Scott Sumner  

It's the economy, stupid

Prosecuting Truancy... What Does Fusion Mean for the ...

Here are some things that seem very likely:

1. The global stock/oil/bond yield plunge is at least partly due to expectations of slower nominal GDP growth. I know of no other economic news could explain a sudden decline of this magnitude. One plausible theory is that investors are losing confidence in the ECB, and/or the slowdown in China.

2. With the S&P now trading around 1800, a recession in the US next year seems very unlikely, albeit slightly more likely than a month ago. More likely the Fed will once again be wrong about its 3% growth forecast for "next year" for the umpteenth consecutive time.

3. Global policymakers like Janet Yellen and Mario Draghi would be able to make far more informed decisions if we knew what was happened to expectations of future aggregate demand. But because they are not willing to spend 2 million dollars setting up a highly liquid NGDP futures market, we do not have that information.

4. Monetary policy in all the major economies has tightened somewhat in the past month. However the degree of tightening may well be less than many people assume. Again, we simply don't know, but could easily find out if we wanted to. Nobody (including the economics profession) seems to care.

Last year I was sharply criticized by many individuals for my belief that QE had not significantly depressed interest rates. They pointed to evidence that rumors of ending QE had raised bond yields. We now have pretty conclusive evidence that I was right and they were wrong. Here's one common mistake they made:

a. We did have some pretty clear evidence that at least some of the rate increases were due to rumors of tapering. But only a small portion, not a significant portion. The rate increases occurred gradually throughout the year. Late in the year tapering was unexpectedly delayed, and bond yields fell only modestly. That was the first piece of evidence that I was right. They should have fallen sharply (if my critics were right), as the Fed restored the previous market expectations about tapering. Then German yields fell to levels far below American yields, without QE in Europe. Another piece of evidence my critics were wrong.

b. My critics missed the fact that while tapering rumors were clearly raising bond yields on a few specific days, most of the increase during 2013 was spread gradually throughout the year, and was reflecting much stronger than expected growth in the US (and elsewhere) in the second half of 2013.

c. Who was right? We now have a pretty definitive answer. Bond yields have plunged dramatically lower this year despite no "news" on tapering. Instead it reflects slowing expected global growth, just as market monetarists claimed. Most of the so-called "tapering" increases in bond yields during 2013 have been unwound.

The mistake people made was a common one, and had two parts. They forgot that more than one factor can explain a price change, and that a price change in a given day that is clearly linked to a particular news item does not imply that all the price changes that year are also linked to that news. We now know what we should have know all along, macroeconomic expectations are the dominant factor driving nominal bond yields. And keep in mind that global band markets are closely linked, so real interest rates in the US reflect not just US economic activity, but global growth as well.

The common (right wing) argument that QE was "artificially" holding down interest rates has now been blown out of the water, although anyone who looked at David Beckworth's posts on this topic would have reached that realization several years ago.

PS. Thirty year TIPS spreads are at 2.03%. That sounds well anchored, but the Fed is actually targeting 2% PCE inflation, which is equivalent to about 2.4% CPI inflation. (The TIPS are based on the CPI, and hence TIPS spreads are usually significantly above 2%.) So long term inflation expectations do seem to be falling, and are now well below the Fed's target. I think this reflects a modest loss of credibility, due to fear the Fed can't handle a low rate environment with their interest targeting tools. But in fairness, they still have much more credibility than the ECB, at least for the next few years.

Ten year TIPS spreads are at 1.88%

PPS. People who have been hawkish since 2008, warning that QE would cause high inflation, really need to throw in the towel. Always remember; good economists don't make forecasts, they infer market forecasts.

Comments and Sharing

COMMENTS (17 to date)
Michael Byrnes writes:

How does today's strong unemployment claims number fit in? Is this part of why you say "the degree of tightening may well be less than people assume"?

maynardGkeynes writes:

Many say that TIPS spreads underestimate expectations. I think this is true. The reason given used to be lack of liquidity relative to T-bonds, but I think its more because they are way overbought by hedge funds // carry traders, and to a certain extent, pension funds, who don't have a lot of other options on real return assets.

Ken from Ohio writes:

I really appreciate Prof. Sumner's discussion of the US bond market - particularly because it supports my personal bias.

