Consulting by RPM || Free Advice Blog

TIPS Have Underforecasted Inflation

Back in 2003, the Treasury began selling 5-year Treasury Inflation Protected Securities, or TIPS. (Longer maturities were available starting in 1997.) What happens is that the government pays a fixed coupon rate, but the principal is adjusted based on increases in the Consumer Price Index (CPI). Thus, TIPS yields are one of the closest things you can get to observing the real interest rate; it measures what lenders need to be offered to part with their money for a period of time, over and above the fall in the purchasing power of their money.

TIPS are really neat because, in theory, they should allow you to back out the market’s expected rate of inflation (subject to a million caveats, as everything in mathematical finance is). The nominal yields on Treasurys (and yes, that’s how The Man spells it, not Treasuries) incorporate both the real yield and expected inflation, and so Nominal minus TIPS (for comparable maturities) should give the average expected inflation rate during the life of the bonds. (Again, I want to stress that this is a simplification. For example, regular Treasurys are more liquid than TIPS, and so you would expect the former to have a slightly lower yield for this reason.)

Anyway, a lot of people are currently trying to calm investors by pointing to the bond market. “Look,” they might say, “the monthly averages show that in August, five-year nominal Treasurys were yielding just under 2 percentage points more than TIPS. So that means the market expects average inflation of only 2 percent per year, over the next five years. Do you Chicken Littles think you know more than all the world’s bond traders?”

OK I think one would have to be INSANE to predict average (price) inflation of only 2 percent over the next five years. It will be much higher than that. (Note that I am talking about the overall CPI for urban consumers, not the “core inflation” that deviously removes food and energy prices.) So what gives? Well, one thing is that–as noted in the parenthetical remarks above–there might be a liquidity premium placed on nominal Treasurys, even versus TIPS. Another is that nominal Treasurys are safer, especially as things get crazier and crazier.

It’s not so much that the government will default on TIPS, but rather that they might stop indexing them for inflation. Another possibility for why the market is apparently underestimating future inflation is that the bond traders know full well how full of BS the BLS is, and so the “Inflation Protected” securities aren’t really fully covering their owners. For example, if an investor expects actual price inflation of 5 percent per year, and he requires a real yield of 1 percent, then in theory he should buy a TIPS yielding 1 percent. But what if he knows that the BLS will understate the true inflation rate, and instead announce annual CPI increases of only (say) 3 percent per year, in contrast to the true inflation rate of 5 percent? In that case, the investor who requires a real yield of 1 percent will insist on a TIPS yield of 3 percent. Thus, naive analysts who trust the BLS (or who think bond traders do) would say, “Sweet! The bond market is anticipating strong economic growth, with expected real yields of 3 percent!” Note that this same bond trader–who remember expects actual inflation of 5 percent and requires a real yield of 1 percent–would buy regular Treasurys yielding 6 percent. So by our method of simple subtraction, we would erroneously conclude that this bond trader expects 6 – 3 = 3 percent inflation, when we know he really anticipates 5 percent. The difference is how much the bond trader thinks the government will understate inflation.

Finally, I have done some empirical analysis to see how the (Nominal-TIPS) technique has done so far. Now unfortunately, you can’t do a true test, because the 5-year TIPS have only been around for a little over five years. However, even so I think the chart below (click to enlarge) is very instructive. It contrasts the monthly “expected future five-year inflation rate” (based on nominal minus TIPS yields) versus the monthly actual, backward-looking year-over-year increase in the CPI. I think it should be obvious that the bond market is not currently forecasting 2% inflation over the next five years.

U.S. Government Decides to Take Over Insurance Sector, Too

While you were sleeping (almost), the feds decide to nationalize one of the world’s largest insurance companies. Apparently Paulson is the kind of guy that buys every property he lands on; it’s just play money, right? What’s another $85 billion among Wall Street friends? Anyway here are the gory details:

The precise details of the government’s plans were still being formulated late Tuesday. The primary option being hammered out involved the Fed providing AIG with a short-term “bridge” loan of $85 billion, according to people familiar with the situation. In exchange, the government would receive warrants in AIG representing the right to buy its stock, under certain conditions. That could put the government in a position to potentially control a private insurer, a historic move, particularly considering that AIG isn’t directly regulated by the federal government.

