Adjusted 10-Year TIPS-Derived Expected Inflation

This measurement of expected inflation is from the Cleveland Fed:

Adjusted 10-Year TIPS-Derived Expected Inflation

The upward trend at the end is not what the Fed would like to see, of course, but as the next graph shows, market participants expect further declines in interest rates as the Fed attempts to stabilize the economy with the consequence shown in the previous graph of higher inflation in the future:

Comments

[kett82]

Hmmm…, the Bernanke conundrum.

Best regards!

[anne]

Though I have noticed this particular increase in the measurement of expected inflation, I think it of minimal significance. Inflation protected Treasury securities simply look to be over-priced, and I find looking at the 10-year Treasury yield to be currently a better measure of expected inflation, which is of no concern. TIPS are being over-sold to investors.

[pgl]

I still say - an expected inflation rate of 3% is not exactly hyperinflation. Lower interest rates - PLEASE!

[esb]

-nor is 4%, or 5% or whatever comes after that-

As I have said here before, the US central bank is a one-trick pony, and the trick is inflation.

Inflation is the tool (or trick), employment is the goal.

Positioning and trading against a one-trick pony is essentially effortless.

BTW, the policy and strategy committees at all of the tier-one investment banking firms have concluded that ten year T paper has no remaining signalling value, being under the influence of the PBoC and other central banks.

[Bruce Wilder]

I'm afraid I agree with esb, not anne, on this one. I doubt that the 10 year T has an inflation signal.

Inflation is not Bernanke's "conundrum", it is his modus operandi. He studied the Great Depression in detail, and his conclusion was that inflation could have saved the plutocracy from ruin and from the New Deal. That is how he will see his mission now: he will try to postpone the day of reckoning, by "risking" inflation. (I put "risking" in quotations, because there's really no "risk" in the ordinary sense -- the inflation that follows is a certainty, but economists don't talk that way. There's uncertainty about the exact path, because of the complexity of the system and the computational impossibility of simulating it in advance, and any professional prognosticator would be wise to hedge and obscure his predictions.)

The potency of monetary and fiscal policy is limited by the specific economic circumstances of the U.S. -- factors like the Iraq War, and the non-existent savings rate. The strong dollar policy, followed for so long, favored Wall Street over manufacturing with predictable consequences, which are now constraints on the system: it is hard to squeeze import substitution out of a manufacturing base in ruins, and it is hard to set interest rates sensibly, when the consequence of a sensible, non-inflationary short-term rate would be bankruptcy for a number of major banks.

But, even more broadly, the U.S. has exhausted the economic paradigm for expansion, which the country has been following, with variations, since World War II. I am thinking of cheap gas and suburbs structured around cheap gas (not to mention a foreign policy corrupted by the need to preserve cheap gas). The variation adopted in the 1980's, to keep things going, of two-income households, broken labor unions, increasing imports from China and asset inflation at home has also been exhausted.

Bernanke's plan to save the plutocracy will not save the country. While Bernanke is "risking" inflation to keep the banking system from collapse, the banking system will have to be recapitalized from abroad -- in other words, a big chunk of the U.S. financial system will sold to China and the Abu Dhabi and Japan and Singapore and Saudi Arabia.

Paranoia about the banking system has been a theme of American politics since the days of Hamilton and Jefferson. It was the signature issue of politicians as diverse as Andrew Jackson and William Jennings Bryan. Paranoia does not mean that they are not out to get you; it means you are pretending not to know who they are. I anticipate the anti-banking hysteria, which will follow, when Ron Paul's friends, and everyone else, realize that the Arabs and the Chinese control Citi and Morgan.

I think the U.S. could come out of this, but it would take a complete restructuring of our economic expectations and habits. Whenever the country has been given the political opportunity in the past to break our addiction to cheap oil, we've gone in the other direction. We went with Reagan over Carter. But, I don't see how we don't just keep sinking deeper into the mud, without a huge change in direction and a change in the paradigm we use to coordinate economic growth.

Some very big numbers have to shift -- we have to have a savings rate, for example. I don't see how the numbers add up to full employment, after, say, 5% of national income shifts from consumption to savings. Health care spending has to actually decline. Decline. It is not like there is some other growth sector in the American economy, generating good paying jobs. But, there it is.

[dirtyal]

Bruce: I pretty much agree with all you said. The only place I need more information is on the "asset inflation at home" question. I don't see that it has been exhausted, only that the emphasis has changed.

What is $100 a barrel oil if not "asset inflation at home"? What about other basic commodities?

Just because home prices turned out to be a bubble, doesn't mean, IMHO, that we have asset inflation under control.

If the dollar becomes worthless enough, what refuge will anyone with a net worth have except taking refuge in hard assets?

[Meh]

Bruce, you scare me because what you say parallels my thoughts about just about every "post-manufacturing" economy in the world today. In the long run there may be a viable "mostly service economy" model out there, but it's very difficult to see how we get there without very large societal upheaval and likely large amounts of unemployment and stagnant (if not falling) quality of life for many people.

