Arnold Kling  

Scott Sumner Back to Normal

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That is, he is saying things I disagree with.

1. Between July and November 2008 the Fed adopted an ultra-tight monetary policy.
2. Real interest rates on indexed 5 year T-bonds rose from 0.5% to 4.2%
3. The tight money caused NGDP growth to plunge from its usual 5% to negative 3%.
4. The AS/AD model predicts you'd get about 1% inflation and negative 4% real growth.
5. That's what we got, therefore modern macro nicely explains the recent recession.

According to Sumner, we know that the Fed tightened because we know that real interest rates on TIPS rose. The real rate is the nominal rate minus the expected rate of inflation. Because the nominal rate did not rise, the increase in the real rate came from a big drop in expected inflation. So we know that the Fed tightened because expectation inflation dropped, and we know that expected inflation dropped because the Fed tightened. That's too circular for my taste.

I'm also not convinced that we can read expected inflation in the TIPS market. Take right now, for instance. The TIPS market is saying that inflation is going to be low. But is that what the people who are buying gold believe? I don't think so.

I dare you to try to tease inflation expectations out of financial markets right now. It is as if the people who believe in low inflation are buying nominal U.S. treasuries, the people who believe in high inflation are buying gold, and the two markets are not talking to one another. Why aren't the inflation bulls shorting treasuries, and why aren't the inflation bears shorting gold?

One explanation for financial markets is that short-term nominal interest rates are low, so that speculators are willing to try a "carry trade" in anything--gold, long-term bonds, stocks, whatever. If that's the story, then folks, we're really living in BubbleWorld, and you can't read rational inflation expectations into any asset prices.

[UPDATE: David Beckworth gangs up with me (sort of) on inflation expectations. But I gang up with Sumner against Beckworth's interest rate indicator.]

Comments and Sharing

COMMENTS (16 to date)
JPIrving writes:

Or maybe much of the rise in the gold price is due to "peak gold"? This is what Sumner said a few weeks back anyway. I don't know what to believe.

steve writes:

I am not saying this is likely to be true. But perhaps, the gold market is not shorting the treasuries because they don't just believe inflation is coming but rather hyperinflation. If this is the case, it doesn't matter what the return on treasuries in dollars is it effectively amounts to 0. So, no point in shorting treasuries.

Or more likely, the gold market players are shorting treasuries, they are just a much smaller market then the treasury players so it doesn't have a huge effect.

steve writes:

So why aren't treasury players shorting gold. Again perhaps they are but keep ending up having to cover there shorts due to people actually taking delivery.

Ryan Vann writes:


I think you might be onto something. Anyone want to dig up some short/put data on gold?

Jorge Landivar writes:

1. I pity anyone who has been short gold the past year. Well, them being short makes the people who are long richer in this case. (YAY SQUEEZES)

2. The AS/AD model is true, but it doesn't actually tell us anything useful wrt what the AS and AD curves are. Recalculation, john geanakoplos's theory, and Hayek's Trade Cycle theory all try to explain why AS and AD are.

3. AMB doubled within a few months in the second half of 2008, that has to mean something.

steve writes:

Another possibility I can think of. Maybe the runup in gold isn't about inflation at all. Maybe it is all about counter party risk. Can't get any lower counter party risk then gold in hand. U.S. Treasurys could be considered a close second.

This could be true even during deflation (lots of bad loans). So perhaps, the bond and gold markets are in agreement.

8 writes:

A major shorter in the gold market, Barrick (ABX), closed their hedge book 10 months ahead of schedule.

I think of TIPS buyers as the classic conservative investor. If there's inflation, they are mostly protected. If there's no inflation, they get a small return (greater than their money market currently offers). If there's deflation, they own U.S. Treasuries and the value of the dollar is likely to increase.

TIPS fail if there's a non-inflation based sovereign default. I doubt there are many investors or financial professionals peddling retail advice that are thinking about sovereign default.

Elvin writes:

Sumner also supposes that the Fed had perfect foresight about inflation. "Adopting" isn't the right word, as that implies a conscious decision.

As I remember, July of 2008 was schizophrenic: soaring commodity prices and rampant complaints about inflation amid weakening demand and financial stress factures everywhere. Oil prices broke in mid-July, but the slackening in comsumer demand wasn't evident until mid-September when all hell broke loose with Lehman, AIG, the GSEs.

