Bryan Caplan  

The Inflation Illusion?

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Once I finish refinancing my 30-year fixed-rate mortgage at a ridiculously low nominal rate, a giant inflationary surprise would probably be in my best interest.  But Scott Sumner says I shouldn't get my hopes up.  The first and foremost of his "10 Reasons Not to Fear Inflation":

I am a product of the 1970s, with a visceral distaste for inflation.  Yet despite the massive budget deficits and doubling of the monetary base, I am for some strange reason worried about excessively low inflation, rather than high inflation.  Why?

1.  The bond market shows very low inflation expectations.  Especially the TIPS spread.  As I have said many times, "good economists don't make predictions, they infer market predictions."  (It's fun to create maxims that imply you are almost the only "good economist" in the world.)

Convinced?


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COMMENTS (18 to date)
Eli writes:

Bryan, that's pretty good evidence, but I have some lingering doubts.

My concern stems from undoing the quantitative easing the Fed has been engaged in (is that called quantitative tightening?). Of course in theory the Fed can sell the assets it bought and decrease the money supply as velocity picks up. But with quantitative easing, the Fed is trading in assets that are *less liquid* than it is used to dealing in. How likely is it that the Fed will be able to time the sell-off correctly to avoid inflation on one hand and further recession on the other hand? It's not impossible to do, but it is something new and different, and I'm not entirely sure that it will go off without a hitch.

Dr. T writes:

"Convinced?"

No.

My simplistic view of inflation is that there are two causes: consumers having too many dollars that are chasing too few goods (not a worry for now) or the government printing too many dollars (definitely a worry in the near future).

Obama has shown that he will make terrible economic decisions as long as they help him reach his political goal of a socialistic/fascistic restructuring of a much more powerful national government. If Obama believes that reducing national debt by printing money will help him reach his political goals, then we will be swimming in newly printed twenties and hundreds. My investment manager believes this scenario is possible, and he is advising clients to adjust their portfolios to make them more inflation-proof.

Kevin writes:

I am convinced that the plan is to monetize this whole problem. So many Americans have so little net worth that inflation means next to nothing as long as they still have jobs. Print enough money, and every house that was mortgaged for $200k and worth $15ok will trade $300k, making everyone happy except for the boomers, foreigners, and anyone expecting to retire.

So in a way, I do find inflation an okay outcome. Who wants to retire anyway?

Dan C. writes:

I understand the arguments, but I'm not convinced. I believe Bernanke when he says that he has more tools to prevent deflation. It also seems clear that our government is focused on mitigation of near-term pain in the economy. Improvement in household balance sheets would be an essential component of that. Encouraging spending now would reduce the unemployment problem. Monetizing the debt would be helpful, too, if they don't spook the Chinese.

Mattyoung writes:

Housing should rebound to its deflated value. The question is whether the housing run-up was all bubble or was some of that real value increase relative to other goods. I am currently (though I change opinions often!) of the opinion that part of the housing run up was a real technological shift of housing relative to transportation.

David S. writes:

Scott Sumner has a touching faith in the ability of the Fed to calmly raise interest rates as the economy picks up, even as unemployment (a lagging statistic) remains high. I, on the other hand, have no faith in the ability (or willingness) of the Fed to withstand the withering political fire that such a policy would generate. If they decide to try to fight inflation at all, which I doubt, they're going to be late and slow.

Besides, the only possible way out of the current mess is for the Fed to monetize the debt. And the size of the deficit doesn't give them much choice in any case, as the Treasury will be issuing so many bonds that the Fed will have to serve as their buyer of last resort to avoid a total collapse of the bond market.

In the spirit of this blog, I've put my money where my mouth is: I've put just about all of my savings into TIPS. I expect the gains, even after taxes, will offset the upcoming erosion in the purchasing power of my salary.

Gavin Andresen writes:

I'm with David S. I just did a cash-out refinance of my fixed 30-year mortgage, and am investing the cash in TIPS.