Although I don't have the data to support it (I should try to find the numbers) it has been my feeling that the magnitude of QE was insufficient to move treasury yields.

My opinion has been that treasury yields (and German yields also) have been influenced more by global capital flows - a "flight to safety".

And when the markets realize that the global economic outlook (for many, many reasons) is not so bright - capital flows away from equities and into "safer" bonds.

I think that is what has been happening in the markets the last couple of weeks.

I don't have the data to prove that. So if a commenter has capital flow data to prove or disprove my statement, I would be happy to see it.

Does the Bundesbank have a very peculiar sense of humor (not just econ)? Buba executive Andreas Dombret just gave this speech: "The euro - taking off or staying grounded?"

Sorry, it's tragic.

Greg Jaxon writes:

US QE explains the 2012/Q2-2014/Q2 trend of falling rates, and ECB QE explains the current run-up in US bond prices. At negative interest rates in Europe, we should be seeing a "Euro carry" trade develop analogous to the Yen-carry of Japan's infamous lost decades.

Money flowing from the commodities market to the bond market is part and parcel of this deflationary era. QE (because it drastically lowers the risk in bond speculation) only calls the tune, it does not force the march out of commodities and capital enterprises. The idea that it can reverse that flow is simply wrong.

John Hall writes:

Inferring market forecasts? That sounds like Black-Litterman's reverse optimization step to portfolio management.

Kevin Erdmann writes:

Scott, here is a post I did yesterday, with a graph of forward interest rates from the June 2016 Eurodollar contract and the December 2021 contract.

Note that in the spring & summer of 2013, both rates rose, with 2021 rising as fast or faster. If the rise had been primarily from a taper, we should have expected to see a compression between the too, as short term rate expectations would have risen while long term expectations would have declined.

Then, later, as the taper was delayed, the 2016 rate fell, as we would expect. But, the difference between 2016 & 2021 rose significantly, which suggests that the rate changes were a product of the taper delay. In other words, the taper was seen as justified by economic strength and the subsequent delay was seen as a welcome loosening of policy.

Then, as the taper was actually implemented, 2016 rates remained stable (since the economy grew strongly, suggesting that rising rates would come as expected), but long term rates slowly fell (possibly because the market slowly realized that policy would be too tight over the long run).

The odd thing here is that there seems to be minimal liquidity effect, but expectations in all the QE episodes appeared to effect rates slowly, concurrently with OMO purchases and the tapering of purchases. Maybe this is because the context is so unusual that markets aren't displaying any forward looking behavior. The marginal investor really doesn't know what to expect from each QE.

Conventional descriptions of Fed activity are defended by arguing that rates were pushed down when QE's were announced, and rising rates during QEs were because the market was already expecting them to end. But, I'd really like an answer to this question, because this seems odd to me. The liquidity effect comes from a sort of market inefficiency - expectations might eventually push rates up, but buying pressure in the trading pits from OMOs isn't fully countered by daily market action, so while the Fed is buying, rates decline. But, if this is the mechanism, how can the liquidity effect happen prospectively? It seems like this explanation is very selective about when markets are efficient and when they are not. How can they be inefficient enough to have a liquidity effect but efficient enough for the liquidity effect to be prospective?

BC writes:

"PPS. People who have been hawkish since 2008, warning that QE would cause high inflation, really need to throw in the towel. Always remember; good economists don't make forecasts, they infer market forecasts."

Scott, what are your thoughts on the following Ashok Rao post: []? By looking at inflation options markets (caps and floors), the argument is that, while QE didn't cause inflation, it may have caused an increase in inflation risk.

Yancey Ward writes:
With the S&P now trading around 1800, a recession in the US next year seems very unlikely,

What makes you think that???

Scott Sumner writes:

Michael, Yes, that was extremely strong, but I focus more on market indicators. The four week moving average is the lowest ever, as a share of the workforce.

Maynard, Any bias is likely to be fairly small. Don't forget that other markets are telling the same story.

Greg, Money doesn't flow between markets. When you sell an asset someone else buys it. The money doesn't leave the market. I'd encourage you to look for explanations consistent with the EMH.

Kevin, I agree there are some puzzles with QE--I'll take a look at your post.

BC, Interesting, but I don't see why he said QE2 would have affected inflation expectations between mid-2011 and early 2012.

