Tag: Federal Reserve

Can We Rely on Inflation Expectations?

The Wall Street Journal has pointed out that in his recent press conference Federal Reserve Chair Ben Bernanke used the words “inflation expectations” (or some variation) 21 times. His argument is that we need not worry about inflation because we will see it coming, and then the Fed will do something about it. Such an argument relies heavily on the ability of inflation expectations to predict inflation. Which of course raises the question, just how predictive are inflation expectations?

The graph below compares inflation, as measured by CPI, and inflation expectations, as measured by the University of Michigan consumer survey, the longest times series we have on inflation expectations.

Clearly the two move together. For instance, the correlation between current inflation and expectations is almost 1 (its 0.93), while the correlation between inflation and actual inflation a year later is slightly less at 0.81. The relationship declines as we move further into the future. So yes, consumer expectations appear a reasonable predictor of the direction of inflation. However, they don’t appear to be a great predictor of the magnitude or the frequency of changes. For instance, the standard deviation of actual inflation is about twice that of expected inflation. As one can easily see from the chart, expectations are quite sticky and rarely pick up the extremes. During the late 1970s and early 1980s, expectations did move up, but then never reached the heights actually experienced, nor did consumers ever actually expect deflation during the recent financial crisis (if we are going to base policy on expectations, we should at least be consistent about it).

For about the last decade we also have market based measures of inflation, based upon inflation-indexed bonds. The TIPS measure tends to be less correlated with actual inflation, but does a better job of capturing the extremes. Although interesting enough, TIPS was already predicting that deflation would be short-lived before we even experienced any deflation.

The point is that while expectations are useful for qualitatively purposes, they do not have a strong record of recording the extremes. Given that most of us expect some positive level of inflation, the real debate is over how much. In this regard, either survey or market-based expectations are likely to be both a lagging indicator and an under-estimate of actual inflation.

Wednesday Links

Response to Joe Weisenthal’s Critique of My Politico Opinion Piece

Yesterday I had an op-ed in Politico suggesting that U.S. lawmakers should consider not raising the federal debt limit (at least for now). I argued that freezing the ceiling would assure investors that the United States is serious about reducing its debt, and that it would serve as a commitment device for lawmakers and President Obama to forge and follow a serious debt-reduction strategy.

A financial website writer named Joe Weisenthal strongly disagreed with my column. He seems to misunderstand several of the points that I was making, and so I offer the following response to his comments:

From Weisenthal’s post:

Another day, another economist advocating that the US default on its debt.

The latest is Jagadeesh Gokhale of the Cato Institute, who has a big piece advocating an immediate freeze of the debt ceiling.

It’s so convoluted, we hardly know where to begin, but let’s just address a few sloppy parts.

Many knowledgeable federal officials, like Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke, as well as left-leaning lawmakers, insist that the answer lies in lifting the debt limit. They warn Congress about the dire consequences if it fails to do so. President Barack Obama has chimed in — though he voted against raising it when he was a senator.

They all assert that failing to increase the debt limit could sharply undermine the economic recovery.

But that view could be wrong. A temporarily frozen debt limit could instead signal U.S. lawmakers’ resolve to get our fiscal house in order. It may even reassure investors about long-term U.S. economic prospects.

This line about “reassuring investors” is nonsense. Investors are already reassured, which is why interest rates have only fallen amidst all the squawking from the political class about this “crisis.”

From the start, Weisenthal doesn’t follow my argument. I am not concerned about the state of market confidence today, but what it would be if the debt limit were frozen. The contrarian view that I expressed in my op-ed is that participants would interpret a debt-limit freeze positively, just as they appear to have interpreted the recent downgrade of the U.S. economic outlook by Standard and Poor’s positively — U.S. equities, U.S. treasuries, and the dollar are up less than 48 hours after S&P’s downgrade announcement.

He also misunderstands why interest rates have declined. It is because of the Federal Reserve’s sustained intervention in bond markets, not because there is little investor concern over the United States’ long-term fiscal outlook.

Returning to Weisenthal’s post:

He then gets to the discussion of a default.

…the current prospect of a technical default, from failing to increase the debt limit, would not be due to any real national insolvency. Given today’s low interest rates, the federal government could easily raise the resources needed to meet today’s contractual government obligations.

This doesn’t make any sense. How do “low interest rates” matter to the government in a situation where it’s legally unable to borrow?

Here, Weisenthal misunderstands what it means to freeze the debt limit. It does not mean, as he believes, that the government is “legally unable to borrow.” It only means that the government cannot issue any additional debt beyond the limit. But the government can (and will) continue to roll over its existing debt, and must do so at current interest rates, which makes those rates relevant to the discussion.

More Weisenthal:

Anyway, here’s the biggest whopper of them all:

How might investors really view this ersatz U.S. debt crisis? If some lawmakers’ refusal to vote for increasing the debt limit without also passing prudential fiscal policies resulted in a technical U.S. default, it would demonstrate their significant political strength.

Might that not actually induce investors to buy long-term U.S. debt — reducing long-term interest rates and improving the U.S. investment climate?

Oy, where to begin? First of all, the notion that a “technical default” would induce investors to buy long-term U.S. debt is prima facie absurd.

Perhaps he knows something I don’t, but I don’t see this as absurd at all. I’d expect that a serious commitment by political leaders to get the nation’s fiscal affairs in order would inspire investor confidence in U.S. securities. If anything, it’s absurd to think that investors would be encouraged by Weisenthal’s preferred policy of the nation continuing to expand its borrowing without a plan to manage its debt.

Back to his post:

Second, as we stated above, longterm US interest rates are at historical lows, so the idea of needing to reduce them further to improve the US investment climate is rubbish. And finally, why do we want people to buy more long-term US debt? Ideally we want people going out and actually investing in things with their money: companies, employees, lending to corporations, etc. Aren’t debt hawks supposed to hate the idea of government borrowing crowding out private spending. [sic]

The problem with this comment is that today’s historically low interest rates are not a reflection of freely operating market forces. They result from the Fed’s massive interventions through its Quantitative Easing policy.  The Fed has increased its portfolio of market assets — now approaching a staggering $2.7 trillion — in part by purchasing treasuries with longer maturity than it used to purchase before 2008. Without that injection of liquidity (note to Ben Bernanke: I didn’t say the Fed is “printing money”), market rates would be much higher.

Weisenthal does rightly worry about the effect of U.S. government finance on other sectors of the financial market. Fortunately, investors are beginning to branch out beyond government securities. But even as the Fed has been purchasing so many Treasuries to keep interest rates artificially low and fund the government, it has also purchased private assets because investors have not been buying U.S. private assets as much as they used to. The Fed has been propping up particular U.S. sectors (e.g., securitized finance, insurance, auto, home, credit card loans) to keep them from failing. If you removed the Fed’s $2.7 trillion liquidity injection from markets, interest rates would be much higher today. (How the Fed should conduct monetary policy is a different topic, beyond the scope of this post.)

Government officials are afraid that investor exits from Treasuries (and U.S. assets in general, both government and private) will accelerate if the debt limit is frozen, as I mentioned in the Politico article. I’m suggesting that view might be incorrect.

Weisenthal concludes:

Basically, Gokhale is just throwing a bunch of stuff at the wall, failing to produce an argument, and hoping you don’t really get it. Sorry.

Respectfully, I think my argument is quite coherent, though I admit it’s not the conventional view offered by many other commentators. Indeed, that’s why I wrote the op-ed.

Wednesday Links

  • Please join us on Thursday, April 7 at 2:00 p.m. ET for “The Economic Impact of Government Spending,” featuring Sen. Bob Corker (R-TN), Sen. Mike Lee (R-UT), Rep. Kevin Brady (R-TX), former Sen. Phil Gramm, former IMF director of fiscal affairs department Vito Tanzi, and Ohio University economist and AEI adjunct scholar Richard Vedder. We encourage you to attend in person, but if you cannot, you can tune in online at our new live events hub.
  • The last time we saw a green energy economy was in the 13th century.
  • This isn’t quite what we meant by “defense spending.” For a refresher, see this itemized list of proposed cuts that could save taxpayers $150 billion annually.
  • Prosperity reigns where taxes are low and right to work prevails.”
  • In case you missed it last Friday, check out Cato director of financial regulation studies Mark A. Calabria discussing the Federal Reserve on FOX News’s Glenn Beck show:

End the Fed: More than Just a Bumper Sticker Slogan?

To put it mildly, the Federal Reserve has a dismal track record. It bears significant responsibility for almost every major economic upheaval of the past 100 years, including the Great Depression, the 1970s stagflation, and the recent financial crisis. Perhaps the most damning statistic is that the dollar has lost 95 percent of its value since the central bank was created.

Notwithstanding its poor performance, the Federal Reserve seems to get more power over time. But rather than rewarding the central bank for debasing the currency and causing instability, perhaps it’s time to contemplate alternatives. This new video from the Center for Freedom and Prosperity dives into that issue, exposing the Fed’s poor track record, explaining how central banking evolved, and mentioning possible alternatives.

