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April 02 2012


Printing money does not lead to inflation, argues Argentine central bank president | 2012-03-26

The president of Argentina’s Central Bank (BCRA), Mercedes Marcó del Pont, stressed the importance of the recently approved bank’s charter reform and denied that printing currency leads to the creation of an inflationary state “since inflation is rooted in other causes”. Marcó del Pont: tensions with prices must be looked on the supply side and the external sector”.

“The new charter will provide the government with more tools to deepen the development model and to give priority to investment credit” said Marcó del Pont in a Sunday interview with two pro-government local newspapers Página 12 and Tiempo Argentino.

The banker added that “it is totally false to say that printing more money generates inflation, price increases are generated by other phenomena like supply and external sector’s behaviour”.

In that sense, the BCRA president explained that “the priority right now is the investment credit, because it is one of the issues in which Argentina is still with insufficient coverage. We look for credits of longer-term investment plans at reasonable rates with the return of these investment projects.”

“We discard that financing the public sector is inflationary because according to that statement the increase in prices are caused by an excess of demand, something we do not see in Argentina. In our country the means of payment are adjusted to the growth of demand and tensions with prices must be looked on the supply side and the external sector”.

Marcó del Pont remarked that criticism of the way the state is funding itself “have a clear ideological condiment, it is that or either the public sector has to make adjustments or go abroad to get credits and/or loans”. She added that the debate is very similar to that referred to “the use of BCRA reserves to pay for sovereign debt”.

Under the new charter of the bank the primary and main task of the BCRA will not be only to preserve the value of the currency but must also include inflation, jobs, economic development with social fairness, financial stability and the need to coordinate with government policies.

“We’re recovering the sovereign capacity to formulate and implement economic policy”, said Marcó del Pont who anticipated some pictures will be coming down from the bank’s hall of fame “beginning with Milton Friedman.”

The banker explained that the criteria to determine the optimum level of reserves will be determined in coming days and will involve several existing and new elements. Under the new BCRA charter funds above the ‘optimum level’ can be used for other purposes such as development financing.

“The formula will include issues referred to imports, short term foreign debt payments, the evolution of bank deposits and accumulation of foreign currency assets”, said Marcó del Pont who forecasted that in the first quarter the sum will be below two billion dollars but for the whole year the sum is estimated in 9 billion or more.

January 15 2010

"Inflation Targets and Financial Crises"

Andy Harless says that, in the future, the Fed should target a higher level of inflation to give it more room to maneuver in a crisis:

Inflation Targets and Financial Crises, by Andy Harless: There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.
For most of the past 20 years, the first approach – supported by a liberal dose of optimism that was buttressed (in the US, anyhow) by the experience of several financial crises with only mild consequences – was in favor. It’s suddenly unpopular now that we have gone through a crisis with severe consequences.

The order of the day seems to be some combination of the second and third approaches. Congress wants to overhaul financial regulation, and the Fed is reconsidering its erstwhile rejection of the role of bubble-popper. I am by no means the world’s foremost opponent of government involvement in the economy, but I find myself rather uncomfortable with these approaches, for much the same reasons that such a minarchist might be.

Regulation is costly, and I am skeptical as to whether Congress is smart enough, or has the right motivation (or the right group dynamic), to produce a regulatory regime that will be successful in achieving the benefit (avoiding future severe financial crises) without imposing unduly large costs. Regulators are human, subject to blind spots, bouts of unwarranted optimism and pessimism, and the temptation to rationalize actions that benefit their own interests more than those of the public. Without denying that some aspects of our financial system have been under-regulated in recent years (particularly given the public’s direct financial interest via actual or implied insurance programs), I question whether regulatory reform will be a significant improvement. Some things that have been under-regulated will be regulated appropriately, no doubt, but some things that have been appropriately regulated will become over-regulated, and some things that have been under-regulated will remain so.

