Inflation as measured by the Personal Consumption Expenditures index ticked up yet again this month, now at 2.3% annual, a new high not seen since March 2012. PCE inflation has been inching up all year, starting at 1.8% in January. Since the yield curve is now flirting with levels under 20 basis points, it’s time to question whether, as mainstream economics likes to believe, a negative yield curve signals lower long term inflation expectations ahead.
Spoiler alert: It doesn’t.
The conventional thinking was echoed last week by Federal Reserve Chair Jay Powell, in his keynote speech at Jackson Hole. He made the claim that the Fed had somehow anchored inflation expectations and that therefore inflation will come down by itself without any aggressive central bank action. For example, if inflation is at, say, 5%, but inflation expectations are “anchored” at 3%, then even if inflation briefly hits 5%, the long term expectation of 3% inflation will tend to bring inflation back down towards 3% without aggressive monetary policy tightening.
The relevant quote from the speech is this:
Anchored expectations give a central bank greater flexibility to stabilize both unemployment and inflation. When a central bank acts to stimulate the economy to bring down unemployment, inflation might push above the bank's inflation target. With expectations anchored, people expect the central bank to pursue policies that bring inflation back down, and longer-term inflation expectations do not rise. Thus, policy can be a bit more accommodative than if policymakers had to offset a rise in longer-term expectations.
The argument is an internal contradiction. It can be broken down as follows:
Low inflation expectations happen when people expect a central bank to institute policies that will bring inflation down Therefore, low inflation expectations mean that a bank can be more accommodative than otherwise, meaning not having to institute policies that bring inflation down
Let’s put the contradiction aside for a moment. Conventional macroeconomic thinking assumes that a flat or negative yield curve means low inflation expectations. A simple googling can confirm this. However, the theory that a flat or negative sloping yield curve means low inflation expectations and therefore low inflation is an extension of the Phillips Curve fallacy that inflation and stagnation cannot simultaneously occur -- in other words, that stagflation is impossible. A negative sloping yield curve does signal recession, but not necessarily lower inflation.
Empirical data shows this quite easily. First a broad view:
From this broad view comparing the yield curve to the US inflation rate, there is no indication whatsoever that a negative yield curve leads to lower inflation. It’s hard to see here, so let’s zoom in to the first period on this chart when the curve was negative, 1978 to 1980, and we’ll add in inflation expectations to boot.
The blue line shows the 10Y-2Y yield spread, which is below zero for the whole period, meaning a negative curve. During that time, both actual inflation, and inflation expectations, climbed. On the graph is 1 year forward expectations, but it’s virtually the same for all charts on the 5 year outlook.
The next period that the yield curve was negative was from December 1988 to March 1990, with only brief periods of breaking above a zero spread. During this time, both inflation and inflation expectations stayed pretty much constant, with inflation above 5% and inflation expectations hovering around 4%. If a negative yield curve signaled lower inflation expectations, one would assume that inflation expectations would edge down as the yield curve flattens, and fall faster if the curve went negative. It doesn’t.
Next was the period from January to December 2000. What happened then? Same thing. Inflation and inflation expectations stayed pretty much constant the whole time that the curve was in negative territory.
Here is the same chart for the last time that the yield curve went negative, from June 2006 to May 2007.
Here we do se e a brief slip in inflation, but it climbed right back up while the yield curve was still in negative territory. So we see that empirically, it’s the exact opposite. When the yield curve inverts, that has been the signal of rising inflation in the near term. We can see this on the first wide chart plotting the yield curve against the inflation rate from 1978 to the present. In the areas around 1980, 1990, 2000, and 2006-2007, during or very shortly after the yield curve goes negative, inflation spikes.
What does bring inflation down is interest rates higher than the rate of inflation. Logically this must be true. If consumer prices are rising at 6% and interest rates are at 3%, then it makes sense to borrow money at 3%, have it lose value at a rate of 6%, and pay back the loan with devalued money when it comes due. This encourages more borrowing and debt, increasing the velocity of circulation and pushing inflation higher. If borrowing costs 12% though and prices are rising at a 6% clip, then going into debt isn’t worth it, money velocity comes down, and prices stop rising.
On a long term chart, we can see that the effective federal funds rate has been almost always above the inflation rate up until the 2001 recession. The overnight rate being consistently below the inflation rate is a relatively new phenomenon that has only existed since the Great Recession.
As for inflation expectations, they can only remain subdued as long as people believe that the Fed will eventually raise rates above the inflation rate in order to quell it. This is why every jump in the official inflation rate from here is dangerous. If the CPI keeps combing (we are now at 2.95% on the CPI) and the Fed does not indicate any particular concern, we’ll start to see those “anchored” inflation expectations become less anchored, along with the inflation rate itself.
The real anchor is the expectation that the Fed will subdue inflation, which can only continue if it actually does this in practice. Powell may find himself soon in the unenviable position of having to once again, after a 10 year hiatus, push the federal funds rate above the inflation rate.
What has brought inflation down in the past is when the yield curve rises back up after it descends into negative territory, but it isn't the curve rising necessarily that brings it down. It's rates rising above inflation rates that brings it down, which can sometimes be reflected in a positive yield curve. It all depends on what rises faster - rates or inflation. Right now inflation is rising faster. As long as the Fed keeps allowing this, it will continue.
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