging oil prices neither help nor hurt the economy. What matters is the thing causing a price change. If it’s more supply, that’s good. If it’s tighter monetary policy (as in recent weeks) that’s bad.
Another thing we never seem to learn is that low interest rates don’t mean easy money. Kevin Erdmann brilliantly skewered that misconception in the comment section of a recent MoneyIllusion post:
Well, I guess any fears about the rate hike should be allayed now that we are getting all this stimulus from low rates at the long end!
And why don’t we have a NGDP futures market? I created one for 2015, with financial assistance from Gabe Newell, who is CEO of Valve computer games. (Actually two, with the assistance of other commenters, but unfortunately the second closed down.) But why does having essential information about the US economy depend on whether a former Bentley professor is able to raise enough money for a prediction market? Where is the Fed? Aren’t they a tad bit interested in finding out about how they screwed up? What about the Treasury? How about elite macroeconomists? Are they smarter than the markets? I predict that future generations will be stunned by how long it took to set up a system of prediction markets for key macro variables.
I guess I’ll have to try to raise money for another prediction market for 2016—I just don’t see why I am the one who has to do all the work.
Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:
1. investors’ best forecast about what inflation will average 5 to 10 years from now
2. the inflation risk premium over a horizon five to ten years from now – that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
(There’s also a liquidity premium component, but movements in this component have not been all that important in the past two years.)
There is often a lot of discussion about how to divide a given change in breakevens in these two components. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.
It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. A decline in the first component of breakevens signals a decline in this form of credibility.
Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.
But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low – that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.
Should we see such a change in investor beliefs since mid-2014 as being “crazy” or “irrational”? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines. Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large asset holdings. Isn’t it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC’s goals?
To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.
And of course the two rising forces in American politics are socialism and nationalism, both of which are anathema to stock investors. Even though their respective leaders probably won’t be elected president, the strength of their support is a harbinger of things to come.
Have a nice day!