Monday, February 5, 2018

Panic Over Inflation?

The S&P 500 has dropped about 6% since last Thursday, so people are looking for reasons why. Given the proximity to Friday's US jobs report, could there be something in there that looked like bad news to market participants? Some think this has something to do with news about inflation. For example This FT article, this one in the Guardian, and this one in Quartz piece together the following narrative:

1. Wage growth was up in the jobs report.
2. More wage growth causes higher inflation.
3. Higher inflation causes the Fed to increase its interest rate target.
4. Even with the same FOMC composition as we had last week, we might anticipate tighter monetary policy in the future on Friday's news.
5. With dovish Janet Yellen gone from the FOMC, and with a (possibly slightly) less dovish Powell as chair, hawkish regional Fed presidents voting in 2018, and the addition of hawkish Governors (Quarles, Goodfriend, and whoever else gets nominated and confirmed to the empty Governor slots) we could get four 25-basis-point interest rate target increases in 2018.
6. Higher interest rates reduce output.
7. If future output is expected to be lower, that lowers current stock prices.

Does that make any sense?

First, let's look at year-over-year increases in nominal wages, from the Friday jobs report:
So, there was a big increase in wage growth relative to last month. But wage growth is not much higher than it was two years ago. Further, if we look at the real wage (measured as the average hourly wage divided by the personal consumption deflator) and productivity (real GDP divided by total hours worked), here's what we see:
In the chart, I've normalized by setting each variable to 100 at the start of the last recession. Productivity, by this measure, has been close to flat since the end of the recession, but the real wage is still catching up to it. Economic theory tells us that productivity growth should determine growth in the real wage, and that seems roughly consistent with the chart.

And inflation (year over year PCE inflation) looks like this:
So, the Fed's preferred measure of inflation has been increasing toward the 2% target, though still falling somewhat short. Further, if we look at the PCE levels, relative to a 2% trend, from the beginning of 2007, we get the following chart:
If the Fed had been following a price level target rather than an inflation target, there would be a lot of ground to make up - relative to base period of January 2007, the PCE deflator would now be 4.5% below the 2% trend path. This reflects the sense in which the FOMC is not achieving symmetry in its inflation targeting procedure. Inflation targeting with symmetry, i.e. caring as much about positive as about negative deviations from the 2% inflation target, should achieve roughly the same outcomes as price level targeting.

The financial media seems also to be making a big deal of recent increases in nominal bond yields. For good measure, let's look at the 10-year nominal bond yield and the 10-year TIPS (inflation-indexed) yield:
So, there is a small increase in the 10-year real bond yield, and a larger increase in the 10-year nominal bond yield. Thus, we can infer that the primary driver of the increase in nominal bond yields is anticipated inflation. Qualitatively, we can see something similar at a five-year horizon, but the the increase in the five-year nominal Treasury yield is larger than for the 10-year. To summarize, the key movement is in the breakeven rate (nominal bond yield minus TIPS yield), so I'll show that for both the five-year and the ten-year Treasury yields:
So, the 10-year breakeven is above 2%, and the 5-year is under 2%, but close to it. For the Fed, this is good news, as it says that market participants expect the Fed to hit its inflation target (roughly) on average for the next five years, and for the next 10 years. TIPS are indexed to the consumer price index, which is upward-biased measure of inflation, so we might be a little more comfortable if these measures were 10 or 20 basis points higher, but this is pretty good.

There has also been some concern recently with the slope of the Treasury yield curve. Usually people look at the 10 year yield minus the 2-year yield as a summary measure, but I'll go even shorter, and look at the 10-year bond yield minus the 3-month T-bill rate:
As is well-known, the yield curve tends to be flat or negatively sloped leading a recession. One reason for this could be that monetary policy moves slowly, and the markets see a recession coming before the Fed cuts rates significantly. But the markets anticipate that the Fed will cut interest rates during the recession, and this then is reflected in long bond yields. So the yield curve flattens, or short-term interest rates might even exceed long-term rates. The slope of the yield curve right now is just short of its average in the sample shown in the chart. The average is 1.55%, while the current value is 1.38%. So the yield curve is definitely not flat currently, and if we relied on yield curves to predict recessions, we wouldn't be predicting one anytime soon.

What's the conclusion? There's not really any sign of excessive inflation in the data. There are indeed signs that inflation, and anticipated inflation, are very close to what is consistent with a 2% inflation target, for the indefinite future. So, I'm having trouble drawing any connection between the behavior of inflation, the behavior of the Fed, and the drop in stock prices.

There is potential risk in terms of monetary policy decisions, though. As I discussed in my last post, the Fed is as close as it typically gets to achieving its goals. But the FOMC has been getting up a head of steam for interest rate increases. As I've mentioned before, I think they have the sign wrong. That is, consider the following chart:
Inflation has been coming up recently, as nominal interest rates have gone up (that's the 3-month T-bill rate in the chart). That's consistent with Neo-Fisherian logic - increase the nominal interest rate if you want more inflation. Of course, inflation was low in 2014-2015 in part because of a fall in the price of crude oil. Nevertheless, some people were arguing that inflation would go down as a result of the Fed's interest rate hikes, and that certainly hasn't happened. The problem is that the Fed could continue to increase interest rates when this is not warranted, overshoot inflation, and continue to hike, thus overshooting even more. Fortunately, that's a politically difficult route to take, so I doubt it happens.