Before beginning, I’d like to announce that Gabe Newell (CEO of Valve) has generously funded the next year of Hypermind’s NGDP futures market, and I hope to announce some new contracts (including the exciting 2014:4 to 2015:4 contract) in the next week or so. I also plan to start posting daily NGDP futures prices, as soon as I can figure out how to get a link to that market. I hope to get iPredict’s NGDP futures market fully funded by January.
The recent news has been dominated by the sharp fall in TIPS spreads. In the US, 5-year inflation expectations are down to 1.25% and the 10-year TIPS spread is 1.68%. Does this mean money is way too tight? Not necessarily, but it does suggest that money was way too tight back in early 2010 and mid-2011.
Recall that I often say, “inflation doesn’t matter, only NGDP matters.” Back in early 2010 and mid-2011, CPI inflation briefly rose above 2%. Europe also experienced above target inflation at about this time. Many observers misinterpreted this data, believing it had implications for the proper stance of monetary policy, whereas in fact NGDP is the variable that matters.
So if NGDP was so low, why was inflation above target? If there is anything we know about Phillips curve models it is that they are consistently unreliable. In early 2010 and mid-2011 there was a big increase in global commodity prices, driven by fast growth in places like China. This had no bearing on US NGDP or monetary policy. The underlying demand conditions were quite weak in both the US and Europe. In recent months the commodity boom is unwinding, and lower headline inflation is showing up. But this does not necessarily mean money is too tight in the US (although it quite likely is a bit too tight to hit the Fed’s dual mandate over the next 5 or 10 years.) Instead, the recent deflation is a distinct echo of the actual NGDP “deflation” (and why is there still no word for falling NGDP!!) that occurred in the early part of this decade. That’s when money was much too tight, but supply disruptions in the Middle East and Chinese demand temporarily inflated oil prices, helping to disguise the deflationary pressures. Now it is showing up.
This all makes the hawks look ridiculous today. Indeed they have not one but two big problems:
1. The hawks fought against monetary stimulus in 2010 and 2011, arguing that we needed to focus like a laser on 2% inflation. OK, but 5-year inflation expectations are now 1.25%, even lower in Europe. What do the hawks say today?
2. The hawks are uncomfortable with low interest rates, and have developed dubious ad hoc “theories” that low rates will create asset market bubbles and financial instability. But how do we get higher rates? The hawks ignored the wisdom of Milton Friedman (that ultra-low interest rates mean money has been tight) and the Germans got the ECB to raise rates twice in 2011. The result is exactly as Friedman would have predicted. The US is about a year away from exiting the zero bound, whereas the eurozone is 5 or 10 years away, at best. The German plan backfired.
Hawkishness was the superior monetary model in the 1970s, but has since degenerated into an atavistic set of urges: No inflation! Higher interest rates! (As if those two goals are compatible.) It’s very sad, and perhaps a blessing in disguise that Friedman is not here to seen his ideas being abandoned by the right wing of the profession.
PS. Did I forget to mention that the misleading TIPS spreads are just one more reason why we need a Federal Reserve-funded NGDP futures market? If the government won’t fund this nearly perfect example of a “public good,” with a benefit/cost ratio of more than 100,000 to 1, who will? Not the Austrians. Not the Keynesians. Not the New Classicals. Not the RBC economists. Only the MMs are stepping up to the plate to make it happen.
PPS. Oh, and where are all the people who said in mid-2013 that Bernanke’s tapering comments caused much higher bond yields, proving that only QE was holding down yields? QE ended many months ago, and rates keep falling lower and lower. The market is financing our still large budget deficits at 2.74% on the 30-year bonds. Is that the “liquidity effect?” Is that “Cantillon effects?” Don’t be silly.