As to the punch bowl approach, my concerns are similar. Undoubtedly there have been times when the Fed – if it had seen that as part of its function – would have popped an incipient bubble and avoided a much larger pop in the future. But if the Fed considered itself to be in the bubble-popping business, it might well have popped some healthy expansions long before they began to pose severe systemic risk. In retrospect, we can all agree that the last phase of the 1990’s tech boom was “bubbly;” but overvaluation concerns were being raised long before it reached that phase. If Alan Greenspan had followed up immediately on his famous 1996 “irrational exuberance” remark by using monetary policy to beat down that exuberance, I dare say the cost to economic growth would not have merited the benefit to financial stability. And, as it happened, by the time things had gotten dangerously bubbly, a lot of his skepticism seemed to have disappeared. A bubble is mediated through the public consciousness and reaches its peak when normal skepticism has all but evaporated. Are central bankers somehow immune to that consciousness?

The only conservative approach to the possibility of financial crises – the only approach that minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave – is the last of the four I mentioned: inflation. Of the four approaches, it’s probably the least popular right now, especially among those who consider themselves conservative. All alike, populists, traditionalists, and technocrats hold that inflation is bad, and that low inflation, once achieved (as it has been) is so precious that it must be not be risked, let alone intentionally tossed aside, for the sake of some imagined greater good. That attitude brings to my mind the perfectly cleaned and ordered living room in which nobody is allowed to sit, lest they mess it up again.

Low inflation does have its advantages, but economists have been hard pressed to come up with any bigwith full-time jobs, who, according to polls, suddenly hate those jobs, probably because they’re being asked to do the additional work of those whom their employers can no longer afford to keep on payroll, or because they feel their own job security in jeopardy), that should seem rather a severe disadvantage!

Among the most well-informed of the most vocal advocates of a low-inflation regime, the advantage cited most vociferously is stability. Only by maintaining low inflation rates, we are told, can central banks instill confidence in their policies. Even just raise the unofficial target from 2% to 3%, and all Hell will break loose, because….well, if 3%, then why not 4%? and if 4%, why not 5%? and if 5%, why not 10%? and so on. It’s a variation on the old “slippery slope” argument: not that we would actually slide down such a slope (since most sophisticated economists wouldn’t want to be caught making a standard slippery slope argument), but that it would be hard to give credible assurances to the contrary. The idea, I think, is that unless you can maintain something that looks reasonably close to true price stability (0% inflation), nobody will know what to expect. (2% is apparently considered close enough to zero – essentially the highest you can go and still be “close enough” to zero – and some argue that, once we have fully accounted for quality improvements, changes in consumer choices, and other such distorting factors, a measured 2% is more-or-less the same as a true 0%.).

Some would also argue that, whatever the ideal might be, an expectation of 2% inflation (actually just above or just below, depending on which price index you use) is what we have, what has crystallized over the past 10-15 years, and that it is therefore the only inflation rate about which we can have stable expectations going forward. It’s much easier to have confidence in a well-established existing regime than in a new regime that has only just been announced. Of course, this argument relies on the premise that markets do in fact still have confidence in the 2% regime – a premise for which supporters present as evidence the average results of long-range inflation expectation surveys. I do not find such averages very convincing. More people than usual expect deflation, and more people than usual (compared to the last 10 years) expect high inflation. And even those who expect canonical low-but-positive inflation – as the most likely single outcome – are more worried than usual that their expectations may be wrong in one direction or the other. Confidence – in low, stable, positive inflation – is not what I am hearing or seeing. Or feeling.

But this is one of those situations where you thank your adversary for bringing up the most important issue. “Stability” is what we all want. And it is precisely the pursuit of stability – in the long run – that leads me to advocate higher inflation targets. Let me, for the moment, concede, for the sake of argument, that higher inflation targets today might increase uncertainty, and that this increase in uncertainty might damage the recovery more than the expectation of higher product prices would help. Even so, the world does not end when this recovery is complete. (I do rather fear, however, that the world may end before the recovery is complete, only because the world must end eventually, and – in the light of Japan’s experience – there is no guarantee that the recovery will ever be complete.) Let’s suppose that the “stable inflation” medicine proves fully effective, the economy makes a complete recovery, and growth resumes a normal path --- for a while. What will happen next time there is a severe financial crisis?

Let’s distinguish between financial stability and economic stability. Financial instability often – but not always – leads to economic instability. I recall from 1987 (when I was in my first year of graduate school) a certain episode of financial instability in the equity markets. It didn’t last long, but it was huge news for a couple of weeks. It did not induce economic instability: in fact, it turned out to be almost a complete non-event economically. By contrast, instability in credit markets, over the past couple of years, has induced the worst economic crisis most living Americans can remember. The financial crisis itself has been a particularly severe one, and it would not have been possible to avoid some economic impact. But surely we could have gotten off with a much milder recession (and a more robust recovery than we are likely to experience) if the Fed had been able to pursue conventional monetary policy more aggressively.

