The case for tightening is getting weaker and weaker
The recent plunge in TIPS spreads is reaching frightening proportions:
5 year = 1.09%
10 year = 1.42%
30 year = 1.61%
Yes, I know they can be distorted by illiquidity, but they are not THAT far off market expectations. And don’t forget they predict CPI inflation, which runs about 0.3% above the Fed’s preferred PCE. In essence, the Fed has a 2.3% inflation target. They aren’t likely to hit it.
Also recall that since 2007 the Fed’s been consistently overly optimistic about future growth in AD—the markets have been more pessimistic, and more accurate.
Also recall that Fed policy has a big impact on the global economy.
Also recall that the global economy seems to be moving into a disinflationary cycle.
Given that Fed tightening has the potential (and I emphasize the potential, maybe a 1 in 6 chance) of driving the global economy into a recession, and given there is basically no upside from tightening now, the Fed’s got to ask itself one question: “Do I feel lucky today?”
PS. And if China is far worse than I assume, then . . . well, look out below.
PPS: I have a new post on libertarianism over at Econlog
Tags:
28. September 2015 at 11:41
Do you have any pointers to research showing how accurate the various measures of expected future inflation are at actually predicting future inflation? For example, should we expect 95% of the time the inflation rate predicted by TIPS spreads is within 10% of actual CPI? I’m trying to figure out why the Fed’s own inflation forecasts are so out-of-line with the market forecasts.
28. September 2015 at 12:02
My question is whether this is about fear of the Fed tightening, or about weak global economic conditions. I think it is the latter, but you seem more pessimistic about Fed policy than I am.
There have been fears about the Fed tightening for several years, so why the big movement now?
28. September 2015 at 12:07
Rather than Dirty Harry you might want to cite Mary Chapin Carpenter;
https://www.youtube.com/watch?v=V0-0f8q8Jlc&list=RDV0-0f8q8Jlc#t=114
———-quote———-
Well I strolled down to the corner, gave my numbers to the clerk
The pot’s eleven million so I called in sick to work
I bought a pack of Camels, a burrito and a Barq’s
Crossed against the light, made a beeline for the park
The sky began to thunder, wind began to moan
I heard a voice above me saying, “girl, you better get back home”
But I feel lucky, oh oh oh, I feel lucky, yeah
No tropical depression gonna steal my sun away
Mmmmm, I feel lucky today
Now eleven million later, I was sitting at the bar
I’d bought the house a double, and the waitress a new car
Dwight Yoakam’s in the corner, trying to catch my eye
Lyle Lovett’s right beside me with his hand upon my thigh
The moral of this story, it’s simple but it’s true
Hey the stars might lie, but the numbers never do
———endquote———–
28. September 2015 at 12:20
Matt, I’m not certain, it’s tough to do that sort of test with such a small data set.
The Fed relies on a Philips Curve model to predict inflation–in my view that’s not a good model.
Jonathan, The slowing global economy makes Fed policy effectively tighter, as the Wicksellian equilibrium rate falls. That’s why the markets are increasingly concerned. So we are both right.
Patrick, Yes, that’s better. Pop culture is not my strong suit.
28. September 2015 at 13:02
@jonathan:
There have been fears about the Fed tightening for several years, so why the big movement now?
It’s kind of an estimated guess, based on past Fed minutes where they said that they would run ZIRP for a “considerable time” after finishing their asset purchases. Those purchases ended in October 2014, and the feeling back then was that a “considerable time” might be defined as 6 months based on a Yellen statement earlier in 2014. Further, the Fed has said that ZIRP is appropriate so long as unemployment is elevated.
Here we are 12 months into a 6 month “considerable time” countdown with unemployment at 5.1%. The Fed has focused on the calendar and unemployment rate as the triggers for rate hikes rather than inflation, so people think a (nominal) rate hike is coming soon.
