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Norway Or The Highway

Who says that inflation instruments are boring? Today TIPS and inflation swaps went on a wild ride, with yields more than 20bps lower early in the day before a selloff in nominal markets finally served to pull inflation-linked ones back down to earth (comparatively). This often happens in inflation markets; the big players (on the client side) have a larger share of the total volume than in the nominal Treasury markets, so when a few investors start to move at the same time the moves can be dramatic. Right now, with real yields negative over a significant part of the curve, many investors are short (or short their benchmarks), believing the inflation-linked bond (ILB) world doesn’t offer value.

This is arguably correct, but as I showed yesterday the risk-lessening advantage of explicitly indexed bonds is substantial enough that it is hard to find an alternative that adds enough reward to compensate for the risk…at least, that’s true these days when most asset classes are threateningly priced. Personally, I am considering selling some of my longer-dated TIPS, acquired at yields near 4% in early 2009, and buying short TIPS with significantly negative real yields but less exposure to a spike higher in real rates. I haven’t decided yet whether to do so, because transactions costs for retail investors in TIPS are sufficient to discourage moves that are not made with full conviction.

(As an aside, I am not worried much about the negative real yields; sure, July-13 TIPS are at -0.67% but with 3y Treasuries at +0.57%, I am still better off if inflation is as low as 1.25% per year for three years. Since oil and grains prices have both been on the rise lately and my model for core inflation just for 2011 is around 1.6%, this seems a decent bet…and I get the “tail” if inflation gets out of hand in 2012).

The 5y TIPS yield ended “only” 11bps lower, but short inflation swaps rose around 25bps. I say “around” because dealer and broker marks in this kind of move are best viewed with some kind of skepticism. But on the chart I showed yesterday, with the 1y inflation swaps spot, 1y and 2y forward, the latest points are around 1.14%, 1.46%, and 1.96%, which means that since Friday the spot 1y is up 25bps, the 1y, 1y forward is up 17bps, and the 1y, 2y forward is up 24bps.

And, while the inflation market didn’t react yesterday to the increasing drumbeat of QE2 in the U.S., I wonder if it is a coincidence that the reaction came after the Norwegian central bank essentially cut the interest paid on excess reserves. Thanks BN for pointing this out – the article on Reuters is here.  Although the terminology is a little different than what the Fed uses, and their policy rates are not yet constrained by the zero bound, the statement made clear that they understand the importance of the interest paid on excess reserves. “This will enhance,” they said, “the redistribution of liquidity in the interbank market.”[emphasis mine] That is exactly the argument I have been making about IOER: if you want the QE2 (and QE1!) liquidity to be distributed into the economy more broadly, to increase M2 and the more-important aggregates, then you need to stop paying the banks to keep the money out of circulation. It is that simple. At least in Norway, they seem to think that it is important that the liquidity moves into the broader economy! This is encouraging, because central bankers do after all attend the same conferences and they do talk.

The economic news today, represented by a somewhat weak ADP figure (-39k versus expectations for +20k, albeit with a 20k upward revision to last month), highlights the fact that will probably be reinforced on Friday: it is, in fact, important that the liquidity moves into the broader economy!

However, I think it’s also important that we keep in mind what quantitative easing can and cannot accomplish.

Recall that MV≡PQ is the monetarist identity. In words, it says that the amount of money in the economy, times the frequency per year that each dollar is spent, equals the price level times the real output. Or, in even simpler terms, the total amount of money spent each year equals the amount of stuff people bought times the price they paid for the stuff. You can see why this is considered to be an identity. It simply must be true. And it follows that %ΔM+%ΔV=%ΔP+%ΔQ … the growth rate of money, plus the growth rate of velocity, equals the sum of the growth rate of prices (that is, inflation) and the real growth rate of the economy.

This is why I don’t worry about deflation. If we assume that velocity is reasonably stable, then an increase in the rate of money growth must result in an increase in prices or an increase in economic growth, or both. If you print enough money, then unless the velocity of money perversely contracts at exactly the same rate you’re expanding the money supply, you will get an increase in nominal output.

But this is both the strength and the limitation of quantitative easing. When the money supply is goosed, the central bank cannot control whether it results in increasing prices or increasing output. And there are good reasons to think it will be primarily the former. When the amount of money in the economy increases, it is easy to see how that results in inflation. Pure supply and demand logic dictates that as the amount of money increases relative to the amount of stuff to buy, the exchange rate of money to stuff increases. That is, prices rise. Why would output rise? Well, with more money in the system, and therefore in each consumer’s pocket, consumers may feel wealthier and therefore spend more, triggering growth.

