Scott Sumner  

We never seem to learn

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At the beginning of 2015, we were told that growth would pick up, because plunging oil prices were "like a tax cut." Well, they are like a tax cut, but of course demand-side tax cuts also fail to boost growth, as we saw in 2008. Growth in 2015 did not pick up, if anything it slowed.

Now we are being told that plunging oil prices are dragging down the stock market:

Stock markets around the world fell heavily Friday as investors reacted to new 12-year lows for oil prices, auto sector woes and China's struggling economy.

Bond yields are also plummeting, as are TIPS spreads. The 5-year TIPS spread is now around 1.2%, indicating only about 0.9% for the PCE inflation rate that the Fed targets. If we had a NGDP futures market for 2016, it would almost certainly be sinking as well. And yet the Fed plans to raise rates 4 times this year, to prevent high inflation.

In fact, plunging oil prices neither help nor hurt the economy. What matters is the thing causing a price change. If it's more supply, that's good. If it's tighter monetary policy (as in recent weeks) that's bad.

Another thing we never seem to learn is that low interest rates don't mean easy money. Kevin Erdmann brilliantly skewered that misconception in the comment section of a recent MoneyIllusion post:

Well, I guess any fears about the rate hike should be allayed now that we are getting all this stimulus from low rates at the long end!
And why don't we have a NGDP futures market? I created one for 2015, with financial assistance from Gabe Newell, who is CEO of Valve computer games. (Actually two, with the assistance of other commenters, but unfortunately the second closed down.) But why does having essential information about the US economy depend on whether a former Bentley professor is able to raise enough money for a prediction market? Where is the Fed? Aren't they a tad bit interested in finding out about how they screwed up? What about the Treasury? How about elite macroeconomists? Are they smarter than the markets? I predict that future generations will be stunned by how long it took to set up a system of prediction markets for key macro variables.

I guess I'll have to try to raise money for another prediction market for 2016---I just don't see why I am the one who has to do all the work.

Even worse, the only FOMC member who seemed to have a good grasp of these issues just retired. Here's Narayana Kocherlakota:

Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:

1. investors' best forecast about what inflation will average 5 to 10 years from now

2. the inflation risk premium over a horizon five to ten years from now - that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.

(There's also a liquidity premium component, but movements in this component have not been all that important in the past two years.)

There is often a lot of discussion about how to divide a given change in breakevens in these two components. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.

It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run. If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%. A decline in the first component of breakevens signals a decline in this form of credibility.

Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.

But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors' assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low - that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC's goals.

Should we see such a change in investor beliefs since mid-2014 as being "crazy" or "irrational"? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines. Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large asset holdings. Isn't it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC's goals?

To sum up: we've seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors' forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC's credibility.

And of course the two rising forces in American politics are socialism and nationalism, both of which are anathema to stock investors. Even though their respective leaders probably won't be elected president, the strength of their support is a harbinger of things to come.

Have a nice day!

Comments and Sharing

COMMENTS (16 to date)
Warren writes:

There are those of us in your readership who might be able to help financially. Can you give us an idea what kind of stake is necessary to start such a market?

Scott Sumner writes:

Thanks Warren, I need to resolve some issues with the failed prediction market (iPredict) first, before I start trying to raise funds.

marcus nunes writes:

Scott, NK wrote: "To sum up: we've seen a marked decline in the five year-five year forward inflation breakevens since mid-2014."
Yes, that coincides with the time NGDP growth began to slide, bringing down both real and nominal variables with it!

Ricardo writes:

A "former" Bentley professor? Did I miss something?

E. Harding writes:

"At the beginning of 2015, we were told that growth would pick up, because plunging oil prices were "like a tax cut.""

-Dean Baker still believes that plunging oil prices boosted U.S. growth.

And all politicians are nationalist; Trump and Sanders just a little more so than the rest.

ThomasH writes:

Socialism is on the rise? What's the evidence of this?

No candidate that I've heard of (even the "Socialist") wants to nationalize the means of production, not even the "commanding heights." The percent of children educated in non-public schools is rising. The percentage of patients treated in non-public hospitals is rising. The range of debate over tax policy is between a small rise in the marginal rate with not much change in collection and a huge change in marginal rates and a large fall in collections. Federal employment as a share of the labor force is going down.

Scott Sumner writes:

Marcus, Good point.

Ricardo, Technically I'm an employee until June, but I no longer teach.

E. Harding, Does Baker have any evidence?

Thomas, Sanders proposes nationalizing one of America's largest industries--health insurance. In any case, polls show a strong increase in the fraction of Americans who view socialism positively, which is likely to lead to future policy actions such as dramatically higher minimum wages.

But no, we are not going to become another Soviet Union, if that's what you mean.

Charlie writes:

Did you listen to this econtalk? Tetlock seems to have had a lot of success building prediction games and even prediction markets. Might be a useful resource.

Scott Sumner writes:

Thanks Charlie.

Josh writes:

Tangentially - isn't cheaper oil also a positive supply shock, and if so, has the lack of benefit stemmed from insufficient NGDP growth, or insufficient magnitude of the supply shock?

Sina Motamedi writes:

Scott, why do you think falling oil prices are cause by tight money and not more supply?

Also, you should check out a new project called Auger, which is building a general-purpose prediction market platform using blockchain.

Sina Motamedi writes:

Here's a link:

Jose Romeu Robazzi writes:

One can find traces of socialism in a lot of places. The banking sector used to be fairly competitive and innovative, although very regulated. Now it is an oligopoly, and the Feds, although they don't usually exert power, under Frank Dodd they have imense power over the industry should they decide they have to do something.

And here is Prof. Sumner complaining that the Fed and the Treasury are not supporting an NGDP futures market. I ask: where is Goldman Sachs? Where is JPMorgan? Where is the NYSE? My point is that the oligopolization of the financial sector has created a lack of innovation. And society suffers, IMHO.

Scott Sumner writes:

Josh and Sina, Certainly in recent years the growth in supply has been the main factor depressing prices. But in recent weeks it seems to me that demand is also playing a role. In any case, I'd only expect lower oil prices to be associated with falling stock prices if it is a demand-side phenomenon.

Hans writes:

Excellent article, Mr Sumner!

Louis Woodhill writes:

Scott, how could participants in your NGDP futures market expect to make money?

Under NGDP targeting, it would be the Fed's job to make sure that anyone that bought an NGDP futures contract at any price other than the one reflecting the Fed's NGDP target lost money. And, the Fed has infinite power in this domain.

How could you have a large, liquid market involving what would amount to betting against the Fed on an outcome that the Fed controls?

Also, what would happen when (as they do every so often) the BEA revised its NGDP number retroactively?

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