Sunday, June 14, 2009

Could it be inflation??? Or, are the vigilantes vigilant?

This week puts the BIG monthly inflation reports on tap. Do we care?

The answer is yes we do since oil prices are flaring and in the U of M report inflation began to raise people's hackles a tad. And if we care about markets we care about inflation now. But is it possible that we will get inflation or will we just worry about it?

Ken Rogoff and Greg Mankiw think we should have some inflation: inflation is your friend (a little inflation is your friend anyway). In late May these economists suggested that a little bit of inflation is just what the economy needed. The trouble is, as you can tell from the reaction in the treasury market, you can't get there from here. see number 22 for the 'inflation is our friend' skit.

Academics have the wrong model for interest rate determination in the economy. It may have worked the way they think at one point, but not any more. The market determines long term rates and while those rates are affected by short terms rates it is better to think of market expectations as setting long rates than to think of long rates as cozying up from some Fed funds rate target.

Under the belief that the Fed sets the level of rates it is possible to get the central bank purposefully or through an error in judgment creating inflation as markets, too, dumbly go along and don't spread long rates high enough over a too-low too long funds rate to forestall inflation. Models based on that sort of process are the main models for interest rate determination.

But once we admit that the market controls long rates the Fed's ability to create inflation is called to question. This is the reality I see and why I think Rogoff and Mankiw are promoting an idea whose time will never come: you can't get there from here. Oh the Fed can expand reserves and money supply can grow like crazy but if markets see it happening (and they would, of course), long yields would rise and that would choke off any growth sending the economy into recession instead of into inflation.

Of course, the bond market isn't perfect, either. But it is a second independent check on the inflation process. Of course we have had inflation even with the bond market and the Fed. But since the late 1970s and the removal of interest rate ceilings and since the experience with inflation in the 1970s and with stopping it in the 1980s markets have come alive with inflation fear. Sine then we have not seen inflation- real core inflation- get any traction. We have seen oil pump up the headline but nothing more.

In the 1980s this fear was called the reaction of the bond market vigilantes. A vigilante is someone who takes the law into his own hands and that is exactly what the bond market has done. But in this case the action implies no lawlessness. The bond market does not do this by wresting control of the printing presses from Fed but by autonomously setting the level for long term rates- without regard for the level of the Fed funds rate. The bond market has not let the Fed be solely responsible for inflation for some time. If the Fed's policies get to be what the bond market considers to be namby-pamby the vigilantes take over.

Of course it is not exactly correct to say that the bond market puts the long rates where it wants them regardless of the Fed funds rate. Rather the market assess if the Funds rate is too high or too long and deviates from its preferred level accordingly.

In any event my view is that inflation is just not happening. Markets are too wary, too closely watching the Fed, and in this environment the idea of having a little more inflation just is not going to fly.

This week's inflation reports are important but no one I know is betting on core inflation doing much of anything. We have seen oil prices spurt and jump-start headline inflation and we know where that goes. It doesn't mean the core goes along. So remember that the thing to watch is not the headline unless you want to bet on some short term market overreaction.

We know that markets are good at that. They can overreact like no nobody's business. I don't think that means we will see $150/bbl oil again soon but we could see something uncomfortable to start the inflation headline going and to spur the bond market on to higher yields. That is the real risk. That's much more real that than the risk of a lasting inflation.

No comments: