Research Review | 26 February 2021 | Inflation

The Increased Toxicity of the U.S. Treasury Security Market
Scott E. Hein (Texas Tech University)
January 2, 2021
This short research paper documents the fact that exclusively watching for rising yields on conventional U.S. Treasury securities to reflect increased inflationary fears in the U.S. is no longer appropriate. With the Federal Reserve seeking to keep short-term nominal yields near zero for an extended period, conventional Treasury yields have not shown the full extent of rising fears of inflation in financial markets. In this monetary environment, the yields on Treasury Inflation Protected Securities (TIPS) have been more reflective of rising inflation fears. TIPS yields have become increasingly negative in absolute terms during the latter part of 2020. The negative yields on TIPS further suggests that all Treasury investors should be expecting lost purchasing power when they hold onto such securities.

Getting to the Core: Inflation Risks Within and Across Asset Classes
Xiang Fang (The University of Hong Kong), et al.
February 1, 2021
Decomposing inflation into core and non-core components (e.g., energy) sheds new light on the nature of inflation risk and risk premia. While stocks have insignificant exposure to headline inflation in the U.S., their core inflation betas are negative and energy betas are positive. Conventional inflation hedges such as currencies and commodities only hedge against energy inflation risk but not the core. These hedging properties are reflected in the prices of inflation risks: only core inflation carries a negative risk premium and its magnitude is consistent both within and across asset classes, whereas the price of energy inflation risk is indistinguishable from zero. The relative contribution of core and energy inflation varies over time, which helps explain why the correlation between stock and bond returns appears to switch sign in the data. We develop a two-sector New Keynesian model to account for these facts.

Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record
Michael D. Bordo (Rutgers) and Mickey D. Levy (Berenberg Capital Markets)
December 2020
In this paper we survey the historical record for over two centuries on the connection between expansionary fiscal policy and inflation. As a backdrop, we briefly lay out several theoretical approaches to the effects of fiscal deficits on inflation: the earlier Keynesian and monetarist approaches; and modern approaches incorporating expectations and forward looking behavior: unpleasant monetarist arithmetic and the fiscal theory of the price level. We find that the relationship between fiscal deficits and inflation generally holds in wartime when fiscally stressed governments resorted to the inflation tax. There were two peacetime episodes in the early twentieth century when bond financed fiscal deficits that were unbacked by future taxes seem to have greatly contributed to inflation: France in the 1920s and the recovery from the Great Recession in the 1930s in the U.S. In the post-World War II era a detailed examination of the Great Inflation in the 1960s and 1970s in the U.S. and the U.K. suggests that fiscal influences on monetary policy was a key factor. Finally we contrast the experience of the Great Financial Crisis of 2007-2008, when both expansionary fiscal and monetary policy did not lead to rising inflation, with the recent pandemic, which may involve the risks of fiscal dominance and future inflation.

Understanding Trend Inflation Through the Lens of the Goods and Services Sectors
Yunjong Eo (Korea University)
October 23, 2020
We distinguish between the goods and services sectors in an otherwise standard unobserved components model of US inflation. Our main finding is that, while both sectors used to contribute to the overall variation in aggregate trend inflation, since the 1990s this variation has been driven almost entirely by the services sector. Two changes in sector-specific inflation dynamics are responsible for this finding: (i) a large fall in the variance of trend goods inflation; and (ii) the disappearance of co-movement between trend goods and trend services inflation. Extensions to our baseline analysis by excluding energy prices and decomposing trend inflation into a common and a relative price component suggest a possible role of monetary policy in explaining our empirical findings. We also document similar changes in inflation dynamics internationally when extending our analysis to Australia and Canada.

Oil Prices, Gasoline Prices and Inflation Expectations: A New Model and New Facts
Lutz Kilian and Xiaoqing Zhou (Federal Reserve Bank of Dallas)
8 January 2021
The conventional wisdom that inflation expectations respond to the level of the price of oil (or the price of gasoline) is based on testing the null hypothesis of a zero slope coefficient in a static single-equation regression model fit to aggregate data. Given that the regressor in this model is not stationary, the null distribution of the t-test statistic is nonstandard, invalidating the use of the normal approximation. Once the critical values are adjusted, these regressions provide no support for the conventional wisdom. Using a new structural vector regression model, however, we demonstrate that gasoline price shocks may indeed drive one-year household inflation expectations. The model shows that there have been several such episodes since 1990. In particular, the rise in household inflation expectations between 2009 and 2013 is almost entirely explained by a large increase in gasoline prices. However, on average, gasoline price shocks account for only 39% of the variation in household inflation expectations since 1981.

Fiscal Policy and Households’ Inflation Expectations: Evidence from a Randomized Control Trial
Olivier Coibion (University of Texas at Austin)f
February 2021
Rising government debt levels around the world are raising the specter that authorities might seek to inflate away the debt. In theoretical settings where fiscal policy “dominates” monetary policy, higher debt without offsetting changes in primary surpluses should lead households to anticipate this higher inflation. Are household inflation expectations sensitive to fiscal considerations in practice? We field a large randomized control trial on U.S. households to address this question by providing randomly chosen subsets of households with information treatments about the fiscal outlook and then observing how they revise their expectations about future inflation as well as taxes and government spending. We find that information about the current debt or deficit levels has little impact on inflation expectations but that news about future debt leads them to anticipate higher inflation, both in the short run and long run. News about rising debt also induces households to anticipate rising spending and a higher rate of interest for government debt.

The ‘Puzzle’ of Vanishing Inflation
Douglas Carr (Carr Capital)
November 14, 2020
Low and unresponsive inflation has been termed a “puzzle.”. The paper combines a monetary model and a growth model to explain low inflation and project its continued decline.
The monetary model forecast in 2016 central banks would fail to sustain 2% targets, which has been true since then. The model explains inflation as changes of the unit value of a currency, a function of long lags of monetary aggregates. The model provides a highly significant statistical explanation for virtually all variability of forward long-term inflation. Its U.S. inflation forecasts are comparable to recognized leaders in accuracy with potential international applicability as well. The responsiveness of inflation to monetary stimulus is increasingly inelastic at a geometric rate, explaining central banks’ difficulty attaining targets.
While the monetary model explains virtually all variability of long-term inflation, the level of inflation is explained by non-monetary factors, population growth and Hotelling interest rate effects. A Hotelling interest rate effect is found in general inflation from production factors such as labor in addition to commodities, explaining why previous Hotelling commodity tests were generally unsuccessful. A growth model finds natural interest, total factor productivity, and population growth converge and all are related to real growth. Each of these factors has declined for fifty years in advanced economies, with a consequent reduction of inflation.
Between the decline of real factors affecting inflation and its inelasticity to monetary stimulus, it is more likely major central banks will be staving off zero inflation or deflation than attaining what are now obsolete 2% targets.

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