27 Oct 2008

Is the Market Forecasting Deflation?

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As I have explained in a previous post, a typical measure of the market’s inflation forecast has been falling, and just recently actually went negative. Specifically, if you take the yield on 5-year Treasurys and subtract the yield on 5-year TIPS, that should give you an approximate reading on what investors think annual increases in the CPI will be over the next five years. (I explain this a bit more in the post linked above.)

Tyler Cowen happily cites this fact, since it buttresses his argument that the credit markets are collapsing. (I.e. if there is no credit, prices fall.)

But if we look at the actual constituents of this “market forecast”–i.e. if we break it down into the nominal and TIPS yields–then we see something very strange. Since 2003 (when the Treasury began offering 5-year TIPS), the spread between nominal and TIPS Treasurys has been 2-points-and-change, presumably reflecting the market’s expectations of moderate price inflation.

But then since about June of this year, the gap between the nominal and TIPS has completely disappeared. To repeat, this is why those calling for a deflationary depression feel vindicated. But if their explanation is correct, we would expect that the TIPS yield fell during the last 5 months (as investors’ forecasts about future growth got more and more pessimistic), while the nominal yields fell even more (as investors grew pessimistic about the economy and started to factor in lower and lower price increases).

But the opposite happened, as the chart below beautifully illustrates. Nominal yields have fallen a little, but the main reason the gap between nominal and TIPS disappeared is that the TIPS yield shot way up. In fact, the 5-year TIPS yield is currently the highest it has ever been, going back to 2003.

This chart is totally incompatible with Tyler Cowen’s explanation. It can’t possibly be the case that investors are currently forecasting the strongest 5-year growth since 2003. Something else must be going on here.

I submit that one explanation is that investors are growing less confident in the government honoring TIPS contracts. Remember, the way these work is that the government pays a contractually fixed rate, but the principal is adjusted based on changes in the CPI. Thus, it is a “Treasury Inflation Protected Security” (TIPS).

But what if the Treasury is running an $800 billion deficit next year? Isn’t it just possible that, before it actually defaults on nominal Treasurys, it first starts cutting corners with the principal adjustment on TIPS? It wouldn’t even have to be an official adjustment in the rules; it could simply lean on the BLS to underreport the increase in CPI.

I am not saying this aspect is the whole story, but I think it is definitely a part of it. The market price for insuring even regular Treasurys against default has risen sharply since January. So I think it is very reasonable to suppose that investors are insisting on higher TIPS yields, because they fear hanky panky in the principal adjustment over the next five years.

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