Monday, September 24, 2012

Tip-ped over

I know people, I'm the economics professor. I'm supposed to give answers instead of ask questions, but I'm afraid that all I have here is questions. Read on if you dare.

The 10 treasury bond is yielding around 1.7% (none of what follows relies on the exact values of the numbers).

The 10 year TIPS yield is around  -.7%.  So a common calculation of inflation expectations, so called break-even inflation is at 2.4%.

From this information, I arrive at two important (at least to me) questions:

(1) Is this a reasonable measure of inflation expectations and (2) If so, what does it mean about the economy?

I question (1) because of concerns about the lack of liquidity in the TIPS market, the old issues of market segmentation, and just generally because equilibrium conditions in financial markets that aren't enforced by pure arbitrage don't actually seem to hold in the data.

I did a bit of research and found a couple Fed branch bank papers on the topic (see here and here).  Both papers conclude (if I am reading them correctly) that the break-even inflation calculation of inflation expectations probably understates expected inflation!

So that leads to question 2. If Inflation expectations are above 2.4%, but the 10 year treasury is yielding 1.7%, why are people holding 10 year treasuries? Because the equilibrium real interest rate on safe securities is negative, like around -1.0%? 4 years after the crisis, risk aversion is so high that people are willing to accept a negative return for in exchange for safety? So either the supply of safe assets is very small, or the demand for safe assets is overwhelmingly high? 

If inflation expectations at the 10 year window are rising, but returns on 10 year treasuries are simultaneously falling, then the equilibrium real rate of interest on safe assets is getting lower and lower (in our case more and more negative).

Does this mean that 4 years after the crisis, people's willingness to undertake risky investments is actually falling? If so, isn't that a very bad sign for the direction of future economic activity?  The Baa seasoned bond yield is 4.9%. If inflation expectations are 3%, then the real return to capital is 1.9%?

Or does it mean somehow that the supply of safe assets is shrinking faster than the demand for safe assets is falling? Can we just blame Europe?
Or are we just making a big mistake in calculating inflation expectations?



Sam Wilson said...

Here's where I sit (and I'm in 300 bucks on a few different bets on this): Inflation-protected securities hedge against inflation, whereas a few commodities (like gold) hedge against both inflation and sovereign debt default. One market is calling for low inflation, one is calling for either high inflation or the Treasury to bust. There's one way for them both to be right.

Of course, there's more than one way for them both to be right, and there are plenty of ways for one or the other to be wrong, which is why I only put down a trio of c-notes.

Agamemnon's still alive though, so you can't tell what color my hair is yet. I hope it ain't red, I really do.

Anonymous said...

I think your "supply" argument is correct.

kebko said...

My two cents:
This is largely a demographic issue. Baby boomers are responsible for the sharp decline in labor force participation, which should not be surprising, and that is surpressing output below naive trends. And, the effects of their life cycle are pushing down real rates. There is a huge portion of the population that needs to ensure that they have income in 10-30 years, even if they have to pay for it. These things have been happening for 10 years, and we probably haven't quite hit the peak yet. Until the effect peaks, I don't expect short term real rates to get much above zero, even in recovery.
But, I am short bonds in the market now, because rates have been pushed too low, whether by the Fed or by a "darkest before the dawn" effect in market sentiment. Indicators like Commercial and Industrial Loans, for starters, have been growing at a healthy pace for some time, but investors are too focused on unemployment, which is being distorted by ultra-generous unemployment benefits which should soon come to an end.
My prediction is that (assuming extended UEI ends at the end of the year) unemployment will be below 7% sometime in 2013, although the papers will bemoan that it's just lower participation, and that both real and nominal rates and GDP will come in above the consensus.

John Thacker said...

FWIW, the Cleveland Fed, which wrote the second working paper you link, using the method in that working for estimating 10 year inflation expectations, which they have here. Their latest estimate of 10-year expected inflation is 1.32 percent (per annum).

That is lower, not higher, than the TIPS spread break even rate.. Perhaps the method would have given higher result in other time periods.

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