But the Fed’s hands were tied. The Fed dropped its federal funds rate target by 5 percentage points in the year and a half following the onset of the financial crisis, and that was as far as conventional monetary policy could go. If the inflation target had started out at 4% instead of 2%, and the federal funds rate had started out at 7.25% instead of 5.25%, the Fed would have had a lot more ammunition. Moreover, the market would have known that the Fed had more ammunition, and investors would have been more confident in the Fed’s ability to minimize the economic impact of the financial crisis, and this would have made financial instruments less risky and thereby ameliorated the financial crisis itself.

You may therefore add my name to the list of those who blame past Fed policies for the severity of the recent crisis – but not because the Fed allowed a bubble to develop. Quite the contrary. The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise. (Higher future product prices might, in fact, have turned out to justify stock valuations that proved to be, in the retrospect of the path actually taken, unreasonable: a bubble is a slippery thing.)

I’m not saying that anyone at the Fed made a mistake. Indeed, Alan Greenspan handled that episode quite a bit better than I (and most others) expected, and quite possibly better than any of us would have under the same circumstances. I haven’t changed my opinion on that point: the Maestro conducted a near-perfect performance; all the instruments were in tune with one another, they entered precisely on the right beats, at just the right tempo, with just the right amount of “personal touch.” But the whole performance was in the wrong key.

In real life, I don’t have perfect pitch, and if I were listening to the performance in my metaphor, I might not notice anything wrong. But experience can be a substitute for ability. I’ve heard Beethoven’s Ninth Symphony performed in D minor enough times that, if I heard an orchestra perform it in E minor, I probably would notice that it sounded too high. I have been skeptical of the low inflation consensus all along, but I won’t fault those who were playing in the wrong key in 1995 or 2000 or 2005. But after 2008, we have the necessary experience. We’ve heard, first hand, how bad it sounds when the vocal soloist has to strain to reach notes that were easy for him to sing from the original score.

Admittedly, his voice is not nearly as strained as my metaphor, so I will say it in plain English. A number of economists have suggested higher inflation targets as a way to strengthen the recovery. Conventionalists counter that such targets, once implemented, will be difficult or impossible to replace once they have fulfilled their promise. But now, of all times, we should be aware of just why we should never want to replace them. Low inflation is what got us into this mess. And yet the consensus among policymakers seems stronger than ever: “Low inflation is awesome!” Dude, it’s lame.
advantage. The typical economic argument would be that the disadvantages of low inflation are even smaller than the advantages. But in the light of recent experience, that argument no longer holds much water: the big disadvantage of a low inflation regime is that, by putting a floor on interest rates that is not far below the inflation rate, it ties the hands of monetary policy when responding to a severe financial crisis. Surely, to the 17 percent of the today’s broadly defined US labor force who are wishing vainly for full-time employment (not to mention the apparent majority of Americans

January 08 2010

Hawkish Talk from the Fed

We're beginning to hear hawkish talk from some members of the Federal Reserve:

The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...
While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...
As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.
Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...
In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.
One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.
This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.
Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...
As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...
Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...

I should note that St. Louis Fed president James Bullard, though generally hawkish, sent a different message when he talked today:

St. Louis Fed chief James Bullard said the U.S. jobless rate will start to fall soon and played down price pressures facing the United States in the near term, saying that the Fed's moves to pump liquidity into the economy were not an inflationary concern.

As noted above, there are two risks, one is high unemployment and the other is high inflation. However, the costs associated with high unemployment are larger than the costs of high inflation (Hoenig' mention of hyperinflation is merely to scare people, that's not going to happen). So preventing high unemployment should be the primary concern of policymakers. The Fed should not be in any hurry to tighten monetary policy, and if anything, it should drag its feet.

[Here's a bit more on the relationship between unemployment and the Fed's target interest rate in the aftermath of recessions. One more note. While I haven't been strongly in favor of further aggressive quantitative easing from the Fed due to pessimism that such policies would work (though I haven't strongly opposed such action either), that is different from being worried that the present policy will cause inflation problems. I don't think it will and I certainly don't think that the economy is anywhere near the point where we need to start worrying about tightening policy. Finally, I wonder what the correlation is between being hawkish about inflation and being hawkish about the deficit. I'd guess it's relatively high.]

