It was another slow day yesterday, part of what is shaping up to
be a typically slow August week. I am always fascinated during
these slow weeks by the fact that the same news that ordinarily
would send markets spinning one way or the other will often seem
ignored altogether, as if each hair-trigger trader is waiting for
someone else to make the first move which never, as a result,
occurs. Other times, a possibly less-significant item will trigger
a bigger move if only a few large positions try to move through the
What that probably reflects is that very large traders - pension
funds, large hedge funds, money managers - recognize that when
liquidity is low there is a larger cost to initiating any move.
Therefore, it takes more certainty of the result before it makes
sense to re-allocate any meaningful amount of the portfolio. (Thus,
the decline in volumes we have seen this year could be seen as
deriving either from a lack of confidence about market direction,
or from a decline in liquidity, or both.)
Yesterday's news was in the form of
an interview in the
Wall Street Journal
, later followed up by an interview on CNBC, of Boston Federal
Reserve Bank President Eric Rosengren. Now, Rosengren is a known
hawk, but he called out his cohorts on the Fed to "launch an
aggressive, open-ended bond buying program that the central bank
would continue until economic growth picks up and unemployment
starts falling again."
This is monetary idiocy. Mr. Rosengren has just become the
Krugman of monetarism: it isn't working, thinks Rosengren, because
a couple of trillion just isn't enough to make a difference. I have
renewed sympathy for Chairman Bernanke if he is forced to deal with
people like this who don't understand what they're doing, but
figure they just need to do more of it.
Let's be clear on the theory: if the Fed increases the money
supply while the velocity of money remains static, nominal GDP (PQ
in the monetarist equation) will rise. But here's where it's
important to actually understand the theory, rather than rely on an
equation. Nominal GDP can grow for two different reasons: because
the real economy has expanded ((Q)) or because the prices attached
to all transactions have risen ((
)). Theory says that if economic actors are fully rational, they
will recognize that the increase in money lowers the value of each
transactional unit of money (dollar) and so the increase in M will
be fully mirrored in P. If economic actors are at least somewhat
stupid or naïve, and take the increase in the money in their bank
account as an actual increase in wealth, they'll spend more and the
real economy will benefit.
This is called 'money illusion', and the evidence of the last
few years is that it's pretty weak. I suspect that's because most
people judge the balance in their checking account in two ways.
First, they notice when the balance itself is increasing over time.
But second, and significantly, they notice that each month the
checks they write take more out of the balance than they previously
did. That is, their reference point is not just the balance itself,
but the interplay of balances and consumption.
This makes it hard to fool them with money illusion.
The Fed's continued talk about how "inflation expectations are
contained" is clearly partly intended to increase the money
illusion effect and thereby increase the efficacy of monetary
policy on the real economy - the ethics of that practice I will
leave to others to discuss.
So if Rosengren had his way, and the Fed bought a trillion
dollars of securities every month, it wouldn't have a big effect on
the real economy. But you can bet it would have a huge effect on
the price level!
Now one place that I actually agree with Rosengren is on the
interest paid on excess reserves (IOER). He said the Fed should
reduce IOER, as I have written
times, and moreover that they should do it gradually so as to make
sure it didn't disrupt money market funds. Oddly, he said he didn't
want to go all the way to zero, so he's arguing about maybe a
10-20bp ease, but since results to such a policy are likely to be
non-linear it's not unreasonable to go slowly.
Maybe it is talk like this that explains why inflation
breakevens have recently been striking out higher. To be sure,
another reason for the rise in inflation expectations, at least at
the short end of the curve, is the 17% rise in spot gasoline prices
since June 21st, but this shouldn't cause a severe effect at the
10-year point of the inflation curve. 10-year inflation
expectations as measured by inflation swaps are up 25bps over the
last two weeks, and breakevens (the spread between TIPS yields and
Treasury yields) has risen by a similar amount.
This is an unusual time of year for breakeven inflation to be
rising. As the chart below (
) illustrates, compared to the last ten years' worth of data on
10-year breakevens it seems almost as if this year's pattern has
been shifted earlier by about two months.
Click to enlarge
I don't have a great explanation for this; most likely, it's
just spurious. But it helps to illustrate that this is an abnormal
behavior. In the last 13 years, 10-year breakevens have declined in
the 30 days following July 25 on 10 occasions, and this is also
true (10 out of 13) at the 60-day horizon. The average additional
"normal" decline in breakevens forward from this date, as you can
see from the green line above, is about 15bps.
Now, that may mean that TIPS are overextended (relative to
nominal bonds; there's no question in my mind that they're
overextended on an absolute basis) and that breakevens are about to
fall back. But it may also mean that there is something more
significant happening here.
I recently highlighted
the unusual recent performance of commodities relative to the
dollar, and this is of a piece with that observation. Our Fisher
model has TIPS overextended, but also has inflation expectations
lower than they ought to be, so that effectively it indicates a
short position is warranted in
TIPS and nominal bonds rather than one versus the other (it first
signaled this on July 31, for the record). The model signals go
back to 2001, and this is the first time that we have ever had that
Something interesting is happening, indeed, even if it is
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