Take out energy and what was the change in prices?

I agree with those that say the high gas prices of early summer of 2008 broke the back of the economy. We could stumble along with a weak housing sector and a weak financial sector, but a panicked consumer and business owner wondering when there would ever be relief was the final straw. The decline in oil prices came too late, consumers and businesses had started to pull back.

Ryan Vann writes:


The counter party risk story makes a lot more sense given the run up in both assets. It also would be a pretty practical move given recent events. A tangent question to ask would be if the amount of gold being traded truly exists and whether US treasuries are really that safe.

Mark T writes:

5 reasons for the disconnect between TIPS and gold.

1) Gold has a lot more speculation in it. TIPS do not lend themselves to that.
2) Tips are sovereign obligations and many who are buying gold are doing so because they do not accept the creditworthiness of the sovereign. So there is a credit component to the decision not just inflation management. As well large TIPS holdings have to be held in a brokerage account so there is brokerage firm credit and SIPC credit risk too.
3) The feds are issuing far less TIPS than the market would actually buy.
4) TIPS generate phantom income for tax purposes -you pay taxes not just on the coupon payment but also on the annual accretion due to inflation.
5) Media, especially the Internet,supports gold speculation more aggressively than TIPS investment.

Doc Merlin writes:

"Take out energy and what was the change in prices?"

Still horribly bad, look at food commodity prices between 2005 and 2007.

Doc Merlin writes:

Sorry, I mean 2005 to 2009

woupiestek writes:

I though that Sumner compared TIPS with T-bills, and got his expectations that way. Anyway, the market is saying that gold prices will rise and consumer prices won't. There is no inconsistency here: consumer prices are not linked to gold prices. Whether this means high or low inflation expectations depends on how you define inflation.

random writes:

The carry trade also contains information about inflation expectations-the carry trade has you borrow short term and invest in longer term assets. Your cost of carry will eventually start to rise when short term rates start to rise, which should occur when inflation rises, and then you are in trouble unless your long term assets rise at the same time as the cost of carry rises. And as long as longer term assets are more sensitive to short term rates than shorter term assets, you are in trouble.

I am not so sure that you can completely disconnect carry trades from the risk of future inflation quite as easily as you make out.

scott sumner writes:

Actually, if you read the paragraph right before the one Kling quoted, I say I don't like using real interest rates as an indicator of the stance of Fed policy. I say the rest of the profession seems to like to use real rates. Or at least they claim that they like them after I explain how absurd it is to use nominal rates (i.e. the German hyperinflation.) So the premise of this post is inaccurate.

My point was; "OK you economists, if you insist on using real interest rates, let's see what happen to real rates in late 2008." If someone has a better way of estimating real rates I'd love to see it. But again, I don't think real rates show anything about monetary policy, it is the rest of the profession that seems fixed on them. And if you want to use them, then this approach does nicely explain how tight money drove the economy into a ditch in 2008. But don't expect it to work every time.

Regarding inflation, yes TIPS are fallable. But other than 1974 (which was distorted by the removal of price controls), when was the last time inflation accelerated during a period of high unemployment? I think it was 1936. So it is possible, but I doubt it will happen.

P Allen writes:

Sounds like a “conundrum” to me which is exactly the point which gold broke out of a well defined 20 year range (200 – 400 troy ounce) to the top side, Greenspan’s conundrum of mid-2005.

A lot of productivity means a lot of leverage. Since the leverage was needed (there’s a shock… another side to the argument) it found a temporary “home” in the commodity markets as the Fed effectively shutdown the financial sector by tightening Fed Funds much too much past the conundrum.

Therefore, this has nothing to do with inflation. If inflation were a problem long-term interest rates (10yr T-Note) would be much higher than the unemployment rate. Obviously, we have the opposite. Deflationary pockets, not inflationary ones, will continue to plague the economy (like they have in 2003 and 2008) given the surplus nature of productivity which, by its nature, is pressuring the output gap way beyond its economically acceptable level.

Expect much lower long-term rates over a longer period as the economy releverages itself no matter if the Fed believes they can control the tide. Conundrum part 2 by the way? The Fed losses control of the short end of the curve.

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