Tuesday, September 8, 2015

Odds of Deflation

The Atlanta Fed posts some great stuff at their "macroblog".

Friday, they posted about a measure of expected 5 year cumulative deflation that can be estimated by comparing the yields of new 5 year TIPS bonds with the yields of off-the-run 10 year TIPS bonds that have the same maturity date.  Since past inflation on the 10 year bonds can be clawed back, but the new 5 year bonds can't have a maturity value less than the original value, the difference in their yields can be used to estimate the expected probability that there will be net deflation over the next 5 years.

Here is the graph from the post.

150904aThis probability has been negligible since late 2013, but it has re-appeared in the past couple of weeks.

You can see the shadow of monetary policy here.  The probability of deflation hit 30% after the end of QE1.  Then it dropped with QE2, and rose again after QE2 ended.  Then it dropped after QE3 began, returned briefly during the "taper tantrum", and subsided after the Fed signaled that it would be patient about tapering QE3.  Since then, the market appears to have seen no risk of deflation until now.

It seems to me that the natural interest rate has been tickling something above the zero lower bound, but recent turmoil has pushed it slightly back down.  It will probably continue to move up with the economy's natural recovery if we let it.  A rate hike now risks getting ahead of it.

While nobody on the FOMC seems to take responsibility for the discretionary tightening that culminated in the late 2008 collapse, it does seem as though the FOMC has made the right moves when they have had to, since then, even if they have been a little premature about withdrawing accommodation.  Let's hope they acquiesce to all of the signs one more time.  I suspect that within a few months, we will have seen some more recovery in the natural rate, and a rate hike won't be as much of a risk.

In the meantime, Friday's employment report coincided with a drop in equities and a drop in long term yields.  My Eurodollar model says the mean expected rate hike moved back about 1 month Friday, from early February to early January.  The market clearly thinks the risk of a September hike is high.

Stock valuations are based on real growth rates.  Expected real returns on equities are stable over time and have little relation to bond rates within normal operating dimensions.  Equities don't benefit from inflation.  They can be hurt, along with all of us, by shocks to real economic activity that can be set off by nominal shocks.  The Fed can't help equities by being too loose, but it can hurt it by being too tight (or too loose).  The idea that equity markets are helped by over-accommodation is fallacious.

Aswath Damodaran had a good post Friday touching on some of these issues.  My only quarrel is that he believes we are wrong to focus so much on the Fed.  I agree that the Fed shouldn't have to be our focus.  But it has to be our focus when Fed policy moves outside reasonable bounds and deflation or hyperinflation become palpable.  The Fed has been outside reasonable bounds since 2006.  A rate hike in September increases the chances of that context continuing.

1 comment:

  1. TravisV here.

    I agree with your criticism of Damodaran. At least Damodaran pushed back against the notion that "Low interest rates are the Fed’s doing".