28. September 2015 at 13:19
Scott:
Sorry, I read this part:
“Given that Fed tightening has the potential (and I emphasize the potential, maybe a 1 in 6 chance) of driving the global economy into a recession…”
As meaning that you were worried about the Fed inappropriately raising interest rates soon, and the effect of this on the global economy.
But if by “tightening” you simply meant “leaving interest rates unchanged while the Wicksellian natural rate falls”, then we are in agreement. Though in this case, I wouldn’t say the Fed “drove” the global economy into a recession; it is rather the reverse.
28. September 2015 at 13:45
jonathan: To restate one of Scott’s frequent arguments: If a driver takes her hands off the wheel and the road curves, wouldn’t you say she “drove” into a ditch? If she doesn’t step harder on the gas when going up a hill, didn’t she cause traffic to slow down?
28. September 2015 at 14:09
Scott – I hate to sound like a broken record here (showing my age!) but the problem really is the euro. Chinese exports to the eurozone have fallen off a cliff, and thus imports to China from the emerging economies have also fallen off a cliff.
Either the Europeans need to amend Maastricht to get rid of the concept of Tier 1/Tier 2 base money, or they need to end the euro itself.
We really are at the stage where the euro is harming not just the periphery in Europe, but the entire global economy.
28. September 2015 at 14:46
I don’t understand why the Fed doesn’t simply come out and say it won’t bother hiking the Fed Funds Rate until YoY PCE core inflation is 2.0% or higher.
28. September 2015 at 16:14
I think the Fed would could improve its messaging.
There are a lot of people were confused by the comments regarding global developments. What is this mission creep?
They should stick with a message that inflation is below 2% and by all indications will remain below 2%, therefore the current level of accommodation is appropriate.
And then to come out and say that we still expect to tighten before year end is schizophrenic. Either policy is correct or it is not.
28. September 2015 at 16:35
I echo Justin D.
Why not have a target-based rule? The Fed will raise rates when inflation, as measured by the PCE, hits 2.5% for three consecutive months.
Scott Sumner is also correct to point out the entire globe is in a disinflationary environment, and possibly a deflationary environment.
In such an environment, perhaps the Fed’s target should be 4% ceiling on the unemployment rate. Why not?
In Japan the unemployment rate is 3% and they still don’t have inflation. Is there something wrong with getting rid of unemployment that I do not understand?
28. September 2015 at 18:06
Lol,
For the millionth time Sumner, TIPS yields and spreads are not market forecasts of inflation.
There are implicit inflation call options which have a value that reduces the yields and spreads.
It is quite possible for higher inflation expectations to encourage those investors to DECREASE TIPS yields and spreads by paying a higher price in accordance with the option.
It is obvious all you’re doing is grasping at straws, anything to justify your drug-like addition to more inflation.
28. September 2015 at 18:16
Sumner non-post, no information here already not beaten to death.
Why don’t Sumner tell us what happens if the Fed prints money and NGDP does not rise? When not only real variables don’t get a rise from the Fed, but nominal ones? If Sumner thinks this is impossible, he should so state for the record.
Also note how Sumner moves the goalposts: first, he says China will not collapse, then, says his range of China growth forecasts is below average, then, in this post, “And if China is far worse than I assume…” hedging his bets with a judicious ‘if’.
PS–Mary Chapin Carpenter is country, not pop, unless you think country is pop. Sumner doesn’t know pop music, but does he know economics?
“So blame it on your lying, cheating, cold dead beating,
Two-timing and double dealing, Mean mistreating, loving heart” – M.C. Carpenter
28. September 2015 at 19:33
@Ben Cole
I would reverse the question and ask: why unemployment should be the sole reason for macro policy? Since when resource utilization is the only reason there exists economic activity ?
28. September 2015 at 21:28
Ray,
“Why don’t Sumner tell us what happens if the Fed prints money and NGDP does not rise?”