But this additional wealth is, of course, illusory. If I personally own 1/200 millionth of the money in circulation, and the value of all accounts is doubled, all my dollar bills exchanged for two-dollar bills, all my $5 become $10, my $10 become $20, and so on, then I still have 1/200 millionth of the money in circulation. I have twice as much money, but each dollar buys me half as much of the economy’s output as it did before. If I spend a higher proportion of my income now because I feel wealthier – if I continue to save $1,000 every month rather than doubling that amount – then I am being tricked into consuming. We call this “money illusion,” and there has been vigorous debate about the existence and potency of this illusion for a very long time. But note that if there is no money illusion, and the money is distributed equally, then my behaviors shouldn’t change in real terms – I’ll just double the amount I spend on everything, and since the same amount of stuff is available but twice as much money is being spent on it, the price of stuff will simply double. No deflation, but then again no real growth.

Well, I don’t know how powerful the money illusion is. At low levels of money growth it may be important, but I suspect that as the level of printing increases the illusion weakens.

So here we go: QE2, if it is combined with an elimination of interest-on-excess-reserves, will probably cause at least some inflation. It is a good instrument with which to avert deflation, but it is a blunt instrument with which to cause growth. Since core inflation (ex-housing) has been around 2-3% over the last year and food and energy are both rising as well, it isn’t clear to me that QE2 is needed to avert deflation. Moreover, it isn’t clear to me that it will do much to spur growth, although Evans yesterday and several other speakers recently seem to be leaning on the argument that the Fed needs to “do more” to bring down unemployment.

The question for an investor, though, isn’t whether QE2 should happen, but whether it will happen, and it is sounding more and more like it will. The political reality is that Congress and the Administration are out of bullets and that “someone” needs to do “something.” The only someone and something left is the Fed and QE2, so that’s what will get done.

Tomorrow, in the last pre-Employment data gasp, Initial Claims (Consensus: 455k vs 453k last) will be released at 8:30ET. Dallas Fed President Fisher speaks at 1:20ET in Minneapolis. Fisher is well-known to believe that gold is an important inflation indicator, so if he comes down on the side of QE2 then you can pretty much mark it down as done. Speaking at 1:30ET, in Nebraska, is Kansas City Fed President Hoenig, but the meeting is closed and it isn’t clear how much information we will get about that speech.

Watch inflation indicators: TIPS, commodities, and the dollar. These markets are starting to get rather exciting.

  1. RockyScientist
    October 6, 2010 at 6:07 pm

    I have never commented on any discussion on any financial blog I have read. I am not an economist. I am not a financial expert. I am (reasonably) smart and even figured out (with some knowledgeable help) that the housing/mortgage problem would be catastrophic and exited the stock market before it imploded.

    So, what did you say that enticed me to write this. It was: “These markets are starting to get rather exciting.” Maybe for you. I do not have the ability to play in this exciting arena like you (apparently) do. These markets depress me. I see us heading for a train wreck (likely by ~2015). I need to think/plan about taking care of my family (wife, kids, grand kids). I am concerned for them.

    Please keep writing like you have been. It is quite educational. But, please, understand we all don’t view the current situation like you do. These are not exciting times for us.

    • October 6, 2010 at 7:40 pm

      Oh, I’m sorry. I didn’t mean to be insensitive. Of course, these are trying times for all of us, whether from an employment perspective or as investors. I was meaning to focus on the particular part of the market that is my focus, the inflation-linked side…which is often seen as very sleepy and many people think is “boring.” To ME, that makes it a better investment, but some people want flash.

      I didn’t mean to imply that we’re all having fun these days. I think we’re all mostly miserable!

  2. Richard Whitney
    October 6, 2010 at 10:23 pm

    How does MV=PQ in an environment where extremely low interest paid on savings, together with lots of high-interest consumer debt, means that money (MV) goes to extinguish debt (Q-old), that is, pay for earlier, unpaid-for output?
    Under normal circumstances, if I pump air (money) into a tire (economy), it inflates. But if there is a gaping unseen hole on the other side of the tire(astronomical debt levels), everyone can see me pump wildly with no inflation of the tire.

    • October 6, 2010 at 11:05 pm

      That’s a very insightful question. The answer is that the effect of deleveraging is that the velocity of money falls. One of the following winds for the last decade or so, despite fairly tepid money growth, has been the sharp rise in leverage (and velocity). The reverse is happening now. As long as the deflation of the debt bubble is steady, though, and not calamitous and unpredictable as it was in late 2008, the central bank can (and must!) compensate for that decline in V by adding a bit more money than they otherwise would. Great question.

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