HT2 Dietwald Claus for ruining my evening…

A Shout Out to Hampton Bay

I think the incentives are bad for manufacturers to write good instructions, since people have already purchased the product by the time they see the instructions, and more important because you already learned how to put the #)%$#$ thing together (in spite of the awful instructions) the first time. I.e., you would not be deterred from buying the same model because of bad instructions. Really, it seems that the only pragmatic benefit is that it builds up brand-name trust, so that you buy other (novel) items from that manufacturer, since you had such a good experience with them with another product.

Annnyway, that is my long-winded introduction to my praise for Hampton Bay. We bought their Adjustable Cone Pendant Track Light (model #440 724–I’m also blogging this in case we need to buy a replacement and forget what we bought!) and the directions had a great tip. I had to cut the wire to adjust the height of the light (hanging from the ceiling). The directions had this great tip: “NOTE: If you are installing more than one light, be sure all the wires are cut to the same length” or something like that. I.e., it was saying you should take out all your lights and get them to that stage of the directions, and then cut them all at the same time, when you can hold the wires next to each other.

Had it not been for that tip, I would have completely installed the first light, before even opening the second light’s box. And then when I went to measure and cut the wire on the second light, I would not have been nearly as accurate in matching the length of the first one. Thanks guys!

One criticism though: The directions were discussing which wires to attach to the blue versus red wire (you had to disconnect them in order to trim). So fortunately I had jotted down a note to myself about which wire went with which other wire color, before undoing them.

Sarah Palin Sells the Headfake, But Gibson Doesn’t Bite–and Other Sundry Observations

People have analyzed the heck out of Sarah Palin’s response when Charlie Gibson asked if she agreed with the Bush Doctrine. For the record, I agree that it is embarrassing that she didn’t know what it was, especially since foreign policy is her obvious weakness. On the other hand, as somebody who just got butterflies before giving an economic briefing to a bunch of 20-something Hill staffers, I know that there always exist reporters’ questions that terrify you. So I felt bad for her, perhaps in the same way that I actually felt bad for Scut Farkus (“He had yellow eyes!”) after Ralphie beat the crap out of him.

Now what interests me isn’t the demonstrated ignorance, so much as Palin’s response to the question. After Gibson asked her, she pauses for a few moments, no doubt considering that she can’t possibly give a definitive answer. She obviously can’t chance saying she doesn’t agree with it. But on the other hand, she knows it’s a trap; she can’t chance saying she does agree with it, because for all she knows, Bush made an asinine comment back in 2003 saying false intelligence claims should be a war crime.

So what does Palin decide to do? She totally bluffs!! She says, “In what respect, Charlie?” Notice the use of his first name? I really hope I don’t sound sexist here: I am just observing that this woman obviously knows some men can be charmed. (Just listen to how Rush Limbaugh gushes over her. And it’s not that he has some hidden agenda; no, I think he literally has a crush on Sarah Palin.)

Now Gibson doesn’t take the bait; he sees that she doesn’t know what it is, and he relishes the fact that he’s got her; it’s why he fumbles around a bit–I think he was trying to hold in his victory shout. This is what he had hoped for going into the interview, and now at this moment he sees he can force checkmate in three moves.

So Gibson says, “Well, what do you interpret it to be?” Now c’mon, the purpose of that is to force checkmate. That’s awesome, incidentally; that’s what journalists are supposed to do. But for the people who are saying, “What are these Republicans talking about? Gibson was just asking her questions!” I would just say, this is what they’re talking about. Gibson went in there thinking, “My job is to show the world what an idiot I know this woman is.”

Now what is hilarious about Palin is, after Gibson shows he is clearly trying to trap her, she bluffs again!! She says confidently, “His world view?” as she nods her head vigorously. In other words, she’s still trying to blow it off; she’s hoping that it won’t be so bad as it feels, that when she’s done with the interview no one will say, “OK don’t panic, we can contain this.”