December 26 2009

'Is Gold a Good Hedge?'

Does gold provide a good hedge against inflation and exchange rate risk?:

Is Gold a Good Hedge?, by Martin Feldstein, Commentary, NY Times: As I walked through the airport in Dubai recently, I was struck by the large number of travelers who were buying gold coins. They were ... joining the eager rush to own gold before its price rises even further. Such behavior has pushed the price of gold from $400 an ounce in 2005 to more than $1100 an ounce in December 2009.
Individual buying of gold goes far beyond ... gold coins... In addition to buying coins..., individuals are buying kilogram gold bars, exchange-traded funds that represent claims on physical gold, gold futures, and shares in gold-mining companies... And gold buyers include ... sophisticated institutions and sovereign wealth funds. ...
Many gold buyers want a hedge against the risk of inflation or possible declines in the value of the dollar or other currencies. Both are serious potential risks that are worthy of precautionary hedges. ... But is gold a good hedge against these two risks? ... The short answer is no...
Consider first the potential of gold as an inflation hedge. The price of an ounce of gold in 1980 was $400. Ten years later, the ... price of gold was still $400, having risen to $700 and then fallen back.... And by the year 2000, when the US consumer price index was more than twice its level in 1980, the price of gold had fallen to about $300 an ounce. Even when gold jumped to $800 an ounce in 2008, it had failed to keep up with the rise in consumer prices since 1980.
So gold is a poor inflation hedge. Moreover, the US government provides a very good inflation hedge in the form of Treasury Inflation Protected Securities (TIPS). ... Of course, investors who don’t want to tie up their funds in low-yielding government bonds can buy explicit inflation hedges as an overlay to their other investments.
Gold is also a poor hedge against currency fluctuations. A dollar was worth 200 yen in 1980. Twenty-five years later, the exchange rate had strengthened to 110 yen per dollar. Since gold was $400 an ounce in both years, holding gold did nothing to offset the fall in the value of the dollar. A Japanese investor who held dollar equities or real estate could instead have offset the exchange rate loss by buying yen futures. The same is true for the euro-based investor who would not have gained by holding gold but could have offset the dollar decline by buying euro futures.
In short, there are better ways than gold to hedge inflation risk and exchange-rate risk. TIPS, or their equivalent..., provide safe inflation hedges, and explicit currency futures can offset exchange-rate risks. Nevertheless,... gold ... may be a very good investment. After all, the dollar value of gold has nearly tripled since 2005. And gold is a liquid asset that provides diversification in a portfolio of stocks, bonds, and real estate.
But gold is also a high-risk and highly volatile investment. Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor .

December 15 2009

Producer Prices Rise 1.8 Percent. Should the Fed be Worried about Inflation?

According to data released today, producer prices rose 1.8 percent last month. Should the Fed be worried about inflation?

My answer is here.

December 08 2009

The Relationship Between Budget Deficits, Fed Independence, and Inflation

At MoneyWatch, some of the pressures the Fed might come under in the future if the government debt continues to rise, and the important role that Fed independence plays in making sure that the debt is not inflated away:

Budget Deficits, Fed Independence, and Inflation, by Mark Thoma: I have been critical of both Alan Greenspan and Ben Bernanke for giving recommendations concerning fiscal policy during their testimony before congress. In Greenspan's case, it was his comments about tax cuts that I found problematic, while for Bernanke it was his comments on entitlements.
But monetary and fiscal policy are connected, and the Fed chair should talk about the impact that a growing debt level might have monetary policy. That is, while I don't think the Fed chair should give advice on the specifics of fiscal policy, the chair should make clear how fiscal policy choices will affect or constrain monetary policy. ...[...continue...]...

December 02 2009

"The Wrong Jobs Summit"

Brad DeLong says the wrong people are meeting at the jobs forum:

The wrong jobs summit, by Brad DeLong, Commentary, The Week: The White House is hosting a jobs summit this week. I, however, cannot but think that ... it will be the wrong people talking about the wrong things.