Why don’t you tell me why you won’t give away your entire cash balance to charity, given that money is effectively neutral to you? It would seem that your real standard of living should be unaffected, since the only affects of money are on nominal values. What should happen is that the prices of everything you buy should drop to zero, so that you don’t have to reduce your consumption in real terms, and the prices of everything the charity buys should go up, so that they can’t increase their consumption by virtue of having the additional money you gave them.
Of course, here is where “effectively zero” and “by any reasonable measure is zero” would for some crazy reason be associated with you being dead set against such a gift.
Actions speak louder than words.
29. September 2015 at 02:51
[…] that the crowd’s managing expectations down on the outlook for inflation. Economist Scott Sumner advises that the recent slide in inflation expectations “is reaching frightening proportions.” As a […]
29. September 2015 at 03:15
If the Fed is effectively guiding NGDP along a stable path (despite claiming to do something else) and at the same time there are positeve supplly side factors shouldn’t we see the reduced inflation expectations that we see? At least in the short term.
Also if the final outcome turns out to be a stable NGDP path then inflation should not matter, right?
29. September 2015 at 06:50
@MF – you’ve jumped the shark my friend…
29. September 2015 at 07:33
Justin D: You wrote “I don’t understand why the Fed doesn’t simply come out and say it won’t bother hiking the Fed Funds Rate until YoY PCE core inflation is 2.0% or higher.”
I suspect that at least some members of the FOMC are wondering if the Zero Interest Rate Policy hasn’t been a mistake. Also, they have all got to be acutely aware of what it will cost the Fed itself to raise the funds rate back to some semblance of normal, say 3% or so.
But if ZIRP has been a mistake, possibly due to the economic damage done to savers, particularly retirees, one implication could be that we never see 2% inflation, but rather just continue the muddling along that Japan has done for over two decades now. If they do as you ask, and ZIRP was a mistake, they will essentially be saying that they’re out of the business of managing either of their mandates, prices or economic growth.
In a comment Scott asserted that he had no intention of reading my work. That’s fine with me. However, some of you might find the following deduction that I made, based on my work. I wrote it nearly 14 years ago in December 2001:
“There is no reason that we must follow Japan’s path. However, there is also no good reason why we will not. Under current economic theory, we are doing what we must to avoid it, but we are also doing the same thing that Japan did (in monetary terms) and simply expecting different results. If Japan’s economic recessions are being caused by monetary events, as I believe is likely, we might think twice before conducting an imitation of their recent policy, as we now appear to be doing.” (Page 8 from the monograph linked below.)
From A Strong Form of Monetary Theory based upon Excess Reserves and Bank Demand Deposits
29. September 2015 at 07:38
Sorry, I meant to say “…some of you might find the following deduction that I made, based on my work, interesting.”
29. September 2015 at 07:41
@Ray
If the federal reserve of the united states of America buys up all the federal government debt and NGDP did not rise, then they would have pulled off the greatest coup in monetary history. The government would have just gone debt free without a cost. That would mostly not happen.
29. September 2015 at 09:37
@Prakash–thanks for trying to defend Sumner. Consider this though: why is this a coup? Why would the Fed owning all government debt be good? It would exchange dollars, which are a form of debt (a government IOU) for another form of debt, a government bond. Recall back in the 19th century bonds, discounted, often traded like money. So the Fed flooding the market with money,and buying up all government paper, serves what purpose? It’s exchanging one form of debt for another, of different maturity (namely money is payable debt on demand, while a bond has a term and must be discounted). I don’t see the coup at all, please explain it better.
29. September 2015 at 10:04
“I suspect that at least some members of the FOMC are wondering if the Zero Interest Rate Policy hasn’t been a mistake.”
They may, but I wonder why. Since 12/2008, PCE inflation has averaged +1.6%/yr, a tad below the 2.0% target.
I look at the last 5 years and there are striking similarities to the late 1990s. A bit less job growth, stock price appreciation and inflation, but overall a similar dynamic.