So that display of Palin’s ambitious risk-taking tells me a lot more about her, than whether she knew what the Bush Doctrine was. (Just as we trust a jury of 12 average Joes–rather than a professional judge–to determine guilt or innocence, so too it might make more sense to allow an average Joe or Sarah–rather than a policy wonk–to decide whether or not to bomb another country.) The episode with Gibson also leads me to believe that she concealed her daughter’s pregnancy from the McCain campaign, and then told them as soon as it was clear there was no turning back on her.

This leads to another issue: Why is everyone mad at the poor vetting done by the McCain campaign? Suppose instead of learning about the pregnancy, instead we learned that the McCain camp forced every daughter of every VP contender to take a pregnancy test with a female McCain staffer who actually watches the girl pee on the tab (or whatever). Can you imagine how crazy the Democrats would go over that? “This foreshadows the police state McCain wants to install! Are we going to trust this monster with our reproductive freedoms?!?!”

Now let’s make sure everyone understands this last point: I am saying there are thousands of people in this country who would (a) Be horrified at what McCain would have had to do to learn about Bristol Palin’s pregnancy if her mother didn’t volunteer the information, and yet at the same time (b) Are horrified that McCain picked a VP candidate who had a pregnant daughter. Isn’t that a bit odd, that McCain is reviled on this score no matter what he did? (I suppose he could, as a rule, only consider candidates without children, but then people would be mad about that policy, too.)

Last issue about Palin: I am ashamed to admit that only when my wife told me yesterday did I learn about Palin’s mayoral policy of making rape victims pay for the police to administer the kit (necessary to identify the assailant). I was puzzled at first, because I had heard tons of criticism of Palin, yet not a word about this rape kit deal. But then I realized what had happened: All of the criticisms I had heard were audio clips played by Rush Limbaugh and Sean Hannity. So of course they are only going to play ridiculous things, like the Pontius Pilate analogy.

I can imagine some hardcore libertarians saying, “What’s your problem? Those are tax dollars. Do people have a right to rape kits now?” However, things are a bit more complicated than that. Most obvious, the government forbids competing judicial and enforcement providers. Also, the price of those rape kits is way higher ($300 to $1200!!) than it would be in an open market. So suppose the government monopolized water, and then insisted that everyone pay $10 per gallon. Would that be responsible stewardship of tax dollars, or instead would it be criminal?

The Economics of Potty Training

Ah, if I were a tenured academic, the papers I could write…

I am struggling with my toddler. For other economist daddies (and mommies), you will appreciate the applications of formal analysis to this topic. You’ve got principal-agent problems requiring payoff rules that are incentive-compatible and overcome seriously asymmetric information. (This latter leads to both Type 1 and Type 2 errors–get it?–of sitting idly on the potty but also having malinvestment in one’s pants.)

For the undergraduate level, you can do a simple analysis in terms of the game Chicken. Make sure the cell for strategy profile (Keep Playing With Toys, Call Kid’s Bluff) yields payoffs of (-1, -100) when Toddler gets uncomfortably damp and Daddy has to let his dinner get cold while he disinfects the dining room floor.

Blood Bath on Wall Street: Buy Gold

Since today has been the worst day for the Dow since the September 11 attacks, I should probably say something. Back in July 2007 I prepared a report for a client (pdf) in which I predicted recession and tough times for the US dollar; you can see op ed treatments here and here.

My basic story is that Greenspan sowed the seeds for the present crisis by keeping interest rates ridiculously low in the aftermath of the dot-com crash. In this respect, I feel sorry for Bernanke and Paulson. Even though they are (in my opinion) making horrible decisions, Greenspan left them a bed full of roaches.