This video is the first installment of a multi-part series on monetary policy. Subsequent videos will examine possible alternatives to monopoly central banks, including a gold standard, free banking, and monetary rules to limit the Fed’s discretion.

As they say, stay tuned.

Bernanke’s Soft-Core Keynesianism Is Even Worse than the Nonsensical Analysis of Hard-Core Keynesians

Earlier this week, the Washington Post predictably gave some publicity to the Keynesian analysis of Mark Zandi, even though his track record is worse than a sports analyst who every year predicts a Super Bowl for the Detroit Lions. The story also cited similar predictions by the politically connected folks at Goldman Sachs.

Zandi, an architect of the 2009 stimulus package who has advised both political parties, predicts that the GOP package would reduce economic growth by 0.5 percentage points this year, and by 0.2 percentage points in 2012, resulting in 700,000 fewer jobs by the end of next year. His report comes on the heels of a similar analysis last week by the investment bank Goldman Sachs, which predicted that the Republican spending cuts would cause even greater damage to the economy, slowing growth by as much as 2 percentage points in the second and third quarters of this year.

Republicans understandably wanted to discredit this analysis. But rather than expose Zandi’s laughably inaccurate track record, they asked the Chairman of the Federal Reserve, Ben Bernanke, for his assessment. But this is like asking Alex Rodriguez to comment on Derek Jeter’s prediction that the Yankees will win the World Series.

Not surprisingly, as reported by McClatchy, Bernanke endorsed the notion that spending cuts (actually, just tiny reductions in planned increases) would be “contractionary.”

Bernanke was asked repeatedly about GOP proposals to trim anywhere from $60 billion to $100 billion in government spending during the current fiscal year, which ends Sept. 30. These cuts would do little to bring down long-term budget deficits but would slow the economic recovery, he cautioned. “That would be ‘contractionary’ to some extent,” Bernanke said, projecting that “several tenths” of a percentage point would be shaved off of growth, and it would mean fewer jobs. …While Democrats got what they wanted out of Bernanke with that answer, he frowned on some of their projections that the spending cuts that are being debated could reduce growth by a full 2 percentage points.

Since he is not a fool, Bernanke was careful not to embrace the absurd predictions made by Zandi and Goldman Sachs. But that’s merely a difference of degree. Bernanke’s embrace of Keynesian economics is disgraceful because he should know better. And his endorsement of deficit reduction (at least in the long run) is stained by crocodile tears since Bernanke supported bailouts and endorsed Obama’s failed stimulus.

But while Bernanke is not a fool, I can’t say the same thing about Republicans. Bernanke has made clear that he either believes in the perpetual-motion machine of Keynesianism, or he’s willing to endorse Keynesian policies to curry favor with the White House. Republicans should be exposing these flaws, not treating Bernanke likes he’s some sort of Oracle.

Johan Norberg on Bubbles Yet to Come

Cato senior fellow Johan Norberg, author of In Defense of Global Capitalism and Financial Fiasco, has the cover story in this week’s issue of The Spectator, the eminent 182-year-old British weekly. Titled “The great debt bubble of 2011,” it warns that governments are repeating their mistakes of the past decade:

There is a broad consensus that the financial crisis of 2007 was at least in part a result of record-low interest rates, huge deficits and large-scale credit-financed consumption. Today, governments across the world are trying to solve the crisis — by means of record-low interest rates, huge deficits and large-scale credit-financed consumption. This time, they are also using more novel means of creating easy money: bank bailouts, stimulus packages and quantitative easing.

After discussing the soaring debt burdens of European countries, Norberg writes:

At this point, it is traditional to say: thank God for those roaring economics in East Asia, India and Brazil. But how real is their remarkable growth? Look closely, and even this may be in part a result of artificial stimulus. India’s and Brazil’s growth is financed by short-term capital from abroad: money that could disappear overnight. Easy money always ends up somewhere. The last time it was in property, this time it is in emerging markets (and often in the property markets of emerging markets)….

Aside from the foreign capital inflows, China had its own stimulus package, as big as America’s. Beijing has printed yuan and pushed banks and local governments to spend like drunken Keynesians. Absurdly, China’s money supply is now larger than America’s, even though its economy is a third of the size. We can see the results of this stimulus in stock market prices and in new roads, bridges and housing complexes all over the country.

Happy New Year! And watch for more on incipient bubbles in the January-February issue of Cato Policy Report.