Arnold Kling  

Real and Nominal Bond Yields

How Capital Regulation Creates... Male Variance and the Remnants...

A reader emails,

I think you'll be surprised when you pull up the 10yr real yield vs inflation expectations. Virtually the entire move in bond yields has come at the expense of the real yield component. 10yr real yield is now -.15% while the 10yr inflation expectation is a relatively "normal" 2.25%. Isn't the bond market saying we have a major growth problem that is separate from an inflation problem?

I think if Scott Sumner were here, he would say that the markets see the Fed tightening policy, with all of the impact of the tightening occurring in real GDP.

A more conventional macro story would be that the markets see the eurozone crisis as lowering the growth outlook for the U.S. Also, a conventional macro story would say that the aggregate supply curve should be fairly horizontal given how far we are from full employment. Therefore, any adverse economic event should have a relatively large effect in reducing real output and a relatively small effect in reducing inflation.

Should I be trying to tell a PSST story? I am not inclined to do so, because I don't think that market expectations are based on the PSST model.

I am in favor of expansionary monetary policy until we can sort out what is going on. If what is going on is almost entirely structural unemployment, then inflation will be at least as high as market projections, and probably higher, and we should stop the expansion. Otherwise, the expansion may do some good.

Am I worried about inflation getting out of control? Yes, but because of loose fiscal policy, not loose monetary policy. My line these days as that we have Progressive fiscal policy and Tea Party monetary policy, and I wish it were the other way around.

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CATEGORIES: Monetary Policy

COMMENTS (16 to date)
PrometheeFeu writes:

I think an expansionary monetary policy would at the very least assist in deleveraging and get us out of malinvestments.

Wayne writes:


You meant contractionary monetary policy, right?

I thought that overleveraging and malinvestments were consequences of the diminishing returns to liquidity and credit expansion.

Also, hasn't the Fed already expanded both quantitatively and, when that failed, qualitatively?

I could be mistaken on both the theory and recent Fed history...

Costard writes:

I fail to see how the Reserve's approach has been in any way "Tea Party". ZIRP and two rounds of QE are not expansionary? Good grief. Do not confuse the central bank's inability to get results with a desire for austerity.

Your entire position is to say, that unemployment is only structural if printing money doesn't fix it. But it is reasonably clear to everyone with warm blood and thumbs that the root of the problem is debt burden, that capital is being committed to debt repayment and cash reserves and that this is not a sort of commerce likely to employ a nation. Any reprieve via expansion - any jobs you create - is achieved only through more debt and more structural unemployment when the liquidity has run its course.

And what is the point of this distinction between fiscally- and monetarily-induced inflation? Is this an either/or proposition? Are investors utterly incapable of summing two risks when deciding between cash and not-cash? It is the confidence of currency holders that decides hyperinflation -- not the outcome of some hypothetical horse race.

PrometheeFeu writes:


Here is the idea I have:
The Fed creates short-run inflation (Maybe even by just going out and buying actual homes at a premium in distressed areas) which reduces the cost of servicing old debt. (Or in other words, forces principal write-downs) With debt service much more affordable, we have fewer people with a need to sell their house. This allows the price of housing to come back up a bit deleveraging home-owners. Now, if the Fed is very open about this and makes a credible commitment, we won't see a bubble because we'll all know this is just inflation, not more loanable funds.

As for the recent policy of the Fed, I don't know what to think. I have heard credible arguments that the Fed is incredibly tight and credible arguments that it is incredibly loose. I would tend to say it's tight because we don't see inflation and I'm not sure I believe in liquidity traps.

John Papola writes:


How does deficit spending lead to inflation? Isn't it just redistribution? Is it a function of foreign dollar holders buying up treasuries and leading to an increase in the US money supply? If that's not it, aren't the dollars that go into those treasury bonds coming out of the flow of spending? If I buy a treasury bond, I can't use it to buy goods. So my purchase of treasuries is no more inflationary than my purchase of stocks or other bonds.

I thought inflation was always and everywhere a monetary phenomenon. Please help me understand.

Eric Larson writes:

Low interest rates means more loans means the money supply grows faster. However, in this environment loans are hard to come by.

Philo writes:

"I don't think that market expectations are based on the PSST model." Assuming the Efficient Market Hypothesis, market expectations are implicitly based on the *correct* model. As an EMHer, I conclude that the PSST is not correct.

