The New Abnormal Returns…

Actually, it never left. A month ago I wondered: “Is The Recent Fall In Inflation Expectations A New Warning Sign?” The answer, we now know, is “yes.”

The new abnormal, as I call it, is alive and kicking… again. The expected inflation rate, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, hit its recent peak back in March at roughly 2.4%. These days it’s down to around 2.1%, and it seems headed lower still. Why? Lots of reasons, although one word probably suffices as an explanation these days: Europe.

Whatever the cause, in keeping with the trend of the last several years the stock market has fallen along with the drop in inflation expectations. That’s atypical in the grand scheme of the market’s relationship with the inflation outlook. But we are in the new abnormal (still) and so equity prices and inflation expectations are positively correlated. That’s unusual, but not surprising, given the debt-deflation climate that continues to prevail. (For the theory behind the empirical fact of late that ties the equity market with the inflation forecast, see David Glasner’s research paper on the so-called Fisher effect.)
This relationship confounds some observers, who still can’t shake the habit of calling for contained and/or lower inflation. But the key issue is recognizing that demand for money fluctuates and so the central bank must satisfy the changing appetite for liquidity accordingly or else the economy suffers the consequences. One way to track the changes in money demand is to look to the inverse M2 money stock’s velocity. In the next chart below, it’s clear that M2 velocity (the ratio of nominal GDP to a measure of the money supply) has been falling dramatically in recent years. In other words, money demand has soared.

The question is whether the central bank has satisfied the changing demand for liquidity? The chart above suggests rather convincingly that it’s failed, as does the persistence of the new abnormal. Even worse, Scott Sumner worries that Bernanke and company are in no rush to change their strategy:

The Fed seems content to wait until our recovery is off the rails, and then pull out still another QE, each one less stimulative than the last, because they mostly work via signalling. Every time the Fed fails to carry through it losses a little more credibility. And the biggest irony is that the credibility loss they are worried about is too much inflation! That’d be like Mitt Romney worrying that people will regard him as too spontaneous and reckless.

Some Fed members are in no rush to change the wait-and-see game plan, as Marcus Nunes reminds. In other words, there’s more abnormality coming, and arguably of the self-inflicted variety.