Let me back up. Ever since the 1930s, economists trying to analyze the determinants of spending have focused on two of the economy’s markets: the market for liquidity and the market for savings. ...
For the government to boost jobs, it must to do something to change the balance of supply and demand in either the market for liquidity or the market for savings. In general, the ... Federal Reserve ... acts to tweak supply and demand in the market for liquidity. The president and Congress act to tweak supply and demand in the market for savings. ...

Right now, if you ask the decisive members of congress—by which I mean the Blue Dog Democrats in the House, or the most conservative Democrats and most liberal Republicans in the Senate —why the president and the Congress are not doing more to reduce unemployment and boost spending and income, the answer you’ll get is ... well, you probably wouldn't get an intelligible answer.

But if you did get an explanation for the lack of congressional action it would go something like this: Attempts to ... boost spending would (a) increase the national debt burden on future taxpayers and (b) lead to a large decline in bond prices and a boost in interest rates. Why? Because businesses would try to increase their liquidity to support higher spending, driving up interest rates, which, in turn, would cause businesses to cut back on investment, thus neutralizing most or all of the stimulative policies.

Similarly, if you were to ask the Federal Reserve why it isn’t doing more to reduce unemployment and boost spending and income, the answer you would get is this: Spending is in no way constrained by a shortage of liquidity..., indeed we have “flooded the zone” with liquidity. As a result, the Fed is disinclined to pursue additional tweaks ... in ... liquidity because it fears such efforts would fuel destructive inflation in the future without boosting employment and spending in the present.

Both of these arguments are comprehensible... But they cannot both be true at the same time. Either the economy is so awash in liquidity that the Federal Reserve cannot do much to boost spending—in which case additional spending by the government won’t generate any substantial rise in interest rates. Or additional government spending will crowd out investment...—in which case the economy is not awash in liquidity, and quantitative easing by the Federal Reserve could do a lot right now to boost spending and employment.

It appears that what we have here is a failure to communicate. ...

Thus we need a jobs summit right now. We need the White House's National Economic Council and key congressional “centrists” on one side and the Federal Reserve Open Market Committee on the other to meet. Those two groups seem to have very inconsistent views of the economic situation. ... Something has to give. If they could reach agreement on whose view ... is likely correct, then a rescue plan—entailing either more government spending or greater liquidity—would become obvious.

Until that “jobs summit” is convened, others are moot.

November 25 2009

Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes

At MoneyWatch:

Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes, by Mark Thoma: There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified. ...

November 07 2009

"A New Approach to Gauging Inflation Expectations"

Good news for those worried about inflation: A new measure of inflation expectations indicates that "longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent":

A New Approach to Gauging Inflation Expectations, by Joseph G. Haubrich, Economic Commentary, FRB Cleveland: This Economic Commentary explains a relatively new method of uncovering inflation expectations, real interest rates, and an inflation-risk premium. It provides estimates of expected inflation from one month to 30 years, an estimate of the inflation-risk premium, and a measure of real interest rates, particularly a short (one-month) rate, which is not readily available from the TIPS market. Calculations using the method suggest that longer-term inflation expectations remain near historic lows. Furthermore, the inflation-risk premium is also low, which in the model means that inflation is not expected to deviate far from expectations.

Policymakers at the Federal Reserve and other central banks continually face the “Goldilocks” question—is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation; survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.

This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.

People’s expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest—or don’t—in plants and equipment, when families buy—or don’t—a new car or dishwasher, they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,1 keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a “stabilizing effect on the economy” and it helps direct production “toward its long-term potential.”

Modeling Interest Rates

For economists, a model is not a toy train or runway star, but rather, a simplified description of reality, usually involving equations. It’s a way to describe how the parts of the world (or at least the financial markets) fit together. Our new approach to estimating inflation expectations starts with a model of real and nominal interest rates—in effect making assumptions and writing down equations that purport to describe how interest rates and inflation move over time.2 The model has two key parts. The first describes how short-term real interest rates and inflation move over time. The model has to capture movements of short-term rates accurately in order to describe the behavior of all interest rates accurately: If short-term rates rise, do they stay high or quickly fall; do they move smoothly or take a few big jumps? The second part of the model describes how those movements in short-term rates and inflation build up and determine longer-term interest rates and expectations.

