The collapse in European bond yields has been truly historic this year, with German 10-year bunds now hovering around 0.9%. Danger lights are flashing. There are obvious explanations: above all, growing deflation fears, as well as faltering economic data and Draghi’s comments last week about fiscal support and QE. Add to that some safe-haven related flows because of fighting in Ukraine. The ECB is now in full alarm mode because inflation expectations are dropping rapidly.
The terrifying thing about deflation is that expectations of falling prices can feed on themselves and become self-fulfilling, creating a chain reaction of deep problems in a modern economy.. The question is what can policymakers do about it.
The dirty secret about modern central banking is that monetary theorists understand very little about the process of expectation formation. That is why so much policy debate drifts into irrelevance.
Economic policymakers usually turn it into a debate about credibility, stemming from the Kydland-Prescott academic tradition which focuses on time consistency and credible commitments. It is often rational to break previous commitments, so why should anyone believe current promises? It also gets linked to another somewhat stale debate about “adaptive” versus “rational” expectations. For example, much of the difference in opinion on the FOMC come down in practice to disagreement about how forward-looking rather than backward-looking consumers are when it comes to inflation expectations. Do consumers and businesses just observe the recent trend, or anticipate problems before they arrive?
The amount of actual empirical work on the matter in all this is negligible, however. It is mostly prescriptive theory rather than descriptive or experimental work. And thinking generally about credibility in policy debates tends to be sloppy, with dozens of traps. One major lesson is credibility is heavily dependent on the context, not something you can apply to any situation.
The importance of expectations has, however, led to much more emphasis on policy communication in the last few years, as a matter of practical necessity (and desperation). Monetary policy has become more like theater than math or engineering. How can you sound more credible? How can you make statements believable? How can you get people to understand your approach? Hence Yellen’s endless communication committee work on the FOMC before taking the top job.
But the deeper truth is academic economists just don’t have the skills or tools to understand much about communication, because of course it falls into psychology and organizational science and rhetoric and persuasion instead. Parsimonious mathematical models are not adequate guides in these realms. And people can reasonably doubt whether policymakers have the skill and capability to deliver, whatever their intentions may be.
Instead, it comes down to asking why people change their minds. That is my main focus in policy issues. Everyone knows from their own experience that attitude change is often a drawn-out, fraught, conflicted process. People often see only what they want to see for long periods of time. They can be influenced by networks and relationships and trust, by familiarity and the salience of issues within their larger sphere. They observe facts, but can explain them away or ignore them. (Watch any tv political debate.) There are long time lags and considerable inertia. And many people never change their beliefs at all, regardless of the evidence.
It is also a classic stock-and-flow systems problem. Inflation expectations in particular are usually very sticky, and take a long time to change. Think of a bathtub: it potentially takes a lot of drip-drip information (flow) to change the amount of water in the bathtub (stock), but the system can also suddenly change abruptly (the bathtub overflows.) People frequently forget that many policy issues have major stocks -i.e bathtubs, sinks, buffers – contained within them and so do not react in a linear way to marginal change. There are complex positive and negative feedback loops, and decisive events can change things rapidly. Expectations aren’t simply “adaptive” or “rational” but complex.
Policy tools like fiscal policy and QE most likely do not make much difference to consumer expectations, certainly in the short term. Just ask the Japanese how successful QE and massive fiscal spending has been in putting their economy back on a sustained growth path.
Because there is so much inertia in inflation expectations, it’s more likely that after a few months European expectations will drift back towards 2% again, and the ECB will claim the credit for something they had little to do with. But if inflation expectations really are becoming destabilized, it could take five or ten years and vast pain to fix the problem.
I was talking about how economic change may be affecting inflation dynamics last week. It’s not just the US. Here’s more evidence: “What killed Canada’s Inflation?” asks this article in the Globe and Mail, as analysts puzzle over why local price rises continue to be so dormant.
It’s the great conundrum of the past year. Canada’s annual rate of inflation has sat below the 1.5-per-cent mark for 18 months in a row, the longest such stretch since the late 1990s. Month after month, it’s confounded forecasts and is now running at 1.2 per cent.
And though we may have hit a trough in inflation, most economists don’t expect it to come roaring back any time soon.
The Bank of Canada is a bit puzzled too, in its MPR published on 22 January.
Our analysis suggests that the weakness in total CPI inflation in advanced economies has a large, common international component that is likely associated with declines in global prices for food and energy. The weakness in core inflation, on the other hand, is only partly explained by a common global factor, despite widespread excess capacity in the global economy since 2009. In this regard , it is somewhat puzzling that the rate of inflation has been declining only recently.