[kett82]

Bruce

I agree with your points…but it is your last paragraph that has me wondering. Where is the incentive to save when inflation (call this mirage what you will) is making the money I have in my hand today worth less tomorrow?

Of course, a liquidity trap is not something either of us will ever live through right?

Best regards,

[anne]

"Where is the incentive to save when inflation (call this mirage what you will) is making the money I have in my hand today worth less tomorrow?"

Good grief; we have spent 35 years averaging returns of more than 12% after Vanguard costs on the S&P index fund so what possible reason could there be to ask "why save?" We have just passed through 5 years of the broadest and deepest international bull stock market I can find record of. Why save, indeed.

[anne]

Heck, if inflation is the worry and there is a wish for complete safety buy the Vanguard inflation protection Ttreasuries fund, which though I think TIPS are too expensive is the ultimate in safety above inflation. Saving and investing intelligently pays.

[anne]

A liquidity trap by the way would make bonds a fine buy, but the point is that thoughtful investing has worked and will work. When I find an analyst asking why save, I figure the analyst is a fool or faker.

[kett82]

Dear Anne,

Thanks for the investment advice. I was thinking more in terms of I run a average houseful with an income of about $45,000 a year. What do I do with the $3 to $4,000 I manage to scrape together during the course of the year? Yes, go to Vanguard, but I assure you the temptation is great to spend it now.

Best regards,

[kett82]

Ok...make that average household...

[dirtyal]

Ann: I didn't believe your S&P number, so I looked it up. You are right (I think) if you include dividends as well as price appreciation.

So the Compound Annula Growth Rate for the Past 6 years--wanna guess? Less than 1%. (excluding dividends) So, maybe, say 3% with dividends.

The question is whether the next 35 years will be more like the past 35 years or not. And do you have to switch your investments from one you were satisfied with for 35 years (US based but certainly a global exposure nonetheless) to an investment that has been highly volitile and certainly not something that you would call a "core holding" because of the volitility.

And if you strip out the emerging economies over the past five years, and if you strip out the dollar effect, what do you really have? Maybe an index that should perform, over the longer term, about the same as the S&P 500?

Yes, saving is good. We all have to do it. But pardon me for feeling that what has been saved might diminish in value so much it won't matter if they repeal the death tax or not.

[Inflation Implications of Investing]

Before constant inflation, the dividend yield on the S&P was higher than the yield on bonds (to compensate for price volatility). Constant inflation drove the after tax bond yield to about zero. People comfortable with volatility switched to equities, driving the dividend yield to below 2%. People uncomfortable with volatility in prices switched to "saving" by building a larger house. Since money used for larger homes is not available to start new businesses, foreign savings had to fill the gap.

Bonds are a bad deal for US savers, as tax on the inflation adjust portion (phantom income in the case of TIPS) of the bond drives the real yield to about zero. People who spend less than average tend to have personal rates of inflation higher than the CPI (essentials tend to go up in price faster than the CPI), which makes bank deposits and bonds an after tax negative yield investment for many.

Since dividends were a large part of past equity returns, future returns may not be so roseate. Valuation increase was also a significant part of past equity returns, which may not continue. Equities should still grow in value about as fast as the economy in general, but the market can drop in half or more at any time. Many people are not comfortable with this risk, and avoid them.

[Inflation Implications of Investing]

As a side note, dividends on the S&P are not sufficient to support the entire population. Dividends paid were only about $246.6 billion in 2007, and divided by 300 plus million Americans, this is less than $1000 per person. The yield on the S&P would drop to useless levels if all Americans attempted to use the S&P as their sole savings vehicle. This would also mean no savings would be available for loans of any sort.

[Bruce Wilder]

dirtyal: "What is $100 a barrel oil if not 'asset inflation at home'? What about other basic commodities?"

A barrel of oil at $100 is 'asset inflation' only if you own an inventory of barrels of oil (i.e. have reserves), so that the oil is an asset and not just a consumable.

Americans owned a lot of the stock market during the 1999 bubble; Americans owned a lot of houses in the housing bubble. So, my key observation would be, yes, $100/barrel oil could be a form of asset inflation, but it is most definitely is not 'at home'.

It seems to me that the world outside the U.S. has a lot of dollars they do not need or want. That fact plays a part in accelerating the rise in the price of commodities, particularly oil. Fundamentally, it is real demand, and constrained supply, that is driving up the real cost of commodities, including oil. But, the dollar cost rise is being accelerated by financial factors, which focus the burden of rising real commodity costs onto the U.S. and its dollar. Americans are seeing a skyrocketing dollar price for oil; Europeans, in the Euro zone, are not seeing a corresponding rise in the Euro price.

The jump in dollar revenues for oil exporters, which follows from these financial circumstances implies dollars are accumulating in the hands of people, who don't want so many dollars, and will wish to exchange them for real products or real assets. First, the banking system is being sold. More will follow.

[Winslow R.]

