The Contractionary[?] Federal Reserve Policies of 2013-2014: Friday Focus for September 19, 2014

Let’s look at the five-year and ten-year U.S. break-even inflation rates–the inflation rates at which an investment in U.S. Treasury bonds held to maturity produces exactly the same return as an investment in U.S. Treasury inflation-protected securities of the same maturity:

The most obvious feature of the graph is the liquidity squeeze of 2008–when people were dumping inflation-protected securities at ludicrous prices because they were thought to be less cash-like than Treasuries, and people wanted cash. It is not always the case that the inflation break-even tells us what Ms. Market’s inflation expectations are; it is not always the case that the price of TIPS relative to Treasuries is set by a thick group of rational arbitrageurs focused on trying to profit from others’ misperceptions of likely future inflation:

The second thing to note is the relatively sharp drop in Ms. Market’s inflation expectations since the mid-2000s: a delta of about -0.8%-points/year. Back in the mid-2000s we thought:

• that the labor market was close to full employment; today we think it is still substantially below full employment;

• that the cushion needed between the inflation target and zero to keep interest rates from hitting the zero lower bound and causing significant macroeconomic distress was low; now we think it is higher; and

• that the overall price level was about where people had expected it to be ten years before, and thus there were few contracts, expectations, and rules of thumb in the economy that needed a higher price level than we had then in order to function smoothly; today our price level is 4% lower than people a decade ago would have predicted today.

All three of these strongly militate for a higher expected inflation path going forward from today than the inflation path anticipated back in the mid-2000s. Yet our anticipated inflation path is not higher but rather 0.8%-points/year lower.

This makes absolutely no sense–unless you believe that inflation as it was back in the mid-2000s and as it was then anticipated to be was markedly too high.

The third thing to note is what has happened in the past eighteen months, since Ben Bernanke began talking about how it was time to “taper” the Federal Reserve’s Quantitative Easing asset-purchase programs:

If you thought that aggregate demand was on an acceptable medium- and long-term track back in the winter of 2013–with the 10-year breakeven at 2.5%/year and the 5-year breakeven at 2.2%/year–you certainly do not think that aggregate demand is on an acceptable medium- and long-term track now, with the 10-year breakeven below 2.1%/year and the 5-year breakeven kissing 1.6%/year.

There is right now a very sharp disconnect between how the Federal Reserve views the last eighteen months–as policy staying the course and remaining on track–and how Ms. Market view the last eighteen months–as the Federal Reserve initiating or accommodating a relatively sharp contraction in demand that is likely to lave the price level ten years hence an additional 4%-points lower than was anticipated. The Federal Reserve’s policy is data-dependent, but the data do not appear to include financial market forecasts and judgments.