Gary Rogers writes:

There is only one argument that will convince me that we have nothing to worry about. That one argument is an explanation of why we will never have to pay back the money we are borrowing. If there is a way our debt will be wiped clean, I will quit worrying. Otherwise we have an unsustainable situation, and like all unsustainable situations in economics it will stop.

Yes, the United States has an unbelievably high credit limit, but it is not infinite. Right now the Chinese, South Koreans and other exporting countries are happy to loan us money at low rates for the same reason cash strapped GM is still loaning money to car buyers; it helps them sell their products. But if the government continues to spend the way it is, our credit will be cut off leaving interest rates that will make the 1970's look mild.

Gabriel M. writes:

Good luck controlling for all the relevant premia in those TIPS!

cm writes:
1. The bond market shows very low inflation expectations. Especially the TIPS spread. As I have said many times, "good economists don't make predictions, they infer market predictions." (It's fun to create maxims that imply you are almost the only "good economist" in the world.)
Didn't the market show very low mortgage default expectations?

There's a simple fact here: The government is adding trillions of dollars to the national debt with no plan on the table to pay it back.

Tom H. writes:

As day follows night, inflation shall follow recession, especially this recession. Demand will pick up but may take another 18 months. "Brutal" inflation will most likely arrive after the Feds realize they have to increase interest to get people to buy their paper.
I'll hedge my bets as always and assume no or low inflation in the near term and 4-5 percent inflation in the medium term (mid 2011 - 2014).

Philo writes:

I'm not convinced there won't be serious inflation soon. I am convinced that that's the way to bet.

Zz's writes:

I am curious as to the Fed would do in this situation:

Inflation has picked up and the FOMC has begun to sell treasuries. The Treasury department needs to raise a significant amount of capital in a given day, say $40 billion. The auction doesn't produce $40 billion in reasonable bids. What does the Fed do?

I imagine that the Fed would make up the difference, and try to then sell the treasuries on days where the Treasury Department is not issuing as many securities. However, this is an ugly situation all around. Could this happen in the next few years or is this just an impossible hypothetical?

P Allen writes:

I’ve been convinced since Feb 16th 2005. Just look at the genesis of the conundrum. Long rates coming down as the Fed deleveraged the economy. Way too much productivity exists right now (outgrowing GDP by roughly .50 percent since 2000. Historically it lags GDP by over 1.00 percent). Meanwhile, the unemployment rate is three times that of longer-term interest rates, a very deflationary signal. Anyway, we will see a sub 1.00 percent 10yr way before we ever see a 6.00 percent 10yr no matter how much money is pumped into the system. The next shoe to drop, consequently, is the Fed “losing control” of the short end of the curve.

M. Simon writes:

I (no economist - I'm deeper into PID loops than bond spreads) have written a little on this subject at

Unstimulating

Here is a bit from the WSJ quoted in that piece:

The U.S. Treasury auction of long-term bonds on Thursday was “terrible”, in the words of one Wall Street economist, with the rate on the 30 year bond jumping from 4.1 to 4.3 percent. This is just the first sign that the debt-based Obama economic stimulus plan is about to become a major drag on the recovery, just as expected.

I'm betting on stagflation.

8 writes:

New home buyers will face higher interest rates, along with higher taxes and higher living expenses; wage growth will not keep pace. The real price of homes will be falling along with existing mortgage debt, even as nominal prices rise.

Methinks writes:

So, are we Japan or Zimbabwe? Japan printed money like it was going out of style, but the overhang was too big and Japan remained in a recession for over a decade.

aaron writes:

I agree, as usual, with 8.

Whether we have inflation or deflation isn't too important right now. It's the price changes that we need to be concerned with.

After the financial crisis became public in September, we did exactly the wrong thing. The economy that our financial system attempts to track changed. We realized that we were borrowing and lending recklessly and we changed how we decide whom to lend to.

We ended up with policy that tried to inflate away a fundamental change in our behavior. Before the crisis, there was a switch from investment in housing to commodities. Because of this, our expansionary policy inflates costs but not assets like we wish. To make matters worse, our attempts to expand the monetary base pull money of from real, productive capital investment to purchase government bonds.

Inflation and deflation are two sides of the same coin, a loss of meaning for our money.

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