North Atlantic Bond Markets and the Near-Term Macroeconomic Outlook: Daily Focus
The bond market has continued to believe the four things it started believing in mid-2013, at the time of the taper tantrum:
- The FOMC believes in an expectational Phillips Curve with a natural rate of unemployment below but near to where it is today, hence inflation is going to start rising slowly after next year when the unemployment rate crashes through the NAIRU heading down.
- The FOMC believes that the expectational Phillips Curve is relatively flat, and so the pace at which inflation is going to start rising will be very slow.
- The FOMC will explain away any failures of inflation to rise over the next four years or so as due to specific factors, and not revisit its view of the appropriate interest rate path until late in this decade.
- Thus the FOMC will raise interest rates, and the average 3-Month Treasury Bill rate over the next five years will not be the 0.4%/year or so expected before the taper tantrum but rather something like 1.4%/year.
And over the past six months the market has come to believe:
- The FOMC’s policies are and will be too tight for it to hit its 2%/year inflation rate target over the next five years.
- Rather, the FOMC’s policies will produce an average inflation rate of 1.3%/year over the next five years–a cumulative undershoot in nominal demand by an additional 3.5%-points.
- But because the FOMC will not realize its policies are too tight–will explain away the quarter-by-quarter undershoots as due to special factors until late in this decade–investments in 5-Year Treasury notes will produce positive real returns, an expectation not held since 2010.
And, as near as I can see, the FOMC factions believe:
- Interest rates need to be raised now so that commercial banks can return to their normal business models and not be forced to attempt profitability via the reach for yield by making risky loans that they cannot properly evaluate.
- The market’s macro expectations are less well-informed than those of the Fed staff, and should be ignored as reflecting fads and fashions, panic and exuberance.
- All or nearly all of the excess 2%-point decline in prime-age male labor-force participation over and above long-term trends is not or is no longer “cyclical”, in that these missing male workers cannot be pulled back into the labor force unless the economy becomes one of such high pressure as to produce unacceptable inflation.
- All or nearly all of the excess 1.5%-point decline in prime-age female labor-force participation over and above the declining structural trend that (perhaps) began in 2000 is not or is no longer “cyclical”, in that these missing female workers cannot be pulled back into the labor force unless the economy becomes one of such high pressure as to produce unacceptable inflation.
- It is not worth running any inflation risks to find out whether our views are correct or not.
From my perspective, all I can think is that the FOMC hs fallen victim to a form of groupthink in which it really does not understand the situation and the risks. The members of the FOMC who seek primarily to normalize interest rates out of a concern for the commercial banking sector do not understand:
- Expectations of normal inflation rates and full employment need to proceed interest rate increases.
- If they do not premature interest-rate increases will have to be rapidly reversed.
- And the time spent near the ZLB will be even longer.
The members of the FOMC who seek optimal control do not understand:
- How uncertain we are right now about the current state of the economy.
- How uncertain we are right now about the current structure of the economy.
- How even if the bond market’s shift over the past six months in its expectations is not a good rational forecast, it is nevertheless a major leftward shift in the IS curve that needs to be neutralized by someone.
- How dire the situation in Europe is.
- How much of the linkages across the Atlantic are due not to (small) trans-oceanic trade flows and their influence on aggregate demand, but rather to psychological animal-spirits contagion.
Paul Krugman is on the case:
…with Bild warning that Draghi’s expected actions will reduce the pressure for reform in ‘crisis-hit countries such as… France.’… Look at ‘crisis-hit’ France; investors are so worried about France that they won’t hold its bonds unless offered, um, 0.64 percent, the lowest rate in history. But never mind… the French must be in crisis, because they still believe in social insurance, and besides, they’re French. Notice also that crisis-hit Spain is now paying a lower interest rate than Britain…. This should… put an end to all the talk about how low British rates are the reward for austerity, and so on….
Very low rates reflect market expectations that (a) the European economy will remain very weak and (b) that the ECB will continue to fall far short of its inflation target…. The market is saying both that there are very few good investment opportunities out there–few enough that paying the German government to protect the real value of your wealth is a good move–and that inflation over the next five years will be around 0.4 percent, not the target of 2 percent….
The markets don’t believe that the US is immune to these ills. Market expectations of inflation… have fallen off a cliff…. [Yet] Fed officials seem weirdly complacent…
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