Economists think longer-term rates such as 10-year bonds are tied to shorter rates in two ways, and the model reflects both. The first and most influential determinant of long-term rates is market expectations of future short rates. Investing in a two-year bond is a lot like investing in two one-year bonds back to back: one now and another one a year later. The yields shouldn’t get too far out of line. But because those two investments are not quite identical, long-term rates are also determined in part by something else. Because of risk, because investors don’t know what rates will be next year—longer-term bonds embed a term premium in their rates, a risk factor that makes long-term rates different from the average of expected future short rates.

This means that the model also has to describe how investors incorporate risk into interest rates. This has two parts. One has to do with capturing the amount of risk perceived to exist, which is in effect, capturing how variable short-term rates and inflation are, and the other has to do estimating the prices of those risks. These considerations introduce several new factors into the model including separate variability measures for inflation and interest rates, and, because investors might feel differently about variability in interest rates and inflation, separate prices of risk.

The model also needs to match two ways of looking at the data on interest rates and expectations of inflation. One is the “time series” way—how a specific interest or expected inflation rate varies over time. The other is the “cross-section” approach, which at any given date (say June 2, 1995) lists the “term structure” of rates at 1 month, 3 months, 1 year, and so forth. An accurate model matches both the time-series side (how rates change over time) and the cross-section side (the pattern of long and short rates at any given time). Put another way, the guess about how expected inflation moves over time must also be consistent with the relationship between long and short rates. For example, if inflation is very persistent, then seeing a high inflation rate today implies nominal long-term interest rates should also be high, as they embed the inflation that is expected to continue.

The next step is to “calibrate” the model, which involves tweaking some key numbers in the equations until the model produces results that match actual data. Some examples of these key numbers—parameters, in economists’ jargon—for the time series side are numbers describing things like how variable and persistent short-term real rates and inflation expectations, and how large the price of risk is for both real rates and inflation. The calibration is done through a statistical analysis (in a rather complicated way we won’t go into here). It’s like calibrating a speedometer: once you measure the readings on a course you know, you can trust the reading in other situations.

In our case, the model gives predictions for nominal rates, and inflation expectations derived from inflation swaps, and the parameters are moved around until predictions look similar to the actual data. More specifically, the model tries to match the yields on Treasury securities from three months to 15 years. It matches expectations of inflation coming from three different sources: Blue Chip economic forecasts, which are short-term expectations of inflation over the next several quarters; the Survey of Professional Forecasters (SPF), which are opinions on inflation over the next ten years; and inflation swaps (a financial derivative in which investors swap a fixed payment for payments based on the CPI), which run the gamut from 1 to 30 years. Knowing there is a close match on rates we can observe, such as actual interest rates and inflation, we are more confident about what the model tells us about things that we can’t observe, such as risk factors and expectations over horizons that the surveys did not ask about.


In a way, the story so far has been all about sharpening the knife. Now is the time to cut something with it. So what does the model tell us?

  • It provides estimates of expected inflation from one month to 30 years.
  • It provides an estimate of the inflation-risk premium.
  • It provides a measure of real interest rates, particularly a short (one-month) rate, not readily available from the TIPS market.

Expected Inflation

Figure 1 shows inflation expectations at an annual horizon from 3 months to 30 years. Despite a somewhat high one-month expectation of 4 percent, expectations rapidly return to the neighborhood of 2 percent, showing only a gradual increase after five years. In the short run, it is common for inflation to fluctuate, particularly since Blue Chip, the SPF, and inflation swaps base their expectations on the Consumer Price Index (CPI), not any of the more stable inflation measures such as the core, the median, or the trimmed-mean CPI. Big shifts in oil, gas, and food often lead to big month-to-month changes in the CPI, which often average out over the longer term. From the standpoint of the central bank, it is the longer-term trend that matters: Monetary policy determines inflation over the long haul, but it has little effect on price changes stemming from a poor harvest or a strike in the oil fields. Figure 1 shows that inflation expectations settle down after about two years; this suggests that the Federal Reserve still has credibility in keeping inflation low and that the massive increase in its balance sheet and the accompanying increase in banking system reserves has not served to unanchor the public’s expectations of inflation.

Figure 1. Expected Inflation

Note: As of September 1, 2009.
Source: Author’s calculations.

