Monday, March 19, 2012

What do inflation hawks know that we don't?

(First, a disclaimer: I am not using the word "inflation hawk" in a pejorative way; I am using it to mean "Someone whose inflation expectations are higher than the consensus forecast.")

Steve Williamson expects higher inflation:
Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise.
If Steve is right, then he can make a lot of money by buying assets that are good inflation hedges. Why? Because currently, financial markets do not share Steve's expectations of "serious inflation sooner than later." As Steve points out, the 10-year TIPS spread is now about 2.5%, meaning that financial markets expect inflation to be about 2.5% - above the Fed's 2% target, but not very serious by historical standards. (Update: Ryan Avent notes that the Cleveland Fed's alternate measure of inflation expectations indicates that people believe inflation will be even lower than that!) If Steve is right and the market is wrong, he can beat the market. If he's confident enough in his forecast, this is exactly what he should do.

But remember, a word of caution! Before you conclude that you're smarter than the market, you should think very carefully about why the market disagrees with you. If you don't have a good idea about why the market disagrees with you, then you shouldn't trade.

Then again, Steve Williamson is a monetary economist, so maybe he is smarter than the market (Update: Steve drops by in the comments to explain that he does in fact think that this is the case. So the rest of this post is a little beside the point, but still possibly worth reading)! Why does he think serious inflation is coming soon? Well, maybe he has some reasons he doesn't say, but in his post, he cites two things. The first is Jim Bullard's theory of why there is currently no output gap. Steve says he likes this theory. The second thing he cites is the amount of money that has been created in recent years - which, according to the idea that inflation is a monetary phenomenon, should eventually cause higher inflation.

But is it worth making an above-market inflation prediction on the basis of these things alone? After all, Bullard's speech is public knowledge. Even without the Bullard theory, the notion that there is no output gap is not exactly restricted to ivory-tower academics (see Felix Salmon and Greg Ip). Nor is the idea that creating money causes inflation. Presumably, these ideas are not new or secret.

So maybe Steve thinks there is some reason why the public isn't buying into these correct theories? Perhaps he thinks that wrong theories of inflation forecasting (e.g. Phillips Curve forecasting) have gained widespread support? Maybe so, but Steve's colleague David Levine might take issue with such a blithe rejection of Rational Expectations.

Or maybe Steve knows something else, something that the rest of us don't know, and is even now buying inflation hedges based on that knowledge? If so, he'd be wise to keep his reasoning secret from the hungry eyes of the market.

Or maybe I've just read Steve's language wrong. Maybe he thinks 2.5% inflation is "significant". It is certainly above the Fed's official target by half a percentage point. (Note: In the comments, Andy Harless points out that the Fed targets a measure of inflation that is slightly different from what TIPS are pegged to.)

In any case, I'm not disagreeing with Steve's prediction, nor agreeing with it. I'm not a monetary economist, and I really am quite ignorant about the theory involved. I just think it's interesting to try to understand the thinking of inflation hawks (again, no insult intended).

Update: Well, it appears my question has been answered. Steve Williamson, from the comments:
Knowledge of money and banking theory is scarce. In many Economics PhD programs...they don't teach much of it, if any. Knowledge of the theory is even more scarce on Wall Street. I spent a good part of last week in New York City...and I overheard plenty of street conversation among people who were apparently market participants, and who were also shockingly naive. The monetary regime we are in is very different from what it was pre-crisis, in ways that I don't think the market, or the Fed, for that matter, completely understands. I have been thinking about money and banking theory for a long time. I could be wrong, but I think I know something that other people don't.
It's theory. Some combination of the theories he cites in the post, and various others that he knows - most of which he thinks Wall Street people either don't know or refuse to believe - make him think the market is wrong and inflation is on its way...


  1. Anonymous5:38 PM

    What is his window for this rise in inflation?

    I ask because he says to look at rising home prices as an indicator, and the most current Case-Shiller forecast I can get my hands on is that home prices will decline by 2.7% this year.

    So... if we go out a year and assume housing prices find a floor and actually see some gains... what is he expecting to amplify the monetary expansion?

