Yesterday I put up a lengthy post arguing that Scott Sumner and Paul Krugman were inexplicably claiming vindication from data that, if anything, I would have thought they would prefer to sweep under the rug. Specifically, since 2008 the stock market’s movements have been much more strongly correlated with the spread between nominal and TIPS yields on 10-year Treasuries (which is a common benchmark of “the market’s expected rate of price inflation”). In Scott’s words, this shows the market has been “rooting for inflation” ever since the Fed fell asleep at the wheel in 2008 and let NGDP growth falter.
I pointed out that I would have thought just the opposite result would have vindicated Scott’s quasi-monetarist framework. In particular, if inflation expectations (as gauged by the spread between regular and TIPS yields) had stayed flat while the stock market zoomed upward in 2009 in response to QE1, then it would have been harder for people like me to say, “That surge in stock prices in artificial; it’s just another bubble.” (Granted, I would have said that, and with no embarrassment. I think Greenspan fueled a stock bubble with much more modest pumping than Big Ben.)
But as it turns out, I don’t have any splainin to do after all. The chart above (which Krugman actually created) has provided me with a nice little illustration showing that increases in the S&P 500 since the crisis began, have been almost perfectly matched with changes in inflation expectations.
In the comments of my post, Scott begged to differ. Here is a portion of his reply:
Bob, Only 4 problems with your post:
1. You misread the graph. It doesn’t show that stocks move in proportion to prices, the scale are vastly different. Stocks move much much more [than] prices, even prices changes cumulated over 10 years.
2. My model does not predict that all of extra NGDP growth will go into RGDP, that’s what Keynesians sometimes claim (the more extreme versions of Keynesians.) I ALWAYS assume an upward sloping SRAS, although I argue it is relatively [flat] in deep recessions. but never completely flat….
First let me paraphrase what Scott is saying here, to make sure the reader understands the back-and-forth between us titans: Scott is saying that in the chart above, just because the red and blue lines move hand-in-glove from 2008 onward, that does NOT mean we can attribute every change in stock prices to a recalculation by investors of inflation rates over the next 10 years. On the contrary, Scott claims that the stock market is moving more than the corresponding shifts in inflation expectations would warrant, but we’re not seeing that on the chart, because the axes have different scales.
But (here’s Scott’s point 2) it’s crucial to note that the direction is always the same, for both series, since 2008. This is (apparently) great news for Scott’s model, because his model says that if Bernanke gets investors to expect, say, 10% more NGDP in ten years, then (say) 8% of it will show up as increased RGDP in 2021, while the other 2% will push up the price level in 2021. (I’m using round numbers; you can’t really add up the percentages like that.)
So investors will push up current stock prices because of both factors–they expect stronger “real” earnings in 2021 (relative to their expectations before Bernanke convinced them he was a real man) and they expect higher prices in general in 2021. (Note that the absolute dollar-price of various stocks will be higher in 2021 on account of both factors, which is why investors bid up current prices for those same stocks.)
So does everyone get Scott’s point? Even though Bernanke’s promise of 10% more NGDP leads to 8% higher real output, it also pushes up prices (and hence current inflation expectations). Thus, when we’re in a situation (as Scott claims) where the big constraint on the economy is insufficient NGDP growth, you will see stock prices and inflation expectations moving in lockstep. In contrast, we didn’t see such a tight fit before the crisis, because there were lots of other factors that were important, and stalled NGDP wasn’t binding.
It’s a beautiful story. As I predicted (and note it was a falsifiable prediction, proving I am a man of science), Scott was able to explain how that chart was his ace in the hole, with all the i’s dotted and t’s crossed.
But as Columbo would say, I have just one more question: Should we take Scott’s word for it that the movement in stock prices is far greater than what could be attributed to a revision of inflation expectations? Since I had a bunch of pressing deadlines this morning at the office, I decided it was a perfect time to spend a half hour investigating Scott’s confident assertions.
First I checked the 10-year case. Just eyeballing the chart above, it looked like inflation expectations (over ten years) went from 0.2% to 2.4% from early 2009 to early 2011. During the same period, the S&P 500 went from 700 to 1300, an increase of 86%.
So the question is, could the jump in inflation expectations account for such a surge in stock prices?
The quick answer is “no.” If you had a stock worth $100 in 2009, and had it roll over at 0.2% for 10 years, it would be worth $$102.02 in 2019. In contrast, if that stock rolled over at 2.4%, it would be worth $126.77. So the change in expected average inflation rates could explain a 24% increase, but not an 86% one.
NOTE: Already this is awkward for Scott. Remember, he is saying that “the real problem is nominal.” So with unemployment above 9%, and people saying this is the worst slump since the Great Depression, it’s a bit weird to me that about 28% (=24%/86%) of The Ben Bernank’s stimulus gets soaked up by price inflation. In other words, that’s a pretty steep Short Run Aggregate Supply curve, eh?
NOTE #2: I also don’t think it’s right to say that investors just care about point estimates of inflation rates. For example, if The Bernank’s crazy policies since 2008 make investors think, “There is a 90% probability of 1% price inflation, a 9% probability of 4% inflation, and a 1% probability we go Zimbabwe,” you might see the stock and bond markets behave as the chart indicates. That is still more in the spirit of my worldview than Scott’s.
But back to the action: After seeing a victory (though admittedly slight) for Scott on a 10-year horizon, I thought, “Well why limit it to 10 years? After all, Scott thinks the market is so efficient that he literally doesn’t even believe in the possibility of bubbles. So what about doing the same analysis for 30-year bonds?”
Unfortunately, I don’t think FRED’s data on 30-year TIPS yields goes back far enough.
So then I tried 20-year bonds. And check this out:
First I figured out when the yields on 20-year Constant Maturity Treasuries bottomed out; it was 2.88% on December 30, 2008.
Then I looked up the 20-year TIPS yield on the same date: 2.20%.
Then I looked at the latest values (February 1, 2011 when I did the calculations) for both series: 4.37% for regular, and 1.81% for TIPS.
So the market’s 20-year average expected inflation rate (estimated using the method Scott and Krugman like) went from 0.68% to 2.56% during the period in question. Using the same approach of starting with a $100 stock and letting it roll over at the two rates for 20 years, you get an appreciation of 45% in equity prices that can be entirely attributed to the increased inflation expectations over 20 years.
Now the big question: How much did the actual S&P increase between December 30, 2008 and February 1, 2011? Well it went from 890.64 to 1307.59. That’s an increase of 47%.
So we see that Scott is still right on a 20-year time horizon: Changing inflation expectations can only account for 96% of the move in the S&P. That other 4% is property of the quasi-monetarists. Learn it, live it, love it.
For what it’s worth, I really did accurately describe my approach above. In other words, I didn’t spend three hours searching through various bond series, and am now just reporting the one that worked. I checked the 10-year, saw it was promising, and then checked the 20, which I think Scott would have to agree is a better test of his worldview. Once I saw the result, I figured I could stop; my work was done here.
One other thing: I have checked the calculations, but hey I’m an Austrian economist and we’re not good with macro or math, so maybe I did something wrong, or maybe Scott will challenge the way I’m testing his assertion in the first place.
To be clear, I am not betting my worldview on the outcome of this calculation. Rather, I am pointing out that Scott’s claim of vindication doesn’t make any sense. It’s as if he took a Magic 8-Ball, asked it, “Does Bernanke need to print more money?” and then it said, “My sources say no.” Then Scott says, “A ha! I told you guys!”
In that context, I am merely saying, “Uh, if you’re gonna use that as your criterion, then you’re wrong. Not that I would have cared if it came out the other way.”