Inflation-Risk Premium

A key advantage of using this model is the ability to split out inflation expectations from the inflation-risk premium. Figure 2 plots them both for the 10-year horizon. There are three things to note in this figure. First, it documents the long, slow effort to wring out inflation psychology from the public: It took about 20 years for inflation expectations to drop from over 6 percent to around 2 percent, where they have held roughly steady for the past six years. Implicit in this is the second point, that current expectations of longer-term inflation are near historically low levels, though up a bit from earlier this year. Finally, the inflation-risk premium is rather low and quite steady.

Figure 2. Ten-Year Expected Inflation and Inflation-Risk Premium, September 1, 2009

Note: As of September 1, 2009.
Source: Haubrich, Pennachi, and Ritchken (2008).

Finding the inflation-risk premium is particularly important because it addresses the accuracy of the so-called “break-even” measures of inflation expectations (“break-even” because investors break even on their returns if inflation is as expected). These break-even rates come from financial markets, either as the difference between the interest rate on nominal Treasury bonds, which are not protected against inflation, and TIPS, which are, or from inflation swaps, where one party makes a fixed payment to receive a payment indexed to the CPI. The problem is that the break-even rate includes a risk premium. This risk premium means that the break-even rate overstates expected inflation and that changes in the break-even rate might arise from changes in the risk premium, not changes in expected inflation.

The inflation-risk premium averages around one-half of a percent for most of the period. It is also varies only between 29 and 61 basis points, effectively keeping between one-third and two-thirds of a percent over the 27-year period. Such a low and steady level means that outside of special periods, such as the present, break-even inflation rates provide a reasonable measure of expected inflation. The dominant portion of the break-even rate and by far the largest changes come from the expectations, not the risk premium. So in most instances, a change in the break-even rate can safely be attributed to a change in expectations. In the end, the model ends up supporting the case for using TIPS as a gauge of inflation expectations.

Short-Term Real Rate, September 1, 2009

TIPS provide a direct measure of real interest rates, but most TIPS are long-term, issued only in maturities of 5, 10, or 20 years. As time passes, of course, their time to maturity shortens, but even then they are not always traded very frequently. Our model, however, can produce (or estimate) short-term real rates. Knowing short-term real rates provides a crucial element in understanding monetary policy. Comparing actual real rates with a what Alan Greenspan above termed the equilibrium rate, sometimes also called the natural or neutral real interest rate—gives an idea of whether Fed policy is expansionary or contractionary. If the Fed sets rates so that the current real interest rate is above the natural rate, policy is contractionary, and if below, expansionary. If policy calls for tightness or ease, then rates must rise or fall. Of course, the natural rate can move around with changes in the economy, so the Fed may have to do quite a bit of raising and lowering just to stay neutral. Finding the real rate is also only half the battle, and probably the easier half at that: Policymakers also have to have some idea of what the equilibrium rate is.

A look at the short (one-month) interest rate from the model in figure 3 shows several things. Recently, the rate has been quite variable, swinging from a plus 7 to a minus 3 percent in 2009 alone, and it currently stands deep in negative territory. Overall, negative rates are uncommon, though not rare. They figure most prominently in the period from early 2002 to late 2004, a period when the Fed was worried about the possibility of deflation.

Figure 3. Real Interest Rate, September 1, 2009

Note: As of September 1, 2009.
Source: Haubrich, Pennachi, and Ritchken (2008).


Financial markets provide a lot of information about the economy and expectations, but sometimes getting what you want takes a little bit of work. Our model, at the cost of some assumptions and complexity, splits out key components of interest rates, which individually often tell more about the economy than does the nominal interest rate alone.

Currently, the model indicates low rates, and stable inflation expectations. Although it is hard to estimate the equilibrium rate, the currently low level of the one-month real interest rate suggests monetary policy is reasonably accommodative. Despite this, our model provides some evidence that inflation is not expected to increase, as longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent. Furthermore, the low inflation-risk premium suggests people are reasonably confident that the dangers of inflation deviating far from their expectations are relatively low.


1. Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 20, 1993, p. 11.

2. Interested readers can find the details in “Estimating Real and Nominal Term Structures using Treasury Yields, Inflation, Inflation Forecasts, and Inflation Swap Rates,” by J. Haubrich, G. Pennacchi, and P. Ritchken. Federal Reserve Bank of Cleveland, working paper, no. 08-10.

[Traveling: Preset to post automatically.]

March 17 2009

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