Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Wednesday, March 2, 2011

U.S. Inflation and Inflation Expectations

Here are a couple of slides, courtesy of my colleague Kevin Kleisen. The first depicts recent U.S. inflation, both core and headline.

So, following a rather sharp decline in the headline CPI rate, we see an even sharper increase more recently. The core measure, however, remains relatively low and stable.

This next graph depicts a variety of market-based measures of inflation expectations. You may recall that the Fed was recently concerned that inflation expectations were drifting too low (relative to the implicitly desired target or around 2%). Inflation expectations now appear to have converged to pre-crisis levels. One could make a legitimate case that to the extent this was a part of the goal for QE2, the policy was a success.

Of course, the fear that many people have is that inflation may somehow get out of control. It is a legitimate concern and one that ranks high on the list of FOMC members.

And then there are a host of other concerns, like the ones outlined here by Pimco Managing Director Bill Gross: Economy May Reverse Course When Fed Buying Ends. I especially like this quote:
"Who will buy Treasuries when the Fed doesn't?" he asked. "I don't know."

I'm sure Mr. Gross is a smart guy. But statements like that just make him sound a tad foolish.

Think about it. A USD is the equivalent of a zero-interest-bearing small denomination Treasury bill. So when the Fed is purchasing longer dated Treasuries, what is it doing? It is selling zero-interest bills for (slightly) positive-interest bills. Would a deceleration in this asset-swap activity really have the dramatic effect Gross suggests? (He is suggesting a sharp spike in Treasury yields). I doubt it. In fact, the implied tightening is likely to keep a lid on inflation expectations and hence keep nominal interest rates low (via the Fisher effect).

But we shall see...


  1. Maybe we should ask what happens when the Chinese stop buying Treasuries? 1) Interest rates rise. 2) Net Exports rise. 3) Us Domestic Saving rates rise. Is this "good" or "bad" ? No idea.

  2. Morris:

    It's probably even more complicated than this. O.K., imagine that the Chinese stop buying Treasuries. What are they going to do instead? Buy other types of sovereign debt instruments and, if so, which ones? Buy gold, or other materials? Or, instead of altering the composition of their saving, will they instead decide to redeem debt for goods & services?

    Although...now that I think about it, your (1)-(3) are still the likely result. And will it be good or bad. For those who like the idea of making Americans work hard to produce stuff and then ship it over to China, it will be good. ;)

  3. The US trade deficit with China is a mystery to me. The rate of return on Chinese investments should be much higher than US investments since China is still developing. This suggests capital should flow into China from the US, not vice-versa. Either the theory is horribly wrong, or the Chinese are taxing current consumption to manipulate trade flows -- likely the latter.

    If the Chinese ever decide to reduce their implicit tax rate on current consumption then I think 1-3 will occur. If the Chinese keep taxing current consumption, but stop saving in U.S. backed assets and save in some other kind of asset (Euro or gold or whatever), then I don't know what will happen.

  4. Morris,

    China is still not as free to development as the U.S. Not even close. Unless you are a small/medium business, you have government officials either in charge or on the board or otherwise involved in managing the company. There is not much incentive to be a noticeably large company in China unless you are politically favored.

    Second, don't trust official Chinese statistics. My instincts (and a few Chinese friends) tell me that they are manipulated regularly, although they are making improvements in that area to have more accurate statistics.

    It's not USSR obfuscation, but it's not fully the real deal either.

  5. David,
    Where is the data in the market based inflations expectations chart coming from? What caught my eye was the 2 year rate. The USSWIT2:IND closed at a low of about -3.6% in mid December 2008. Your chart is showing something closer to -5%. That's quite a discrepancy.

  6. Mark: I did not make the calculations myself. My colleague Kevin did. I forwarded your question to him, and this was his reply:

    Well, the simple calculation of subtracting the real constant maturity TIPS yield from the nominal constant maturity yield can't be done for the 2-year Security. Why? Because the H.15 (the Fed's interest rate release) does not calculate constant maturity yields for 2-yr TIPS, like they do for 5-, 10-, and 30-year securities. Thus, for someone wanting to calculate a 2-year inflation expectations from nominal and real TIPS, they must find securities that have the same maturity dates. Unfortunately, the Treasury does not have 2-year nominal and real Treasury securities that mature at the same time. You can find something close -- a 1 month differential. Now, does one month make a big difference? Maybe not.

    What I chose to do, instead, was to look at the 2-year breakeven inflation rate constructed from a continuously compounded zero coupon yield curves. These data are on Haver: fyiez2@daily.

    You can find out more information from them here (see Gurkaynak, Sack and Wright paper and the data file they have listed): http://www.federalreserve.gov/econresdata/researchdata.htm

  7. Morris: The trade balances are a mystery to me as well. But a part of the explanation might be what I described here: http://andolfatto.blogspot.com/2010/08/global-imbalances-good-for-world.html

  8. David,
    Thank You very much.

    Tell Kevin that I found the data file to be a joy. The 2 year TIPS data show a larger rise in inflation expectations (0.65% to 2.21%) since Bernanke's Jackson Hole speech than the 2-year inflation zero coupon swaps (0.92% to 2.37%).

    P.S. Not that inflation is a joy, of course, but that the effect of QE2 on AD appears to be larger by this measure.

  9. Nobody with real inflation expectations buys TIPS. TIPS depend on the governemnt using honest inflation metrics to make their payments. Silly.

    Physical Silver and gold is where serious people get inflation protection.

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  12. what is it doing? It is selling zero-interest bills for (slightly) positive-interest bills. Would a deceleration in this asset-swap activity really have the dramatic effect Gross suggests. China Direct