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.


  1. I think you make a good argument that inflationary fears are overblown. However, I think you're wrong in assuming that because they're overblown, they didn't scare market participants into acting irrationally, leading to a major selloff.

    1. You're apparently claiming to understand what happened. Market participants were "scared" and they "acted irrationally," resulting in an observable outcome: "major selloff." So if you can understand the phenomenon, I'd say it's rational. Why do you want to call it irrational?

    2. I should add that there is good theory that backs up the idea that rational actors can coordinate on observations that have no fundamental bearing on economic activity. But, the belief that these things matter is actually self-fulfilling.

  2. It's surprising to me how many news outlets are trying to explain stock price movements by the wage-price mechanism or potential short-run nonneutralities of monetary policy - it's as if they think stocks are valued only because of the dividends they are going to pay next year and long-run effects don't matter. Is the Fed funds rate being 25 bps higher than it would be otherwise for one or two years really causing stock prices to fall by over %6 today? I wonder if any of the authors of these articles ran this story through any reasonable model to see if they could get such a quantitatively significant effect out of it.

    At the same time, long maturity TIPS yields have been going up, and in a very simple Gordon growth formula setting the rise in implied future real interest rates is actually enough to give a response of stock prices that's in the right ballpark - taking dividend growth = %3.6 and the equity premium R_e = %6 gives a %4.8 decline in stock prices from a rise in the risk-free rate from %0.55 to %0.7 (the change which is implied by 10 year TIPS yields) which leaves the equity premium and dividend growth unchanged. This kind of effect in real business cycle models is consistent with a transitory negative supply shock, which at least has the benefit of being an explanation that's logically coherent even if it's false.

    I think perhaps we should be explaining Neo-Fisherism to people by asking them what would happen if the Fed targeted TIPS spreads or CPI futures at a specific level, and then reminding them that as long as monetary policy can't affect real interest rates, targeting a nominal interest rate is the same as targeting CPI futures directly in terms of policy outcomes. I know you've tried to give the asset pricing intuition in the past, but I think this direct analogy might be helpful for people who absolutely can't abandon their static IS and Phillips curves.

    1. I like that. If real yields are rising, that's a good thing, as it would reflect a relaxation in the future scarcity of safe assets. Why would that be projected to happen? Maybe because of an expansion in future government debt outstanding. But neo-Fisher logic says that this implies lower inflation in the future, so that Fed will have to make up for it with further increases in the nominal interest rate target. But the movement in the five-year TIPS yield, for example, isn't that much - maybe 25 basis points since the middle of last year, so it's not a big deal. But, as you say, discounting into the indefinite future could give you a large stock price decline. Though it's not clear why the market decides to take all the decline in a couple of days.

    2. Increases in the real interest rate on inflation-indexed government bonds may not necessarily imply an increase in inflation given a Fed funds rate target, because as you've said in the past the Fed funds rate is an unsecured lending rate - it's not clear if you target the Fed funds rate at %2 and the liquidity premium on government debt falls, there's a commensurate increase in the "risk-free rate" which is not contaminated by credit risk or safe asset shortages. I suppose an expected future easing of collateral constraints could still lead to higher expected consumption growth and higher "risk-free rates", so in that case neo-Fisher indeed says we should expect lower inflation for a given level of the Fed funds rate.

      I agree it's not clear why the market takes the decline in a couple of days - normally this would happen if the relevant information was revealed over the course of a couple of days, but I'm not sure what that information is in this case.

      There's one thing I never understood about the wage-price mechanism crowd: if the recession was indeed caused by sticky wages not keeping up with a deflationary shock (an "aggregate demand" shock) and real wages were too high, then recovery from a recession should be associated with falling real wages (or real wage growth slower than productivity growth), i.e nominal wage growth below inflation + productivity growth for some time. Why are people then surprised that nominal wage growth is slow during a recovery with a monetary policy regime of inflation targeting (not price level targeting or NGDP level targeting, under which things could be different)? That's exactly what their theory predicts, and yet the Quartz article describes the phenomenon as "confounding" and says it led people to question "the central tenets of monetary economics", one of which is apparently the wage-price mechanism.

      It's a mystery...

  3. I read the narrative more about interest rates going up which via standard discounting would lower the valuation of stocks. Most coverage stressed that growth prospects are strong, so I took this as more about the denominator than the numerator of a PDV calculation. Of course this story plays fast & loose with nominal vs real rates, so it's not clear it hangs together. But IF -- a big IF -- higher (nominal) wage growth signaled higher real rates that would do it.

  4. What a Fed Funds rate of 1.50% means is that the value of $1.00 today is equal to the value of a promise by a Fed member bank to pay $1.000041096 tomorrow. Accordingly, targeting an interest rate produces a system governed by one equation with two unknowns, and therefore an indeterminate real value for the dollar. Indeterminate systems can "run away" into inflation (like 1979 - 1980) or deflation (like 2008 - 2009).

    Worse, when the Fed began paying "interest on reserves" (October 9, 2008), they destroyed their existing monetary control system (indeterminate though it was), and they still have not realized that they had done this. In a macabre way, this is a good thing, because the Fed is raising the Fed Funds rate to fight inflation when we are actually in a deflation.

    As of about 12 PM EST today, the Dow was down 6.55% from its January 26 high. However, the Dow divided by the CRB Index was down by only 3.29% from the January 26 close. I consider the CRB Index (used as a price index) to be a good measure of the real value of the dollar, so only about half of the decline in the Dow since its peak has been "real," with the rest being caused by a rise in the value of the dollar, which is the denominator for all dollar prices.

    I suspect that the "real" decline in the Dow is the result of market fears that the Fed will do something damaging with their broken, indeterminate monetary control system. Given history, these fears are well founded.