The Decline & Fall Of Inflation Expectations… Again

The Federal Reserve’s two-day FOMC meeting on monetary policy concludes today. Nothing unusual about that. It’s just the latest installment of this regularly scheduled confab. What’s different, however, is the growing political pressure aimed at influencing the outcome. “In an unusual move, Republican leaders of the House and Senate are urging Federal Reserve policymakers against taking further steps to lower interest rates,” the AP reports.

There’s also no shortage of voices in the private sector urging restraint on the stimulus issue. David Malpass, president of Encima Global LLC, advises in today’s Wall Street Journal that the Fed should cease and desist in its monetary efforts because “these policies have hurt growth and added to unemployment by distorting financial markets.” Instead, he recommends that the central bank should refocus on fiscal policy by “directing calls for action to the administration for tax reform, spending restraint and bank regulatory reform—each a proven job creator. The central bank has already bought nearly $2 trillion in longer-term bonds, a massive intervention in markets, with no constructive results. It’s time to move on.”
Move on? To what? Allowing inflation expectations to continue dropping? The implied inflation forecast based on the yield spread for the 10-year nominal Treasury Note less its inflation-indexed counterpart is under 2% again, and falling. That’s not a good sign for an economy facing an elevated risk of recession. The habit of arguing that lower inflation is always and forever preferable isn’t justified these days. What’s needed is a policy that addresses the problems of the moment, i.e., a policy that stabilizes if not raises inflation. Such is the prescription for what Irving Fisher called the debt-deflation problem.

The last time the market-based outlook for inflation was tumbling was in the summer of 2010. What revived the trend? The Fed’s QE2 is an obvious suspect, a policy that was announced at the end of August that year. As economist Scott Sumner reminds:

The market reaction to hints of QE2 suggests that open market purchases can be successful, even at the zero bound. The most likely explanation is that the markets weren’t reacting so much to the action itself, but rather to the implied signal it sent about Fed determination to prevent deflation. And the Fed action succeeded (so far) in preventing Japanese-style deflation.

But QE2 faded a few months back and the economy is stumbling again. The message is that any emphasis on keeping inflation low at the moment is economically misguided, as are the comparisons in some quarters with our current predicament with the inflationary burdened 1970s. Tim Duy at Fed Watch explains:

The constant comparisons to the 1970s are increasingly tiresome. At the end of the day, in the 1970s we were not in a liquidity trap. Today we are. The world is simply different. And we need policymakers that recognize that difference, not dinosaurs who refuse to do anything but live in a narrow view of their youth.

In any case, the numbers are compelling. As Michael Darda, chief economist at MKM Partners, points out in a research note on Monday: “A negative velocity shock appears to be under way in the U.S., as the demand for risk-free cash assets (money) has spiked.” He goes on to report that “the surge [in money demand] looks very similar to late 2008 and late 2001, both recessionary periods. Moreover, the surge in broad money comes as the Fed’s balance sheet has flat-lined; commercial bank credit has been flat for more than 3-1/2 years.”
Darda also observes:

Inflation breakeven spreads have not responded to the Fed’s two-year commitment to keep rates at zero and speculation of an impending sterilized “Operation Twist.” In other words, the credit markets are sending a fairly unambiguous signal that these efforts will either be ineffective or counterproductive. Stronger medicine could help to boost velocity, but is unlikely to be forthcoming in the near term, in our view.

That continuation of passive tightening may please the Republican Congressional leadership (and the White House?!?!). From an economic perspective, however, it’s hard to see how a post-QE2 policy of doing nothing, much less tightening, as some propose, will promote a productive future for the broad trend.
What can we expect with the real yield roughly at zero, and perhaps headed into sub-zero realms? At least two forecasts come to mind: higher gold prices coupled with a lower stock market. Should we be surprised, given current conditions? No, although higher inflation worries have nothing to do with it.

Correction: The original version of this post advised that the Fed’s FOMC meeting begins today; in fact, it concludes today.