Doc Merlin writes:

No, the fed isn't contracting monetary policy, the ECB is expanding monetary policy.

John Papola writes:


Low interest rates reflect a number of things, none of which are the result of so-called "fiscal policy" (running a government deficit).

If interest rates are low due to increases in the base money supply from the Fed, that is inflationary and it's monetary policy. If interest rates are low due to a decrease in the demand for loans, that is neither fiscal nor monetary policy but something happening from the bottom up (perhaps in reaction to regime uncertainty from bad policy). If interest rates are low because of a flight to "safety" by dollar holders spooked about the future (probably due to bad govt policy), that may or may not lead to increasing domestic prices depending on whether the bond purchases are coming from domestic buyers or foreign dollar holders.

None of this is "fiscal policy" producing inflation. It's either monetary policy or international capital flows.

So my question is still open: how does fiscal policy create inflationary pressure?

foosion writes:


I believe the argument is that fiscal stimulus creates more economic growth which increases demand which increases inflation. Velocity increases along the way.

This is only true in a lousy economy. In a better economy, government lending tends to crowd out private lending.

Eric Larson writes:

John, sorry I totally misread your question. Remember the old joke about Milton Friedman seeing the money supply everywhere? I wholly endorse "anywhere and everywhere a monetary phenomenon". The truth is fiscal policy can act a lot like monetary policy. Who doubts that food prices would decrease if food stamp enrollment went back to its pre-recession levels? However, few see them as a major contributor to food inflation.

China's purchasing of our debt is leading to inflation in China. If China diversifies out of US debt, the Fed will be forced to paper over the difference. We could not afford the interest payments, otherwise. Given the short duration of US debt, rates will rise quickly. We are past a Volcker moment and there were no cuts in spending. The debt portends potential inflation just like a dammed river portends potential flooding (if the dam were to burst). Gold is signalling inflation fears, like flood insurance for riverfront property.

PrometheeFeu writes:

@Eric Larson:

"Who doubts that food prices would decrease if food stamp enrollment went back to its pre-recession levels? However, few see them as a major contributor to food inflation."

Actually I would and so would most economists. There is no such thing as "food inflation". Inflation is a general increase in the price level of goods and services. If food prices increase and everything else stays more or less stable, that is a relative price change, not inflation.

Eric Larson writes:

Don't be a pedant. I know about relative price changes. It is quite clear from context I meant "price increase", it is part of the lexicon.

I can be equally curt and nitpicky:

I think an expansionary monetary policy would at the very least assist in deleveraging and get us out of malinvestments.

Actually,no, easy money will not help reduce "mal" investments. What causes "mal" investments in the first place? Easy money's distortion of time-preferences. Who is us? Investments are made by individuals or firms. I don't have time for this minutia ad infinitum. Instead I prefer to be charitable and evaluate arguments in good faith. I am not a pedant.

Costard writes:

John --

That, at least, is no mystery. The heavy debt load that accompanies fiscal extravagance will, eventually, lead to default or monetization. Market participants know this, and the point will come where they demand higher treasury yields, the debt becomes unaffordable, and one of these inflationary outcomes becomes forced (rather than being monetary "policy").

Eric --

That is true with regard to China, however you must remember that we are accumulating debt in the process of trying to stimulate job growth. China's treasury purchases have the opposite effect of moving American jobs overseas. It is a vicious cycle that ends with the insolvency of our government and the bankruptcy of their export economy, and no real gain for either country.

Bill writes:

I think I'm on the same wavelength as Eric Larson and Costard but am a bit surprised by the Keynesian logical underpinnings in the post.

How does expansionary monetary policy by a statist institution like the Fed help things become sorted out?
Malinvestment is partly caused by dilution of the value of money to benefit some over others.

I would like to justify Arnold's argument without accepting the Fed's money-printing spree as being beneficial policy. Can anyone help a young novice with that?

Also Arnold, what would your PSST story be?

Eric Larson writes:


I meant to second your prior posts, but forgot. I think the Chinese government is foolish to lend so much. They certainly help the U.S. government. I have trouble seeing is its effect on the economy. Government spending on the welfare and warfare state are such a large part of GDP that they crowd out bona fide economic activity(aka PSST). A cost/benefit look at spending on the New Commanding Heights brings to mind "...and all I got was this lousy shirt".

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