A Slightly Off-Center Perspective On Monetary Problems. When The Storm Is Long Past, The 5 Year--5 Year Forward TIPS Spreads Will Show 2% Inflation

by: Scott Sumner

Keynes once said:

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

Vaidas Urba sent me some interesting quotations. First Ben Bernanke at the September 16, 2008 Fed meeting, which I propose we call the "Noah's flood meeting," after Hawtrey's famous remark. Here's Bernanke:

But it was noted that the five-by-five TIPS breakeven remains above a level consistent with long-term price stability.

Vaidas also sent me the following from the ECB:

The long-term forward inflation swap rate remained broadly stable over the period under review, standing at around 2.2% on 5 February. Overall, giving due consideration to both the inflation risk premium and the liquidity premium, market-based indicators suggest that inflation expectations remain fully consistent with price stability.

I also found this from the same ECB report:

At the same time, underlying price pressures in the euro area remain weak and monetary and credit dynamics are subdued. Inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with the Governing Council's aim of maintaining inflation rates below, but close to, 2%. As stated previously, the euro area economy is now experiencing a prolonged period of low inflation, which will be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on.

There are two very serious problems here. First, the question of whether Fed policy has long term credibility on the inflation front is quite different from the question of whether inflation is appropriate over the next few years. I don't doubt that even during the Great Deflation of 1929-33, most sensible people expected the deflation to end at some point, and prices to level off or maybe even rise a bit. The Fed needs to hit its targets over the next few years, and by that criterion the markets in September 2008 showed that monetary was far too tight. The Fed should ignore 5 year forward inflation forecasts. Indeed they should ignore inflation entirely, and focus on NGDP growth, which was falling sharply in late 2008.

The ECB report is even worse. It actually predicts that inflation will be well below average over the next few years, and then close in on 1.9% a few years down the road. That means they are predicting a procyclical inflation rate, which is a totally insane policy.

In the past Europeans criticized me for suggesting the ECB should deviate from their single mandate to control inflation. (BTW, it's a lie to claim the ECB has a single mandate to control inflation.) OK, so now even the ECB admits their policy will allow inflation to deviate from the target, and then gradually return to the target. So they are flexible. That should make me feel better, but then we find out they are flexible in exactly the wrong way. A flexible inflation targeting regime calls for below average inflation when the economy is booming, and above average inflation when the economy is weak. They plan to do the exact opposite!

The ECB is basically saying; "We plan to continue screwing up economic policy for a few more years, but don't worry, sometime late in the decade we'll have an appropriate monetary policy." I'm sure the Greeks will be glad to hear that.

P.S. Vaidas noticed the Europeans making the same mistake as the Fed made in 2008. There is an old Chinese curse "May you live in interesting times." (I believe it's apocryphal.) How about "May you live in a large diverse economy overseen by a 'teenager' central bank." The Fed was 15 years old in 1929. The ECB is now 15 years old.

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