Friday, November 6, 2009

Picking my pony

I think Alex Tabarrok is a pretty cool guy. Eh writes textbooks and doesn't afraid of anything. However, he also thinks Arnold Kling is wrong about inflation being just around the corner. His graph of nominal spending suggests that we could use a spot of inflation to boost nominal spending. I think the subtext (and when I asked him in person, he briefly mentioned it) that there could be a big threat of deflation. I don't disagree with any of this, but I don't share his confidence that inflation (and a big surprise inflation, at that) isn't a-comin' for lil' Opie Cunningham to whistle about through his big ol' buckteeth.

Naturally, I have a picture of my own.

I didn't bother marking up my picture the way Dr. Tabarrok did, but mine kind of speaks for itself. Yes, the data only goes back until 1975, but if you're willing to take me at my word, I assure
you that the mostly straight line that stretches to the left continues to stretch to the left way back farther than 50 years. (Data is from the FRB)

Now, I'm 100% on board with Alex's reasoning. To figure out inflation expectations, you check the markets. TIPS (Treasury Inflation-Indexed [Protected] Securities) are government bonds that adjust their coupon against changes to the CPI (Consumer Price Index). As we can see in the next picture (wow! 2 pictures in 1 post, how about that for value?), TIPS spread against normal 10-year bonds is pretty stable.

Pretty wild, huh? Banks are hanging onto massive excess reserves and nobody seems to think that this implies a wave of inflation in the next decade. How can I possibly explain this?

Well, I could borrow from the behavioralist school and suggest that investors are mad, but I don't believe that for a moment. I think a more reasonable story is that people believe that another asset bubble is coming (or that there are going to be some unprecedented market interventions by the Fed and Congress). I won't mention what I think the worst case scenario is because I don't want to violate the spirit of the blog. Still, I worry that if Alex gets his wish, a little bit of inflation (enough to get us out of a nominal spending slump) won't stay small for long. It would be like pouring a bucket of applesauce down the throat of a sweaty pirate named Sweaty Pete. Once you open up the floodgates, Jerry, that'll be all she wrote. Clamping down on what we'll observe when banks lend out normally again will be hella painful.

Optimistically, the Fed will be able to deal with potential inflation in a timely and smooth manner. Let's stay optimistic.

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