It may be that inflation responds more to persistent output gaps, and with a considerable lag. Country-specific factors may also be important in explaining the recent movements in core inflation. These factors vary across countries an include greater retail competition, the waning impact of previous increases in taxes or regulated prices, and low wage pressures.
The same disinflationary forces appear to be at play in the Eurozone.
There is widespread puzzlement among many central bankers – and much hangs on that uncertainty. For the time being, it means the Fed and other central banks can be relaxed about raising interest rates, There is no obvious inflation pressure at all, and the Fed is tapering largely as a first tiny step towards normalization. That reduces the chance of a major shock to fixed-income markets.
But lack of understanding of the current dynamics of inflation also makes surprises more likely, both on the upside and downside. If, as the Bank of Canada suggests, inflation is still responding with a lag to the depth of the previous output gap, that may wear off at an unknown rate. Or perhaps there may be permanent hysteresis effects. We don’t know yet.
The most worrying thing is the lingering downside possibility of deflation and a Japan-style decades-long slump. In practical terms, data and explanations for disinflationary pressure will be a more important driver for the Fed and other majors than labor market factors. Despite recent volatility, I am moderately optimistic about the US outlook. Significant deflationary pressure would change that.
A stew of different factors – Chinese data, time for a pullback in Japan's soaring equity market, algorithmic amplification of initial moves – influenced the sudden outbreak of market volatility in the last day. But one if the main factors was market confusion over Bernanke's testimony.
The reason for confusion is there are two opposite factors at work here.
The first is the Fed is well aware that the equity market is talking itself into a massive rout when QE ends, and the bond market could adjust with brutal speed to any drop-off on Fed purchases as well.
Vaccination is one strategy to try to minimize the agony of catching a serious disease. Small, benign doses may strengthen resistance to the life-threatening fever you might otherwise catch later on. Hence the Fed talk of tapering, of reversability of moves, and of pragmatic adjustment to data. A little bit of talk now may prepare the market for eventual actual tightening as the recovery proceeds.
Early inoculation may also reduce the chance of eventual financial instability caused by people complacently believing the Fed is stuck with its current policy for months or years to come. A little two-way risk is a good thing to prevent asset bubbles developing.
Of course, some of my friends believe the market is too binary for such nuance to work effectively. Maybe that is right. But it doesn't mean the Fed is not going to try to reduce that binary, manic-depressive aspect of market behavior if it can. The message is the first withdrawal of stimulus is going to happen before long, and it does not entail the end of the world.
The second, and opposite factor is Fed worry about premature tightening killing the recovery. In fact, the most important element in the testimony was Bernanke's specific link of QE to mitigating deflation risk.
In the current economic environment, monetary policy is providing significant benefits. Low real interest rates have helped support spending on durable goods, such as automobiles, and also contributed significantly to the recovery in housing sales, construction, and prices. Higher prices of houses and other assets, in turn, have increased household wealth and consumer confidence, spurring consumer spending and contributing to gains in production and employment. Importantly, accommodative monetary policy has also helped to offset incipient deflationary pressures and kept inflation from falling even further below the Committee's 2 percent longer-run objective.
Note he didn't use the euphemism of puppy “disinflation”, but a claim that the grown-up savage wolf of “incipient deflation” is kept from the door by current policy.
I talked about deflation here. The Fed will do virtually anything to stop deflation. That alone explains caution about premature tightening, regardless of any labor market thresholds. Even if there is a little more momentum in the domestic economy and a pick-up in the labor market, any sign of further falls in inflation (broadly defined) or unmoored inflation expectations would make the FOMC not just cautious but terrified.
Thankfully, the news in recent months is good in that department, which is why Fed officials can talk a little more about tapering.
So the FOMC has a difficult communication challenge: stop people doing stupid things because of expectations of prolonged low rates; prepare the way for tightening when the time is right by some tactical inoculation; but also reassure they will not undermine the real economy and anchored inflation expectations by tightening too soon. All parts of the message are necessary.
The most likely outcome is still a studied tiny slackening in QE purchases by late summer, perhaps couched as a technical experiment or one-off adjustment, in order to minimize the chances the market will panic and develop a serious fever.
But if the Fed is not sure the deflation monster is chained up, and the US economy is still fragile – and if Europe and China look weaker – then Bernanke and company are going to be cautious about any substantive withdrawal of monetary stimulus.
We just got through a huge risk point, and at least some temporary celebration is in order. The payrolls number on Friday was enough to drive the S&P through 1600 to another new record. Economic recovery is still on track. Cue champagne. Maybe not a whole bottle, but the glass is more than half full.
Yes, of course, it’s just one number. Economic decision-makers are usually wary of relying on any one data point, even if the markets go through swings of elation and depression as each number comes out.