    People taking out home equity loans? How many people have equity left in their homes, and how much equity do they have left in their homes, and even if lenders were to go crazy making home equity loans, why would we expect home owners to react this way with the housing collapse so fresh in their collective memories?

    I have trouble seeing an inflation driver without components like rising wages and near full employment.

    But what do I know?

    Help me out if I am missing something because I am not a real economist; I just play one in comments sections of other people's blogs.

    Lulz 4 life.

  2. As to whether 2.5% inflation is above the Fed's target range, it depends on the relationship between the CPI and the PCE deflator. The Fed's target is in terms of the PCE deflator, but TIPS adjustments are defined in terms of the CPI. Usually, the CPI inflation rate tends to be higher than the PCE inflation rate. An difference of 50 basis points is quite plausible.

  3. Anonymous5:56 PM

    Hey Noah, might like to check this out. I pressumed the inflation expectations were just the spread on TIPS and non-inflation protected bonds, but the cleveland fed would disagree...

  4. I think the whole game is a bit less interesting than you're making it out to be. For one thing, TIPS market hasn't shown a particularly good record at predicting inflation. Ten years ago the spread was predicting 2.8% inflation or PCE. Of course, no one predicted the housing crash, and that's the point.

    Markets aren't very good at predicting the future, maybe slightly less bad than other methods, but hardly something to be too smug about. Especially ten years out.

  5. Be sure to read the comments of that post, its a howl.

    Steve Williamson made the same prediction last year. oh, and i think the year before...

    and just in case you were confused:

    "I don't make forecasts. I thought I was clear about that. I learn over time."

    "I can't see any other future scenario than more inflation in the future. How much? I don't know. 5% or 6% by the end of the year?"

    scenario? forecast? prediction? you say tomato.

    His well developed theory will be in his forthcoming book. Just in time, I hear Yoram Bauman will need new material.

    incidentally, if you are curious about inflation, heres an interesting website. look through the catalog and see how yesterday's prices compare to today's. For example, in the 1988 sears catalog you can find a bike for $150... which the same price and specs as one being sold online by sears today... given that wages have gone up since 1988, thats productivity for ya, not inflation.

    I have the exact roaster listed in the 1968 catalog (has not changed much!) and bought it for the same price a few years ago... no Keurig though.

  6. The reason that the enormous expansion of the monetary base has not caused inflation is because all the money is flowing to the wealthy with no propensity to spend incremental income. Instead the money is going into bonds.

    We have a bubble in the prices of long term bonds. If inflation gets going, that bubble will burst with a huge bang and large losses.

  7. It's mainly the policy. The Fed has boxed itself in. It's always been clear that the Fed could control inflation by increasing the policy rate. But it has foreclosed that option until the end of 2014. The FOMC also erroneously believes, I think, that it can control inflation through quantitative means - e.g. term deposits and reverse repos. By the time the Fed figures that out, we will have a serious inflation under way. Much higher than 2.5%.

  8. Anonymous9:46 PM


  9. Anon - Thanks, fixed.

    Steve - I see the logic, but why, in your opinion, hasn't the market figured this out yet?

    (Yes, for all my bashing of rational expectations, I am definitely a weak-EMH believer...)

  10. This is a clever post, but I think it relies too much on the way the REH has been packaged. Expectations are supposed to depend on information, and the only way you can expect to be more right than the market is if you have more or better information. The problem is that between information and expectation lies Theory. People differ in the theories of the world they subscribe to. Sometimes a good theory with less information will outpredict a bad one with more, the way a chessmaster in a simultaneous exhibition can outplay an amateur, even though the amateur has much more time to calculate variations.

    It is entirely possible for someone with a better theory to beat the market on average, particularly since it can be difficult to reverse engineer a theory in order to generate its prediction in other states of the world. I know how Soros betted in the past, but I’m not as good as he is in knowing how he will bet in the future. This means that his theory is not public knowledge, except insofar as he has explained it many times over in books and articles.

    Steve Williamson thinks he has a better theory than the ones that now play a bigger role in setting the TIPS spread. On some things I’ve looked into, I think I have a better-than-average theory too. The reasons we develop for believing what we believe are also reasons for believing they are better than the other guy’s beliefs.

