The Destabilizing of Inflation
"Longer-term inflation expectations have remained stable" is a favorite platitude of many central banks. It is more or less the equivalent of affirming that "we the central bank are doing our job."
The Fed said as much in its statement today. What people don't realize is that it is not true any more. Longer-term inflation expectations have been dramatically destabilized since 2008. It is the Fed's fault.
First, a note about short-term inflation expectations. After the Fed's statement, the market expectation of one-year inflation in the U.S. this year fell 40 percent. That's not a typo. At yesterday's close, it was 0.2433 percent, and today it is 0.1475 percent. These numbers come from the yield curve of Treasury Inflation Protected Securities, also known as TIPS, and its spread against Treasuries of the same maturity. The market, in other words, is betting that next year will be ever closer to deflationary, as measured by the Consumer Price Index. This appears to contradict the Fed, who projected PCE inflation between 1.2 and 1.7 percent for the coming year. Given that today's meeting revised down this projection by almost a full percentage point -- the Fed had projected PCE inflation between 1.9 and 2.0 percent in its April meeting -- I think I will continue to trust the market projection.
But the scarier news about inflation, something that I think the monetary policy discussion has ignored, perhaps for fear of its implications, is that long-run expectations have been meaningfully dis-anchored.Before the crisis, the market knew what to expect: inflation between 2 and 2.5 percent for the foreseeable future. Now, not so much. The acute phase of the crisis disrupted inflation expectations, sending the market's expectation for five-year inflation briefly negative, and the 10- and 20-year to near-zero. Since then, they have bounced around the 2 percent level.
And it is the bouncing which is problematic. When the Fed eases, you might expect short-term inflation expectations to rise; long-run expectations should only move to the extent that the long run includes that short run and that the short-run accommodation will not be later cancelled out by a contraction.
What we've seen instead, however, is that the volatility in short-run inflation has extended to a remarkable extent into longer-run inflation. The market seems to be saying that what the Fed does now, in the short-run of the present, has extraordinary, even unprecedented, leverage over inflation in the future.
A QE program, or lack thereof, appears to alter inflation expectations by up to 1 percentage point for every year for 5, 10, or even 20 years.
We can see this more rigorously by looking at the standard deviation of 5-, 10- and 20-year inflation expectations -- and what we see is that inflation expectations have been indeed more volatile post-crisis than they have were pre-crisis. (Note: I date the start of the crisis as the first week of October 2008, and my post-crisis data sample begins in February 2010, when the 30-year Treasury bonds were reintroduced. The finding, also, is generally robust to any reasonable selection of pre- and post-crisis data.)This graph should be deeply disturbing to any economist. The 20-year outlook is now as uncertain as the 5-year outlook in terms of inflation. Long-run inflation has been dis-anchored downward.
When I first noticed this destabilization in January, I thought this was the liquidity trap at work:
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 [i.e. accelerative] impact on inflation expectations.Now I think it is just an uncertain Fed unable to manage the expectational channel.