Evan Soltas
Jan 18, 2012

Wanted: Good Monetary Policy

The disproportionate consequences of untimely contraction

The graph above takes a pair of Treasury bonds, one inflation-indexed, the other not, for several different maturities and calculates their differences to determine a market expectation for average inflation during that time frame. What fascinates me here is the extraordinary volatility in long-term inflation expectations since the end of the recession in July 2009.

It may seem small: we're talking about swings of roughly 1 percent in inflation expectations in the 5-year time frame, and swings of 50 to 75 basis points in the 7-, 10-, 20-, and 30-year time frames. But this is extraordinary--historically anomalous, in fact. Prior to the recession, these breakeven rates were anchored at 2.5 percent, regardless of economic conditions and monetary policy action.

Why does that matter? First, stable inflation expectations are essential to long-run growth. Unpredictable inflation introduces unnecessary risks to lending and borrowing, impeding investment. Yet I'm about to make a case you might not have heard before: the Fed's conservatism is seriously endangering inflation expectations in the medium- and long-run. (Not growth expectations, or "full employment"--that's an easy argument to win. Inflation.)

We can see this in how the volatility of these breakeven inflation rates move with short-run Fed policy--namely, the quantitative easing programs and related asset purchases. Yet these are short-run policies; why are we seeing them impact long-run inflation expectations?

I see this as the clearest evidence I've ever seen of market concern that without continued accommodative monetary policy, we could be heading for a liquidity trap scenario of protracted periods of low growth, low inflation, and high output gaps. The only reason long-run inflation expectations would respond in this way, we can see, is that if the market expected Fed actions now would be highly determinative of the long-run. This is what an economy making an unsure exit from a liquidity trap looks like. It is highly suggestive that the Fed, moreover, remains disturbingly close to deflationary pressures and has significantly more leeway than I would have thought previously for expansions of QE before it has any negative impact on inflation expectations.