  11. Noah,

    I like what Peter says. Knowledge of money and banking theory is scarce. In many Economics PhD programs, including Michigan's they don't teach much of it, if any. Knowledge of the theory is even more scarce on Wall Street. I spent a good part of last week in New York City (just having fun, basically), and I overheard plenty of street conversation among people who were apparently market participants, and who were also shockingly naive. The monetary regime we are in is very different from what it was pre-crisis, in ways that I don't think the market, or the Fed, for that matter, completely understands. I have been thinking about money and banking theory for a long time. I could be wrong, but I think I know something that other people don't.

  12. As has been pointed out, Williamson has been incorrectly predicting inflation for years now. I'd file him with the rest of the hacks and liars.

    As for 'What do inflation hawks know that we don't?', the answer is obvious: predicting inflation is a no-lose deal for a pundit.

    I do wonder what the people who get paid for being right are saying - oh, that's the TIPS market.

  13. Knowledge of money and banking theory is scarce.... Knowledge of the theory is even more scarce on Wall Street.

    nope, no way.

    For example, Goldman Sach's not-your-average-man-on-the-street inflation forecast is 2.2%. They have deep knowledge of money, banking, the firepower for intensive models and theory research.

    Wells Fargo is 1.9% and the survey of Professional forecasters is 2.3%. Pretty deep bench there too.

    At every single bank you are going to find a freight train of economic horsepower with pretty deep knowledge of how - ahem - banking works (and also internal knowledge of the capital plan and projections including lending activity). These are the guys doing the pdfs and powerpoints read by fund managers, not the people you met at starbucks.

    Jan Hatzius is a smart guy, as was his predecessor, ahem, Dudley. so why should i believe "5% or 6% by the end of the year?" ...based on what exactly? Goldman Sachs is top prey. If they thought your theory had any merit they'd be all over it ...

  14. Diego Espinosa10:06 AM

    Listen to Dudley and Hatzius, current and former Goldman Chief Economists. You will find them convinced that inflation is something that happens, "when the economy exceeds its speed limit". Williamson is right: there is no "Plan B" at the Fed should inflation accelerate in the presence of an output gap. They will not aggressively tighten as long as unemployment is high, therefore there is no brake on inflation tail risk. The Street does not mind this tail risk because, again, the output gap is conventional wisdom among both traders and economists.

  15. Anonymous10:36 AM

    "But it has foreclosed that option until the end of 2014."

    The Fed Funds forward market disagrees < >. AIUI, interest rate rises are forecasted around late 2013 and mid-2014. This is actually good news: it signals that the Federal Reserve's policy guidance is working as intended and generating higher growth expectations, so monetary policy will soon be brought back under a normalized policy regime.

  16. @Diego Espinosa

    sure. convince me. show me the data. Post the SAS code. Its a bad day when i have not learned something.

    These economists at the banks are not monks living in the rural mountains of France, they give their CNBC interviews from the trading floor, and they have Bloomerg terminals, and they have NBER subscriptions and read all the literature.

    I am not saying they're right, but if Goldman really thought there was some truth to a 5% inflation forecast by year end, they would publish a piece on relative value in inflation straddles and get you hedged up, they stand to earn a nice $$ for being right. these guys dont get to be top prey by sticking mindlessly to dumb ideas. they get to be top prey by adapting and selling. there are 5000 hedge funds always looking for the next great model. So like i said: convince me, its a bad day when i have not learned somethimg, and i am always open to the possibility that today might be the day that the end-of-the-world-in-three-days lady might finally be right.

  17. Anonymous10:53 AM

    Honestly, I don't understand the inflation logic. Isn't inflation essentially just a stand-in for the cost of labor? Since labor costs represent like 2/3rds of total production costs for many goods and services, I'm not sure how it couldn't be.

    There are obvious exceptions, of course. The rise in oil prices can cause "inflation" (although, obviously, this isn't monetary), as can the rise in the prices of other basic goods/commodities. However, besides oil, I don't know what else could really impact the U.S. inflation story. So we're left with labor costs.

    How do you get inflation without labor costs going up? And how do you get increases in labor costs without the closing of the 'output gap'? I honestly don't even get the argument. If there is something I'm missing, I'd appreciate it if someone would disabuse me of my ignorance.

