In my previous post, I cited Jeff Frieden’s and my proposal for a conditional inflation target. Yet, according to several observers, we are either on the brink of crowding out due to elevated government deficits , or high to hyperinflation, due to monetary base expansion . As has been noted, none of these outcomes have yet materialized, despite months of such warnings.   Here, I wanted to evaluate where market expectations stand on these views.
Nominal interest rates
As of December 28, constant maturity yields on five and ten year Treasury bills are at an all time (post-War) low.
Figure 1: Constant maturity yields on five year Treasurys (blue), ten year Treasurys (red), and on three month Treasurys, secondary market (green). Observations for December apply to December 28th observation. NBER defined recession dates shaded gray. Source: St. Louis Fed FRED.
According to the Fisherian relationship, the nominal interest rate is the sum of the ex ante real interest rate and the expected inflation rate. What do real interest rates look like? One can proxy real interest rates by examining yields on Treasury inflation protected securities (TIPS).
Real Interest Rates
Figure 2: Constant maturity TIPS yields on five year Treasurys (blue) and on ten year Treasurys (red). Observations for December apply to December 28th observation. Source: St. Louis Fed FRED.
Well, it is likely that real interest rates would be lower in the presence of smaller deficits. However, with long term real interest rates negative (and persistently so for the bulk of 2011), it’s not clear that would be such a wonderful thing if lower deficits are associated with less economic activity. After all, it is unclear what the sensitivity of investment to the user cost of capital (for some discussion plausible vs. implausible – aka Ryan Plan/Heritage), see this post. Weighed against any higher investment arising from lower real rates would be lower investment arising from the accelerator effect.
One might worry about characteristics in the TIPS market distorting the estimates of the real yields. Hence, I provide the mid-quarter real rates calculated subtracting the Survey of Professional Forecasters’ mean ten year inflation from the ten year constant maturity Treasury yields.
Figure 3: Ten year constant maturity real interest rates from TIPS (red) and calculated using the ten year constant maturity Treasury yields minus ten year mean expected inflation rates, sampled at mid-quarter. NBER recession dates shaded gray. Source: St. Louis Fed FRED, Survey of Professional Forecasters, NBER and author’s calculations.
One can use calculate the expected inflation rates using the nominal-TIPS spread.
Figure 4: Implied inflation calculated as difference between constant maturity TIPS yields on five year Treasurys (blue), seven year (chartreuse), and ten year (red). Observations for December apply to December 28th observation. Source: St. Louis Fed FRED, and author’s calculations.
If anything, implied inflation derived from market expectations are either constant or declining. Figure 5 from the November Survey of Professional Forecasters shows the median forecast rising up to mid-2009 levels.
Figure 5, from November Survey of Professional Forecasters.
The December WSJ survey of forecasters indicates year-on-year inflation decreasing from 3.29% in December 2011 to 2.35% in December 2013. The median decreases from 3.3% to 2.2%, while the standard deviation rises from 0.30 to 0.79. Much of this is driven by outliers — in particular a 5.2% estimate from Mark Nielson of MacroEcon Global Advisers (Mark Nielson keeps on showing up as an outlier, see , ).
Figure 6: Kernel density graphs for expected inflation for December 2011 (blue) and for December 2013 (red), from WSJ Survey of Forecasters, December 2011.
To sum up:
- Nominal yields are at or near all time (post-War) lows.
- Real interest rates at five or ten year horizons are negative. Five year yields have been below zero for most of 2011.
- Derived expected inflation rates at the 5, 7 and 10 year horizons are all at or below the two percent rate.
- Survey based expected inflation rates over the next ten years is at 2.5 percent.
The Nominal and Real Yield Curves
Finally, it’s of interest to see what the yield curve looks like. In Chinn and Kucko (2010), we document the explanatory power of the yield curve for future economic activity across countries and time. We examined only the nominal curve. As Jim has discussed, one could argue for an examination of the real yield curve, which abstracts away from an inflation risk premium.
Figure 7: Nominal yield curve (blue) and real yield curve (red), as of December 28, 2011. Source: St. Louis Fed FRED.
The real yield curve starts at five years, so one can’t be sure what the real yield curve suggests for the horizon less than five years. What is true is that for securities maturing at the 7 month, three year and one month, and four year and four month horizons, the yields are increasing (or less negative), although with a relatively flat slope. That suggests only moderately accelerating economic activity over these horizons.
I find one point interesting. Back in 2005, when I argued that running budget deficits at full employment was a bad idea, likely to constrain our future policy options should we experience an economic setback, I often heard that we should be borrowing because interest rates were so low. Well, interest rates are now even lower than they were in 2003 and 2004, but now the output and unemployment gaps large; where are those voices now?