Private payrolls grew 2.6%/yr in the 5 years to 8/1999 vs. 2.2%/yr in the 5 years to 8/2015. Stock prices grew 22.0% in the 5 years to 8/1999 vs. 13.5% in the 5 years to 8/2015. PCE inflation was 1.7% in the 5 years to 8/1999 vs. 1.5% in the 5 years to 8/2015.
The glaring difference is that productivity grew 2.8%/yr from 1995Q2 to 2000Q2 but only 0.5%/yr from 2010Q2 to 2015Q2, but monetary policy more or less doesn’t affect medium run productivity gains.
“But if ZIRP has been a mistake, possibly due to the economic damage done to savers, particularly retirees, one implication could be that we never see 2% inflation, but rather just continue the muddling along that Japan has done for over two decades now. If they do as you ask, and ZIRP was a mistake, they will essentially be saying that they’re out of the business of managing either of their mandates, prices or economic growth.”
I’ve been a saver over the last 7 years and couldn’t be happier. Sure, if you’ve stuck your life savings into an interest bearing savings account and have been getting 0.1%/yr, it hasn’t been great, but very few people with a lot of savings at risk fail to diversify beyond a bank account.
I don’t see how the Fed would no longer be managing to its twin mandate. They have an explicit inflation target, and if core inflation never rises above 2% then I don’t see why there would be any reason at all to change the Federal Funds Rate. A commitment not to hike rates in a low inflation environment also would still allow the Fed to ease should economic growth falter, via lower rates or QE.
29. September 2015 at 13:22
Jean, The euro was certainly a big mistake, but I think the problems in the global economy are much deeper. The yuan is clearly too strong, for instance.
Ognian, But it’s very unlikely that they are targeting NGDP along a stable path. If they were I’d agree with you, but as we saw in 2008 they are not. It’s not good to publicly announce one target and secretly try to hit another.
29. September 2015 at 16:47
Most savers did worse because of tight monetary policy. Saying interest rates should be higher so savers make more money is like saying we should increase minimum wage so workers make more money. You can increase the interest rate or minimum wage if you want, but there’s no guarantee assets/jobs will be there to pay that money.
In both cases, the market realities determine the market-clearing wage or the Wicksellian interest rate. In 2001, should Greenspan have refused to lower the interest rate below 5%, no matter what? What do you think would have happened? True, some savers would have earned 5% instead of 1% for a few years, but other than that it would have been a second Great Depression.
I’m curious about Scott’s answer to the question to. I was thinking hypothetically, but how would Greenspan refusing to lower interest rates below 5% in 2001 have looked? Certainly it wouldn’t be 5% inflation, like in most cases where interest rates track inflation. The Fed would have to sell off a ton of Treasuries and destroy a lot of money, right? So we would have deflation, but with 3% deflation and 5% interest rates, the real interest rates would be 8%. That doesn’t seem right.
30. September 2015 at 07:05
Matt, Yes, an attempt to prevent interest rates from falling in 2001 would have led to another Great Depression. And of course both savers and borrowers would have been worse off.
1. October 2015 at 08:11
Prakash, you wrote: “If the federal reserve of the united states of America buys up all the federal government debt and NGDP did not rise, then they would have pulled off the greatest coup in monetary history. The government would have just gone debt free without a cost. That would mostly not happen.”
Interesting thought experiment. Since the Fed is the government, the result could indeed be that the Fed returns its holdings to the government, canceling the total national debt.
However, the banking system would then be sitting on an “asset” of around $20 trillion of excess reserves. That asset would be money owed the banking system by the Federal Reserve, which would not be capable of redeeming it because it would then have no assets of its own, only the $20 trillion liability to the banking system. A bankrupt government would be replaced by a bankrupt Fed.
Somewhere in that process a wise banker might just decide to convert his entire excess position to vault cash, and in the end the Fed might find that currency in circulation was $20 trillion. Whatever it owed would then soon become an afterthought because that would, indeed, cause a hyperinflation, with real dollars in real wheelbarrows. (Actually, I’m not sure how it would sort out in the end, but it’s fun to speculate.)