  18. How do you get inflation without labor costs going up?

    all those unemployed people will start demanding raises. corporate HR will start saying YES to big bonuses and raises when they know there are 2 applicants for every job. I put in for mine already.

  19. Peter:

    I've been treating theory as a kind of information. Which, I think, is exactly what you're saying I should do.


    Thanks, I'll add that to the post if you don't mind! :)

  20. Steve:

    Just one other question. This is personal, obviously, so don't feel pressured to answer, but do you place significant financial bets on your greater knowledge of money and banking theory?

  21. "Steve Williamson made the same prediction last year. oh, and i think the year before... "

    Yes at what point do they admit they were wrong? Hasn't Niall Ferguson admitted he was wrong and yet somehow he is still considered a profound thinker?

    They know that the Fed has been very active in response to the crisis. What they seem to ignore or forget is why the Fed has been active.

    In the seventies you had government spending from the Vietnam War, you had fiscal stimulus in the federal budgets plus an active Fed led by Arthur Burn looking to ingratiate himself to Nixon, plus organized labor had more power back then. I heard on NPR that along with the price increases you had 10 percent income gains. That locked in the inflation spiral and it's not what we have today. Not to mention the housing market in the dumps and the trillions in lost wealth from the popping of the bubble.

    When does Williams expect inflation? This year? Next year? 2014? In 2009 did he predict raging inflation by 2012?

  22. Sensitivity to inflation level seems to be a more decisive factor in determining inflation hawkery than any particular theory; e.g., a hawk might think an inflation level of 4 is high whereas a dove might think it a much better target than 2 given the lack of maneuvering room the latter level offers.

    And then there are those of us who think deflation is so much worse than inflation that we wonder why any policy maker serious about unemployment, over-indebtedness and balance sheet collapse would hesitate to crank the inflation expectations relentlessly to max.

    It's not just a matter of whose ox is getting gored, it's also a matter of benefiting a larger % of the populace and reducing suffering.

  23. Anonymous1:32 PM

    @Peter: There was also this little thing called the "oil shock." It seems like people tend to forget the role it played in stagflation.

  24. urban legend3:12 PM

    dwb --

    "[A]ll those unemployed people will start demanding raises. corporate HR will start saying YES to big bonuses and raises when they know there are 2 applicants for every job. I put in for mine already."

    Agree. As I said elsewhere, based on our actual experience in the early 50s and late 90s, when, in fact, very low inflation co-existed for a long time with very low unemployment, and, compounding that, with labor at its lowest power ever in probably a century, it will be a long time before workers will be able to shed the philosophy, "Been down so long, looks like up to me." To the extent the inflation hawks are worried about excessive labor demands aring from low unemployment, their theory looks beyond laughable. If it's not that, then what is the mechanism?

  25. So, is he acting on his beliefs? (Based on what is quoted here, he should be speculatively buying housing...I have one for him...)

  26. Anonymous4:37 PM

    So... a lot of the comments seem to reflect my own thinking and the market sentiment: With high unemployment and modest average wage gains it's hard to imagine what is going to drive high inflation absent the Government deciding to start paying benefits with newly created money.

    Is there something global we're all missing?

    Still not getting it,


  27. I asked Steve the same question regarding the divergence between his inflation expectations and those implicit in the TIPS/Treasury relationship.

    But rather than making this an RE critique, or even a weak EMH critique, I think it's worth emphasizing that market participants are operating with different models, both formal and informal. The interest rate on Treasuries is not where it is because of RE or EMH, it is where it is, in large part, because it balances bullish and bearish sentiments regarding future bond prices.

    Writing a model whose agents "know" the model misses something very important when, in the real world, agents are acting on the basis of many different models.

  28. When does an economist admit they were incorrect? Would Steve ever say his theories were wrong? Or does he extend his window out until inflation does (inevitably) rise, and then GOTCHA!

    My guess is he keeps his own council on this one.

  29. Anonymous12:47 AM

    Williamson, just as the like-minded and similarly-trained Fed Presidents Lacker, Plosser and Kocherlakota have been overshooting in their inflation predictions for several years now. It's time to realize that these guys have been following models with no predictive power. They are a disgrace to the profession.

