What to expect if you
are expecting (low-inflation) but shouldn’t be
...and why you probably
shouldn’t be
Economists put inflation expectations
and term premium effects on treasury securities in different boxes when analyzing
the yield curve but maybe they should not.
I have had a bit of a ‘running feud’ with Fed officials as I have been
haggling with different visiting Federal Reserve officials when I have been
able to catch them in New York and query them on Fed policy, real interest
rates, and interest rate expectations. The Fed has only one position on these
things and there is a reason for it. I am convinced the reason is not just because
the Fed thinks it is right.
What is at issue here and now is
that the yield curve is getting steeper without any explanation! The Fed
asserts that term premia are rising (for some reason) but that inflation expectations
are anchored- and not a reason for this. One conjecture is that the size of the
federal deficits, political conflicts, the risk of a fiscal event, and huge
slate of bonds to be auctioned are causing investors to seek greater premia on
US treasuries.
As Peggy Lee once asked…is that all there is?
Maybe not…
The Fed is conveniently leaving itself
out of the picture (ignore that man behind the curtain…). And yet, the Fed has
allowed inflation to flare, run high, and has only reluctantly chased it, and vigorously
raised rates, then stopped suddenly, when interest rates reached the level of trailing
inflation. After letting inflation run hot,
I do not recognize this Fed rate hiking effort as a strong anti-inflation move.
The Fed wants to tout its string of 75bp rate hikes but those were essential
for the Fed to catch up after it sat on its hands for a year doing nothing as
inflation surged over its target. To cut
to the chase… I greatly suspect one of the reasons the yield curve’s term premia
are rising is the loss of Fed credibility mixed in with perceptions of higher inflation
risk because of that. The Fed of course
will not go there. My argument is below:
The Issues are…
When I have complained about Fed policy, I point out the
real Fed funds rate in the past cycle was as deeply negative as it had even
been. Sixteen of the twenty lowest real Fed funds rates since 1960 (exceptionally
low negative values) occurred in this cycle. When confronted with this FACT Fed
officials reject this argument since you need to compare the level of interest rates
to expected inflation not actual inflation from the past- so they say. Really? Well,
full points to the Fed on that academic argument. But how does that work in reality? Answer: it does not work…
Chart 1
The University of Michigan
provides several series on CPI inflation expectations five years ahead. There are two here, the mean and the median.
The mean is higher so naturally the Fed usually refers to speak of the median. You
can clearly see that inflation is much more volatile than inflation expectations
here. The CPI’s variability is over two times as volatile as the mean and nearly
four times more volatile than the U of M median. The Fed wants to argue now –
and every Fed member who gives a speech these days - reports this bromide: ‘that
inflation expectations are well anchored.’
But if you look at the history of these series, they seem to be
perpetually anchored! Especially the median! The chart here plots inflation expectations at
the time they are formed not shifted against the period five-years ahead to
which they apply. But it’s obvious that
these series do not predict future inflation well at all.
Now I am going to show you something
that is shocking!
Chart 2
This chart plots the U of M mean
inflation estimate Vs the actual CPI inflation rate at the time the U of M estimate
is formed. The greatly improved fit is achieved by plotting inflation expectations
as rankings against the CPI also plotted as a ranking over the same period. What these charts help to reveal is that the
level of inflation expected is not well correlated with the level
of current or future inflation. But when ranked, expectations are
higher when inflation is higher and with that an expectation-inflation link is
established.
What this demonstrates, in fact,
is something that can be seen in chart 1 if you look closely, that inflation expectations
are not anchored at all. Presented as rankings inflation expectations are
exceptionally high- compared to the range of values that historically it has
taken on. People who form inflation
expectations in this survey are affected by the current environment but are not
willing to be very bold in making projections…that is the Achilles heel for the
Fed.
To me this observation significantly
blunts the usefulness of inflation expectations that the Fed relies on so much.
In fact, it seems to me that it is more likely that we should conclude that
investors really do not form inflation expectations in a formal sense the way
theory assumes. Still, the ranking data strongly indicate they are aware and perceive
inflation risk as higher or lower from time to time. Because of this I believe that
it is likely that inflation risk becomes embedded in the yield curve as part of
the term premium – it’s not a separate issue. That opens the door to saying that
the yield curve is steepening because of a too-tepid monetary policy and perhaps
also for various fiscal reasons.
The Fed will not go there. I will.
I have made somewhat more detailed arguments on this topic in an article you
can read on Seeking Alpha here.
The Fed’s unwillingness to take a reasonable position
on the subject of real interest rates and its unwillingness to accept that it
made real rates exceptionally low in the post Covid period, is just a way for
it to try to avoid the blame for what is happening.
But what is worse is that the
ranking data confirm my suspicion that whether they are good or not, inflation
expectations, in fact, are formed. And they are not good because they do not anticipate
future inflation well. But the relative rise in expectations is clear and demonstrates
that investors inflation hackles are raised. That means
they may in fact be marking up inflation risk much more than the Fed thinks. That
maybe part of what the yield curve is telling you…
You can accept or reject this
argument. I put it on the table. And I think the Fed’s approach of refusing to
look at the traditional real Fed funds rate measures that have been a reliable gauge
of the tightness of monetary policy historically is a real mistake. We are
witnessing a Fed that is being extraordinarily influenced by politics. I am quite
concerned that the Fed will not talk about policy and what it has done in an
even-handed way. The Fed’s fingerprints
are all over this inflation rate and now it is hoping that inflation continues
to ratchet down. I think the inflation deceleration
period is about to slow dramatically. That will then put the Fed in a more difficult
spot with elections coming. How long can the Fed continue to pretend a soft
landing lies ahead? Maybe we should take bets on that…