Financial advice? Get some gold. (At one point today, I’m pretty sure gold was up over 2% while the S&P was down over 4%.) In the coming weeks I will lay out why the Fed has run out of options and will have to either (a) let the market sink, or (b) inflate the money supply. Up till now, Bernanke has done what he could to minimize inflation, by “sterilizing” the injections of liquidity into the financial sector through selling off Fed assets. But the Fed’s piggy bank is running low.

One final point about gold and depressions: For some reason, 99% of financial commentators believe that during sharp economic downturns, you get falling prices. I show why that’s empirically not the case in recent decades here.

Now during the Great Depression, it’s true that there was price deflation. However–and I owe this point to Arthur Laffer–the US was on the gold standard* back then; the dollar-price of an ounce of gold was fixed. So if people rushed to hold gold during the 1930s (as they surely did), the dollar-price of gold couldn’t shoot up 300% (or whatever). Rather, the dollar-prices of other goods had to fall.

In the present institutional environment, there is no gold standard holding back the printing press. The relative price of gold will shoot up (just like in the 1930s), but so will the absolute dollar prices of gold and everything else.

* At least until FDR said, “You know, I find this whole gold standard rather inconvenient. Who controls the guns in this country? I do? Great. Everyone, hand in your gold. And let’s build a fort to stockpile it. Where do we need votes? Kentucky?”

Fed Injects $70 Billion to Push Down Federal Funds Rate

According to this CNBC article:

Federal funds traded in the U.S. interbank lending market slipped to about 4 percent from 6 percent earlier on Monday, after the Federal Reserve added $50 billion of temporary reserves to the banking system in a second overnight repurchase agreement.

The earlier market move happened even as the Federal Reserve added $20 billion of temporary reserves to the banking system via overnight repurchase agreements.

This raises an interesting point: When the Fed “sets” interest rates, really that just means they pick a target rate (currently at 2 percent) for how much major banks charge each other for overnight loans of reserves. So the Fed itself isn’t a direct participant in this market; the federal funds rate is a market-determined one. The Fed does NOT “set interest rates” the same way that the government might “set the minimum wage” or apartment rates under rent control.

However, the catch is that the Fed ultimately controls the supply of reserves, and so it can indirectly move the “market”-determined federal funds rate. As the article above shows, the actual federal funds rate can sometimes deviate substantially from the target, leading the Fed to either inject or remove reserves from the system to nudge the rate closer to the target. (I explain this more fully here.)

In general the two are pretty close, i.e. the Fed is able to fine-tune the amount of outstanding reserves so that the market rate tracks the announced target rate, as the following chart makes clear. Note that blue is the target, while red is the “effective” federal funds rate (click for larger image). Also note that there is a few days’ lag in this data, and also it gives daily averages. So even if we waited a few days and looked back at this chart with the latest data, it wouldn’t show a huge spike in the red line up to 6 percent, since over the whole day today, the market rate won’t be at 6 percent (since the government just injected an additional $50 billion to knock it down).

Murphy on Freddie & Fannie Takeover

In Sunday’s Philadelphia Inquirer, I argue it was not good. A juicy excerpt:

If Congress defangs the alternative minimum tax, as it did last year to prevent a large increase on the middle class, the latest Congressional Budget Office forecast projects a record deficit of more than $500 billion for the fiscal year starting Oct. 1. Making the federal government ultimately responsible for roughly half of the nation’s mortgages will make it impossible for the next president to take other measures to help a sputtering economy, such as tax relief.
…
Because of the desire to avoid “moral hazard” – encouraging risky investments by large firms because they believe the government will bail them out if things turn sour – the government-engineered rescues of the Bear Stearns Cos. Inc. and now Fannie and Freddie were designed to punish common shareholders. Fed Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. did not want to reward bad bettors on Wall Street with taxpayer money. Yet this insistence on stern terms might have doomed Fannie and Freddie, making the takeover inevitable.

In a vicious cycle during the last year, investor behavior has been based less and less on fundamentals and more on government announcements. If Paulson’s secret strategy has been to show that throwing around billions of dollars won’t fix a broken economy, taxpayers can only hope this was the final demonstration of the rule. This is hardly the path to economic recovery.