Holy Hockeysticks, Batman!

Somebody call algore.  Because we gots yer real hockey stick, right HERE!

Nod to Angry Alex.

 

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?

 

 

Abolish Inflation Tax

John T. Plecnik writes an interesting piece on the "Inflation Tax"

Abstract:
Inflation erodes the purchasing power of money and distorts some income tax liabilities upward, which in turn discourages savings and investment. When inflation is caused by the central bank “printing” money to fund deficit spending, it results in a transfer of real wealth from the holders of dollars or assets denominated in dollars to the government and, in normative terms, may be conceptualized as a tax. The effect of the so-called inflation tax is regressive, because low-income taxpayers often lack the sophistication or liquidity to invest in hedges against inflation.

Following the double-digit inflation of the late 1970s and early 1980s, the U.S. Treasury Department and a host of legal scholars proposed sweeping reforms to comprehensively index the Internal Revenue Code for inflation. However, their proposals were never enacted into law. Instead, Congress chose to respond to inflation on a case-by-case basis. Many of those responses, such as the preferential rate for capital gains, afford relief to the wealthy, but do little to help the poor and middle class. To counter the pernicious effects of inflation and make the Code more equitable, this article proposes an inflation tax credit. Under the proposal, low-income taxpayers may elect between (i) substantiating the average balance of their bank deposits and treasury bills to receive a credit based on that balance, and (ii) taking a standard credit based on their gross income.

We Get Letters! Euro-zone inflation...

Will C writes: I recently listened to a Russ Roberts podcast interview where you discussed inflation, among other things. I thought of your interview when I recently read that Italy was suffering from inflation. I wonder if you could answer a question - on your blog or whenever time permits - about Italy, the Euro, and inflation.

I figured that inflation would be about the same in all of the Euro countries since they have a common currency. If inflation is a monetary phenomenon how could Italy have inflation but Germany does not? Perhaps what I read is incorrect and Italy is not experiencing inflation.

The answer is not very interesting. Inflation rates do NOT differ much in the Eurozone. Maybe from a low in Germany of 1.4% to a high of 5% or 5.5% in Estonia. As for Italy? Not so much: Italian inflation is up to 3.5%, from 2.2%, but that's not really inflation.

(click for a more inflated image!)

The differences are changed in measured relative prices in the index calculated from a survey. The biggest components are housing, food, and clothing. These change at different rates (though not MUCH different) in different countries. Some of it depends on barriers to external trade, since there are no formal trade barriers within the EU.

Here is some info: In September 2011, the lowest annual rates were observed in Ireland (1.3%), Sweden (1.5%) and the Czech Republic (2.1%), and the highest in Estonia (5.4%) and Lithuania (4.7%). Compared with August 2011, annual inflation fell in seven Member States, remained stable in five and rose in fourteen.

So the "always and everwhere" bit is a matter of DEFINITION, not CAUSE. The claim is that inflation in the EU cannot be consistently greater than the rate of increase of the money supply (though as we see in the US, it can be less). But there can be changes in relative prices, which will affect measured inflation, sometimes quite sharply. Is that "real" inflation? As far as the people paying the higher prices, sure. But in terms of definition, I'd say no.

Inflation targeters: yer doing it wrong!

Recent experience has led some people to argue that central bank inflation targets should be raised above their 2% levels in order to better accommodate the problems of monetary policy at the zero interest bound.

Not so fast, say Uribe and Schmitt-Grohe in their new NBER Working Paper, "The Optimal Rate of Inflation" (ungated version available here)

The central goal of this chapter is to investigate the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary nonneutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Our findings suggest that the empirical regularity regarding the size of inflation targets cannot be reconciled with the optimal long-run inflation rates predicted by existing theories. In this sense, the observed inflation objectives of central banks pose a puzzle for monetary theory.

And then there's this:

Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero.

A paper on this topic by these authors would obviously be self recommending except that I have read it and am actively recommending it.

Merle Hazard

Merle Hazard. Arthur Laffer sings along, as Bretton Woods.

(Nod to Mike S)

Hugo Cracks Down on Inflation

Hugo cracks down on inflation.....by beating up people who raise prices.

Very clever. He can bankrupt the middle class in six months.

WHY he would want to do that is hard to say. But it is an effective policy, if that is the goal.

Two quite useful posts

on inflation

and on the "carry trade" argument we have argued about before. Angus has noted a weak dollar is not a problem, and of course that's right. But a strong dollar is also not a problem. That's why, as Angus put it, using technical economics language, "Who gives a crap about the dollar?"