One good reason for that caution is people are often stung when data is revised later. In fact, the big news on Friday was the positive revisions to previous February and March data, not the latest addition of 165,000 to US payrolls in April.
What the revisions tell us this time, however, is that the alarming spring wilt of the economy which we’ve seen for several years in a row is not happening yet. Instead, the economy seems to be slowly picking up some momentum.
Avoiding the Deflation Demon
It’s especially good news, because any faltering in growth now would raise the specter of deflation, or falling prices.
What’s wrong with falling prices? Confined to one sector, they can be very good for consumers. Computers and software have been seeing falling prices for decades, for example.
But when the price level of the economy as a whole falls, people spend less because they believe they will soon get things cheaper. Just like waiting to buy the next laptop or iPhone, you might hold off other major spending while waiting for better value later.
If expectations shift so people expect falling prices, then it could undermine demand all across the economy. The “real interest rate” paid by borrowers becomes higher. Even worse, as prices and wages fall, debt stays the same. So the burden of repaying debt becomes steadily heavier.
Why does this matter now? Europe is looking steadily weaker economically. Chinese growth may be slowing. Japan is doing its best to escape its low growth trap , but it’s not clear if it will succeed. With a fragile world economy, it is vital that the US recovery stays on track. If it does not, deflation becomes a much more frightening possibility.
It’s all about what you expect
If you are interested in how Bernanke and the Fed think about this, take a look at this foundational speech by Bernanke on deflation back in 2002, before he became Chairman. In essence, it lays out the gameplan for how the Fed will deal with deflation.
Any sign that we are slipping towards falling prices would mean another major shot of QE. The Fed cannot take the risk of letting a deflationary mentality set in. The Fed would take abrupt action to stave off any signs of deflation.
The trouble is QE is only moderately effective at best. The tools that other central banks have used, like funding-for -lending in the UK and buying ETFs in Asia do not seem to have been much more effective either. The tool cupboard is bare.
So far, we’ve been lucky. The key decision-makers are mostly puzzled (and relieved) about the benign behavior of inflation in recent years. Slack isn’t causing as much deflation as you’d expect…yet. Expanding the Fed balance sheet isn’t causing the upward pressure on inflation monetarists typically expect. Markets assume QE is just mostly bubbling frothily into equities rather than consumer inflation.
Many in the central banks think inflation is behaving surprisingly well so far purely because of anchored expectations. People just continue to expect inflation will be around 2%, regardless of all the crash and massive injections of liquidity and weak growth.
But we don’t understand expectation formation very well, as I’ve pointed out before. Central bankers like to think that stable inflation expectations is due to the credibility they built up over two decades before the crisis. And that may be true. But it may also be wishful thinking.
So we are at a crucial pivot point. If growth falters in coming months or there is a major crisis abroad, deflation is a serious tail risk. That’s because, as Bernanke points out in that speech, it is almost always triggered by falling aggregate demand. Monetary policymakers will be absolutely determined to try to stop it, because once people expect falling prices it can be very difficult to halt and reverse the process.
There are opposite risks as well. If growth continues and demand picks up, bond market yields could soar, causing mortgage and other borrowing rates to climb.
The most likely outcome is continued anemic growth and gradual tapering of QE starting late summer.
That means we can be glad that the economy is picking up. But we could have a wild ride to come. Inflation expectations are critical. And they are a matter of perception.
What should a central bank do to stop the next recession? Here’s a smart comment by Benn Steil on the debate on whether central banks should target nominal GDP instead of inflation, in order to better stabilize the economy. The approach gets attention when central bankers are looking for every last drop of juice for monetary policy. But the “bad weather” policy would be much less attractive in normal circumstances.
I get impatient with the whole argument, however. The debate is increasingly like the proverbial scholastic arguments about how many angels can dance on the head of a pin. The point of a monetary policy target is ultimately to influence public expectations.
And the dark secret of monetary policy – the great blind spot – is central bankers and economists know very little about how expectations are actually formed by business and the public.
Indeed, much of the difference between “hawks” and “doves” (as one of them put it to me) is largely whether inflation expectations are more backwards or forward-looking.
Expectations are a matter of belief and perception, not simply observation of commitment rules, or the utility of rational-expectations models in economics.
Economics has been searching for “microfoundations” which help model individual economic actors’ behavior, and how it may change in response to policy. But credibility is not simply a matter of what the central bank claims, but whether it can persuade other economic actors about its future actions, in an environment in which even four-year old children know not to believe most political promises. Credibility is much more complicated than simply time consistency in the Kydland-Prescott literature, even if that started as a brilliant step forward. Dynamic optimization models are not enough. You have to be empirical and go look at actual expectations, not get lost in the math.
Once again, you can’t make sense of policy or the economy without looking at how people think and see things. Perception matters.