Lack of Inflation Baffles Economists

Are we caught in a liquidity trap?

July 13, 2011

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inflation eagleInvestors betting on inflation don’t have much to show for their prognosis. Last week, The New York Times reported that yields have fallen off for U.S. inflation-protection bonds in the past quarter, a contrast to a year earlier when inflation expectations were higher. Longer term, TIPS have performed in the middle of the pack of government debt issues.

“Over the last five years, inflation-linked bond funds have returned 6.36 percent, annualized, compared with 6.04 percent for intermediate government debt funds and 7.4 percent for long-term government bond funds.”

Last year’s spike had much to do with gasoline prices, which have since abated, as well as concerns about quantitative easing, which was supposed to raise inflation a little bit. That doesn’t appear to have happened.

Not that other countries aren’t concerned about inflation. Central banks in China (6.56%) and India (7.50%) have hiked interest rates. Last week the European Central Bank also raised rates – despite a periphery that is awash in debt and overwhelmed by the tides of recession. Still, it was to 1.5% Australia, like Canada, was spared the worst of the recession, but was quicker to raise interest rates, before calling a halt, this month, at 4.75%. In Canada, the overnight rate is still 1%.

China and India have booming economies, so there are inflationary pressures. It’s less clear that the eurozone does. As for the U.S., Federal Reserve attempts to create inflation have failed.

Which leads to a conundrum for economists. As Berkeley economics professor and former deputy assistant treasury secretary in the Clinton Administration Brad DeLong put it: “There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down. … We’re on target to have $10.7 trillion outstanding by mid- 2012 — doubling the Treasury debt held by the public in just four years. Supply and demand tells us that a steep rise in Treasury borrowings should produce a commensurate fall in Treasury bond prices and thus higher interest rates.”

It hasn’t. To explain that, DeLong has to go back to an argument he rejected in his grad school days, an argument that even its Nobel-prize-winning author, John Hicks, later repudiated.

“At the end of 2008, as the economy collapsed and the pace of net Treasury debt increases quintupled … I presumed we had a little time for expansionary fiscal policy to boost the economy — a year, maybe 18 months — before the bond-market vigilantes would arrive. They would demand higher interest rates on Treasury bonds, which would begin seriously crowding out the benefits of fiscal stimulus. The U.S. government would have to react, pivoting from fighting joblessness, via deficit spending, to reassuring the bond market via long-run tax increases and spending cuts to Medicare and Medicaid.

“But it didn’t happen in 2009. It didn’t happen in 2010. And it isn’t happening in 2011. There are no signs from asset prices that the market is betting heavily that it will happen in 2012. Looking at the yield curve, it appears the market intends to swallow every single bond that the Treasury will issue in the foreseeable future — and at high prices. The prices of inflation-protected bonds suggest that the market expects the new Treasury issues to be devoured without any acceleration in inflation.”

In Hick’s elaboration of Keynes’s theory, the explanation is this: “A financial crisis initiates a sudden flight to safety among bondholders — widening interest-rate spreads, diminishing the private sector’s desire to sell bonds to raise capital and encouraging individuals to save more and consume less as they, too, hunker down. Thus bond prices rise, and interest rates drop. As rates fall, firms see that they can get capital on attractive terms and so issue more bonds; households see the low interest rate earned on their savings and lose some of their desire to save. The market heads toward equilibrium.”

Except when it doesn’t. And as blogger Yves Smith, the author of ECONned, a book about the financial crisis, points out, not even Keynes believed that financial markets tended toward equilibrium. Instead, it’s the animal spirits, which are distinctly depressed these days.

As a result, says DeLong, “The decline in interest rates and the rise in savings are accompanied by an increased desire among businesses and households to safeguard more of their wealth in cash. As a result, the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, workers are fired, and their savings evaporate with their incomes.”

It doesn’t help that 14 million Americans are unemployed, and significant numbers have dropped out of the workforce altogether – which means the headline rate of 9% unemployment is more than double, if one were to use the statistical definitions of 1981. (On the other hand, that same data source says inflation is actually running at 10%, which would seem to contradict the classic Phillips curve, as well as its reinvention as the non-accelerating inflation rate of unemployment.)

So it’s no surprise that monetary policy seems to have reached its limit, As DeLong argues. “But when rates become so low that there’s little difference between cash and short-term government bonds, open-market operations cease having an effect; they simply swap one zero-yielding government asset for another, with their hunger to hold more safe, liquid assets unsatisfied.  This is the liquidity trap.”

Japan, in other words. The way out? Higher government spending. But that’s not what’s on the table in the U.S. Indeed, many fear it, arguing that costs of current fiscal policy will see yields rise substantially anyway, let alone adding further stimulus.

But as always, there’s Japan – two lost decades and change – notes Smith: “At a time when the US government is getting free money, borrowing on the short end for zero percent and interest rates are 3%, not 9%, why would anyone believe this stuff? Riddle me this: why aren’t Japanese JGBs yielding 9% instead of 2% all the way out to 30 years when they have debt to GDP of 200%?”

The dismal science, it appears, has happy explanations for the good times, but not much else for dismal ones.

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