Triple eye wrote:"The yield on the S&P would drop to useless levels if all Americans attempted to use the S&P as their sole savings vehicle. This would also mean no savings would be available for loans of any sort."

You had a good run until you 'lost it' at the end.

Savings do not constrain loan growth. Fed/gov/banks have an infinite ability to create new loans. Money is not some rare resource mined from Mt. Olympus.

[Winslow R.]

"I anticipate the anti-banking hysteria, which will follow, when Ron Paul's friends, and everyone else, realize that the Arabs and the Chinese control Citi and Morgan."

Not sure how to interpret this? I have no problem with the Arabs or the Chinese. I do have a problem with bankers that think they should have special status to borrow funds at a subsidized rate be they American or otherwise.

Hysteria is such a strong term that implies irrationality. Though I could see how a toxic combination of racial fear and justified outrage would lead to something irrational.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

The return on the Vanguard S&P index from opening on August 31, 1976 to December 31, 2008 has been a remarkable 12.01% a year. This is after all Vanguard costs. Taxes due have been minimal since turnover in the index is minimal so capital gains are not realized for years or reralized at all unless an investor sells shares. Devidend taxes have continually declined.

Saving small or large amounts is terribly important.

[Inflation Implications of Investing]

Winslow R..."Savings do not constrain loan growth. Fed/gov/banks have an infinite ability to create new loans."

Using money creation to fund loans is limited by the ability of the economy to tolerate inflation. Once inflation reaches a certain rate, the economy tends to stagnate. If hyper inflation starts, the economy tends to collapse. We have been using foreign savings to supplement money creation as a means to fund new business for some time.

Business investment must be funded by the difference between production and consumption. Forced saving is the mechanism by which money creation generates this difference. As prices rise, those with fixed incomes (and incomes that rise slower than inflation) consume less, and savings are 'forced' out of them. This additional saving finances the extra investment.

However, you can't squeeze too much forced savings from fixed income people, as they often tend to be fairly near subsistence level to begin with. (The rich hire managers to buy inflation hedges for them.) The point of diminishing returns is rapidly reached. When fixed income people can no longer live on their income, everyone else starts to demands COLAs to escape this unhappy fate. More and more inflation is needed to get the same forced savings, and hyper inflation collapses the economy.

[Winslow R.]

"Using money creation to fund loans is limited by the ability of the economy to tolerate inflation. Once inflation reaches a certain rate, the economy tends to stagnate. If hyper inflation starts, the economy tends to collapse."

Better. Have you heard that taxation can be used to keep this hyper inflation at bay? In fact, without proper taxation, money becomes worthless pretty rapidly. I'd blame the current bout of inflation on a failure to loan money on 'useful investments' as well as a failure to properly tax.

"Business investment must be funded by the difference between production and consumption."

Not true. You must be reading Delong or somebody. Funding for business investment is constrained by the political will to limit inflation as you stated above. No political will there is no limit.

"Forced saving is the mechanism by which money creation generates this difference. As prices rise, those with fixed incomes (and incomes that rise slower than inflation) consume less, and savings are 'forced' out of them."

Not if increased production from new investment creates rapidly growing nonfinancial assets and someone else desires to 'save' slowly growing financial assets.

"This additional saving finances the extra investment."

We've been through all of this before at this site. If you believe in the velocity of money which it seems you do, money growth is a politically controlled variable which needs to be balanced through taxation to not exceed GDP growth plus desired 'savings' growth in order to avoid inflation.

[Inflation Implications of Investing]

Winslow R..."Have you heard that taxation can be used to keep this hyper inflation at bay?"

Tax the extra money away from consumers so they can't bid up the price of consumer items. Of course, if the gov then spends this tax money, it will drive up the cost of whatever items it buys. The extra tax would have to be retired from circulation to avoid driving up prices. This would be a balancing act that may be beyond the ability of our system to implement. Tax policy changes erratically, and every dollar tends to be spent.

So why create the extra money in the first place? Just tax the "rich", and use the money generated to fund low interest rate loans to business. Much easier to implement in a targeted fashion than trying to use tax policy to extract the surplus money from consumers.

Winslow R..."Not if increased production from new investment creates rapidly growing non-financial assets and someone else desires to 'save' slowly growing financial assets."

If enhanced production increases consumer items fast enough, then the extra money would indeed keep prices stable. The key to this system would be insuring that all surplus money creation is used to increase productivity. This is radically different from our current system, but theoretically possible to design.

I'm not sure what you mean by "slowly growing financial assets". If you mean bonds, or other dollar denominated debt instruments, then private savings would still be required. That is, savers would have to be willing to lose after tax purchasing power over time (so real interest rates can remain low). Currently, foreign savers are filling this role.

You present an interesting scenario. It is much different from our current system (or any other that I can think of), but theoretically possible. Zimbabwe, for example, could not eliminate its hyper-inflation by simply increasing taxes on consumers. Zimbabwe spends the excess money creation on consumption, rather than on productivity enhancing technology. Extra taxes would just further reduce the standard of living of consumers.