Wednesday, October 05, 2005
High (Inflation) Anxiety
Today's headlines were pretty clear: "Inflation Jitters Sap Stocks" (WSJ), or "Economy Gets Another Inflation Warning" (AP). To be sure, stocks did take a severe tumble, with the S&P 500 down 1.5% and the Nasdaq 100 down 1.7% on heavy volume. Inflation fears weren't helped by the ISM reports that showed prices paid by supply managers jumped in September. Nor were they helped by the Dallas and Philadelphia Fed presidents' statements on Tuesday that the Fed will "continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one." JPMorgan and Citibank, among others, put the Fed funds rate at 4.5% by early next year, pretty much in line with April 2006 Fed funds futures.
But hold on a second, because the longer term Treasury market is telling us something very different.
The 2-year Treasury closed today at 4.21%, the 5-year Treasury note closed at 4.23%, and the 10-year note closed at 4.36%. The long bond (maturing in 26 years) closed at 4.58%. None of these figures point to any kind of substantial inflation expectations in either the near future nor down the road.
Indeed, if one takes the the 10-year Treasury yield as the market's best forecast of nominal GDP growth, these yields suggest the economy is facing 10 years of slow growth and mild inflation.
Such an approach is well supported by the research. A paper published in the Federal Reserve Bank of Kansas City's Economic Review (1997, 3rd quarter) shows that the yield spread between the 10-year Treasury note and the 3-month T-bill is a very good forecaster of real GDP growth in the years ahead, consistent with prior results.
Using their model, we arrive at a point forecast of real GDP growth for 2006 of 2.3%. That figure is about a percentage point lower than the investment bank consensus. However, it is very much in line with other securities prices. For example, the 5-year TIPS yield is 1.55%, implying an inflation rate of about 2.68%. 10-year TIPS weigh in at 2.5% inflation. CPI futures at the CME, although very thinly traded, are priced consistently.
These securities indicate far lower GDP growth and far lower inflation than the street's economists, who are more in the vicinity of 3.5% real GDP growth and 3.25% inflation for 2006.
To get a corresponding GDP forecast from the Fed model, for example, we'd need to see a 10-year/3-month yield curve slope 120 bp steeper than it is today. To get a corresponding inflation forecast from the TIPS market, we'd need to see 10-year Treasury yields well over 5%.
Whom does one believe? Real money is riding on the securities. The Fed's model explains nearly half the variation in growth. On the other hand, the Wall Street economists tend to follow trends, often lag actual economic conditions, and have every incentive to keep investors investing (see p. 8-9 here).
If we believe the Treasury market, the U.S. economy is facing slow growth and mild inflation for the next three years. This is quite different from what the headlines are saying (although quite consistent with a drop in equity prices). Essentially, the market expects the Fed will overtighten monetary policy, slowing growth to a crawl; inflation will be subdued. The Fed did this in 1995, and seems quite willing to repeat itself. Corporate earnings will suffer, the consumer will suffer, and the stock market will suffer. See our blog of August 10 for more details. --GAHJr
But hold on a second, because the longer term Treasury market is telling us something very different.
The 2-year Treasury closed today at 4.21%, the 5-year Treasury note closed at 4.23%, and the 10-year note closed at 4.36%. The long bond (maturing in 26 years) closed at 4.58%. None of these figures point to any kind of substantial inflation expectations in either the near future nor down the road.
Indeed, if one takes the the 10-year Treasury yield as the market's best forecast of nominal GDP growth, these yields suggest the economy is facing 10 years of slow growth and mild inflation.
Such an approach is well supported by the research. A paper published in the Federal Reserve Bank of Kansas City's Economic Review (1997, 3rd quarter) shows that the yield spread between the 10-year Treasury note and the 3-month T-bill is a very good forecaster of real GDP growth in the years ahead, consistent with prior results.
Using their model, we arrive at a point forecast of real GDP growth for 2006 of 2.3%. That figure is about a percentage point lower than the investment bank consensus. However, it is very much in line with other securities prices. For example, the 5-year TIPS yield is 1.55%, implying an inflation rate of about 2.68%. 10-year TIPS weigh in at 2.5% inflation. CPI futures at the CME, although very thinly traded, are priced consistently.
These securities indicate far lower GDP growth and far lower inflation than the street's economists, who are more in the vicinity of 3.5% real GDP growth and 3.25% inflation for 2006.
To get a corresponding GDP forecast from the Fed model, for example, we'd need to see a 10-year/3-month yield curve slope 120 bp steeper than it is today. To get a corresponding inflation forecast from the TIPS market, we'd need to see 10-year Treasury yields well over 5%.
Whom does one believe? Real money is riding on the securities. The Fed's model explains nearly half the variation in growth. On the other hand, the Wall Street economists tend to follow trends, often lag actual economic conditions, and have every incentive to keep investors investing (see p. 8-9 here).
If we believe the Treasury market, the U.S. economy is facing slow growth and mild inflation for the next three years. This is quite different from what the headlines are saying (although quite consistent with a drop in equity prices). Essentially, the market expects the Fed will overtighten monetary policy, slowing growth to a crawl; inflation will be subdued. The Fed did this in 1995, and seems quite willing to repeat itself. Corporate earnings will suffer, the consumer will suffer, and the stock market will suffer. See our blog of August 10 for more details. --GAHJr