  30. Williamson, just as the like-minded and similarly-trained Fed Presidents Lacker, Plosser and Kocherlakota have been overshooting in their inflation predictions for several years now.

    One thing Williamson and I agree on is that "The Fed isn't hiding anything. I just think they don't know what they are doing."

    ... by listening to the inflation hawks that have been consistently wrong.

    First SW tells me that "inflation rate is determined by the demand for and supply of the whole gamut of intermediated liquid assets"

    (I agree - "money" in the banking system is a slippery idea eg T-Bills I consider money, they can be substituted for collateral/cash margin).

    Then: QE is ineffective (i disagree, while at the margin QE purchases were a small fraction of the stock the Fed's own research shows at least 50% was accomplished through the expectations channel)


    "For all we know, there may be a lot of substitution going on between observed and unobserved intermediation activities. Still, the second chart [growth in M1,M2, and currency] does not make me optimistic about inflation."

    so does money matter or not? Is there substitution going on or not? i have no idea from these charts.

    If QE is ineffective and there are lots of substitutes (without inflation) then that would be the precise reason *not* to be worried about the growth in m1, m2, and currency.

    And as for looking for an increase in home prices as a sign of "inflation": at the beginning of 08, case schiller HPI was off 15% while the PCE was up 4%. In 2006, C-S HPI was up 12% while PCE was up 3%.

    I don't see any prediction of assymetry....

  31. Noah- Not quite sure what to make of your comment to me. So, I'll better explain what I am thinking. Which is to say, even though my inflation prediction is in line with yours I think your relying on EMH too much without adding a credible model or analysis of your own.

    I prefer a more Bayesian approach where the market is one piece of information. This, I take it, is what Krugman does. He does his modeling then checks it against the market. If the two agree that's additional evidence for believing his model. If it does not he marks down his belief in the model results, but does not automatically fold his intellectual tent.

    Also, as Keynes pointed out, we sometimes don't actually know what the market is 'predicting,' which is part of the reason markets don't move in ways Gaussian statistics would predict.

  32. OGT:

    OK, I like this this better than what you were saying before (who cares if markets are bad predictors, if individuals are even worse!).

    Now think about how willing you'd be to bet real money on your predictions...that will give you a concrete measure of how certain you are that the market is wrong.

  33. Stephen Williamson, and as was directly quoted above, the Fed hawks, have been wrong for four years about inflation.

    As Krugman has pointed out, they keep expecting inflation to occur in the domestic economy because the Fed has drastically expanded the balance sheet of notational money.

    Well, I would expand the search for high interest rates showing high return on capital to all the interest markets. Remember, the 10 year also has an implicit inflationary component, which is essentially dead at this moment, even in the corporate AAA markets.

    Now, if the holders of capital all are making the same mistake of assuming rampant inflation is just around the corner, why does Williamson assume his model, having uttlerly failed for four years at the Fed zero bound is accurate now? After all, Japan has been on the cusp of serious inflation for what, 20 years?

    Further, foreign investors, instead of running away from the dollar, are being further driven into the dollar by the euro crisis, neutering the presumed hyperstimulation of QE2, and forcing indeed a slow crawl toward QE3, to provide more high powered money assets in overseas markets as the euro destabililizes.

    In short, his models are entirely insufficient in considering international crisis uptake of high powered monetary assets created by the Fed, and the inability to stimulate domestically due to congressional obstinacy.

    We provide liquidity to the world, and they demand even more! Each time a new wave of the euro crisis has risen, this demand threatens to slow our domestic economy, and we respond with another round of QE.

    The real sign of this is the temporary surrender of the hard status of the Swiss Franc due to panic in Euroland inundating them with money. Now, fix your models from the old fairly closed system and you might just see where we might get some inflation, someday, as some of this finally unwinds.

    However, given the Euro crisis is likely to last another FIVE years, the real question to ask is what inflation beyond gasoline?

  34. Anonymous3:28 PM

    Goldbug:"The FED printed a trillion dollars, we must have inflation!"

    Sane person:"The housing crisis destroyed 8 TRILLION"

    Goldbug: "But the FED printed a trillion dollars we must have inflation!"