Yancey, I'd expect stocks to fall much more sharply if a recession was expected. They are still close to record highs.

Roger McKinney writes:

If QE doesn't reduce interest rates below the market level, what's the point of doing QE? I thought the whole point for the Fed doing QE was to reduce long term interest rates. Are you saying that the Fed can't do that?

But you're right that they hysteria over inflation was unfortunate. Much of that came from followers of Austrian econ. But they forgot what Mises wrote - the only mistake worse than ignoring the quantity theory of money is taking it as working mechanically. People may not respond to low interest rates or increased money supply by buying consumer goods.

Of course price inflation has happened in assets, such as the stock market, but increased government borrowing or business borrowing is needed for cpi inflation, neither of which has happened much.

The latest stock market declines could be signalling a recession in six months. The stock market and money supply are the leading indicators in almost all models of the business cycle. If so, we will have a rare recession without a rise in interest rates.

Of course, Hayek predicted that could happen in his Prices, Interest and Investment. Profits can fall as a result of the Ricardo Effect even if the Fed doesn't raise interest rates.

Kevin Erdmann writes:

Here, I update the chart I mentioned before.

The posts aren't exactly on this topic, but I thought the graph of forward rate movements might be of interest to you.

And, regarding the QEs, am I right that the story about prospective liquidity effects is incoherent, or is there something I am missing?

Andrew_FL writes:

@Roger McKinney-As a sort of psuedo-Austrian, I agree the focus on and prediction of large consumer price inflation was unfortunate. It was also a theoretical mistake, not something that pops out of Austrian theory.

It's also worth noting that Austrian theory does not regard a lack of consumer price inflation as a lack of cause for concern. They aren't price level stabilizationists. If they were they wouldn't say that the 1920's were unsustainable.

I doubt the stock market is a good indicator of whether there will be a recession or not. This is probably more like 1987, when a stock market decline portended...nothing.

Don't quote me on that.

Zathrus writes:

Hi Scott, if you haven't already seen this box in the latest IMF WEO I thought you might find it interesting. They use market reactions in a VAR to show that initially after the tapering talk around 60% of the rise in bond yields was a 'money shock' (ie. the liquidity effect). By June of 2014 all of the rise in bond yields was all a 'real shock' (ie. higher growth and/or inflation).

In the VAR a money shock is defined as one where the S&P 500 and bond yeilds move in opposite directions, whereas a real shock is one where they move in the same direction.

Page 69, end of chapter 2:

Federico writes:

"The global stock/oil/bond yield plunge is at least partly due to expectations of slower nominal GDP growth". That makes sense, but what about the plunge in the dollar over the last few days? If the slower NGDP growth was engineered by the Fed shouldn't thast be a tightening of mon policy and therefore a strengthening of the USD? The USD behavior is really confusing. Note that I'm mainly referring to what happened last Wednesday

Roger McKinney writes:

Andrew_Fl, good points! I think we need a real inflation rate in the same way we adjust gdp for inflation. A real interest rate would add the rate of productivity growth to the nominal inflation rate because prices should fall with increased productivity and a fixed money supply. Of course, asset price increases should also be included.

The stock market is not a perfect predictor of recessions. It has predicted something like 10 of the last 8 recessions. But who or what has a better record? No one and nothing! That's why every model I know uses it and it's dangerous to ignore.

BTW, I took the 2011 decline too seriously and gave up some earnings in the stock market.

Colm Barry writes:

"... act that the regulators tend to design regulation more in favor of the industry that they regulate than in favor of the public that these are supposed to protect ..." The problem and the reason for this observation is that you need to be knowledgeable of the subject matter you want to regulate. If you want to regulate hunting, you will likely be a hunter. If you regulate the medical profession, you likely are a medical doctor etc. As the sociology of professions has shown, there is an effect called "professionalization" whereby a group of professionals begins to first regulate itself (q.v. "chartered accountants"), then obtains a "charter" or legislation insulating it from "unprofessional competition" like the barbers who today cannot operate, only surgeons can. These professions tend to develop an "esprit de corps". You can see how soldiers from nations who might actually be hostile to each other can come together for international competitions, e.g. scouting, swimming etc. and be utmostly courteous against each other - they recognise the fellow professional in their counterpart.

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