Inflation round-up

The Reserve Bank of India is officially an inflation targeter. The agreement between the Ministry of Finance and the RBI was signed on February 20, and published a few days ago. The target is to "bring inflation below 6 per cent" by January 2016. For financial year 2016-17 and subsequent years the target will be 4±2%, so the acceptable inflation band will be 2%-6%. That would represent a significant reduction from the typical inflation rates in India since 2008.

RBI governor Raghuram Rajan has de facto followed an inflation target since the start of 2014, but the monetary policy framework was not official. Prior to inflation targeting, the RBI's policy target can be described as flexible, as it included, besides inflation, the rupee exchange rate and banking sector stability.

Amol Agrawal, at Mostly Economics, doesn't like the agreement.

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Eurozone inflation expectations are sinking, say researchers at the New York Fed. Survey-based inflation expectations have been falling at the one, two, and five-year horizons. They're particularly worried that the whole distribution of inflation expectations is shifting down, not just the median, or the lower percentiles.

A report by Generali, however, shows that inflation expectations measured by inflation swaps have picked up during 2015.

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Inflation, relatively: The following map shows inflation relative to each country's own history (the 10-year z-score), as of 2014-Q4. Despite abundant talk of Russian inflation, prices are increasing slightly more than they have, on average, over the past ten years, adjusted for standard deviation (z score of 0.13).

The highest inflation rates, relative to their own medium-term experiences, are for Argentina, Bolivia, Venezuela, Japan, and Gabon. The lowest inflation rates, relative to their own experiences, are in Greece, United Kingdom, Hungary, and Poland, in that order.

The eurozone is pretty green (meaning low inflation), but if you squint you'll notice that Sweden and Switzerland are experiencing relatively less deflation than their European neighbors. Even the U.S. is deviating more from its own history than Switzerland.

One-year inflation rate, 2014-Q4, 10-year z-score, relative to own country's history. Source: FactSet data, gunnmap.herokuapp.com, author's elaboration.

Those shifty inflation expectations

Market-based measures of U.S. inflation expectations plummeted over the last quarter of 2014--which is a concern now that inflation is so low. In particular, two market-based gauges are often quoted: the break-even rate from 5- and 10-year bond yields, and rates from inflation swaps.

Janet Yellen thinks that factors other than inflation expectations may be moving these "inflation compensation" rates (emphasis mine):

There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.

[...] 

Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.

Summarizing, Yellen mentions four things that, together or individually, compress "inflation compensation" (the yield charged by investors for bearing both inflation and inflation risk):

1. Oil prices
2. Exchange rate
3. Safe-haven flows
4. Dispersion of inflation expectations

As I said, there might be correlation among those four factors. I would add a fifth item, which is perhaps correlated to "safe-haven" flows: liquidity. As the market in nominal treasuries is deeper than that in TIPS, and investors have a preference for liquidity, a surge of inflows to the dollar may increase the liquidity premium that TIPS must offer, reducing the break-even inflation rate. I wrote about this a long time ago.

Recent developments offer a glaring example of how "inflation compensation" measures can be a noisy gauge of true inflation expectations. See, for instance, these charts:

Source: FRED.

Source: Capital Economics, Global Economic Update, Jan. 27.

Notice the co-movement of the short-term changes of long-term "inflation expectations" and the price of oil. I can't think of a reason why today's changes in the price of oil should affect so much the market's assessment of inflation five years from now, over the following five years. Neither break-even rates nor inflation swap rates seem, then, reliable gauges of inflation expectations.

The Federal Reserve Bank of Cleveland has published for quite some time an estimate of inflation expectations that combines surveys of forecasts with market prices to come up with a (better?) measure of inflation expectations. (The methodology paper is here.)

Below is a chart of the price of Brent, the 5y-5y expected inflation measure from break-even rates, and a 5y-5y estimate from the Cleveland Fed's time series. The Cleveland Fed doesn't give you the 5y-5y forward rate, so I computed the latter with the usual spot-forward formula:

$$(1+\pi _{0,10}^{e})^{10}=(1+\pi _{0,5}^{e})^{5} (1+\pi _{5,5}^{e})^{5}, $$ where \({\pi}_{n,m}^{e}\) is the annual rate of inflation expected \(n\) years from now, over the next \(m\) years. The forward inflation rate we're interested in is the second term on the right-hand side.

Up until 2008, the gap between market-based and Cleveland Fed estimates was small and transitory. Then the two diverged, especially after 2010. For a while I was suspicious: the Cleveland Fed's estimates had become more than one percentage point lower than the estimates from break-evens, and the level was persistently close to 1.5%--too low, from a(n admittedly subjective) point of view.

Of late this has changed, as the 5y-5y breakeven has plummeted, but the Cleveland Fed's estimate has not. More importantly, the Cleveland Fed's measure continues to be much less sensitive to the price of oil than the market-based estimate, which is a desirable feature for an estimate of long-term inflation expectations.

Two important questions: Did the market-based estimate of expected inflation become more sensitive to the price of oil after 2008, as the chart suggests? (Beware, the price of oil might be a proxy for something else.) Why?

The (surprising?) resilience of inflation expectations in the eurozone

One way for central banks to gauge long-term inflation expectations is to look at the \(n\)-year-forward, \(m\)-year-ahead expected inflation rate. For instance, the two-year-forward, three-year-ahead expected inflation is the expected change of prices two years from now, over the following three years. As of December 2014, that would be the inflation rate expected in Dec. 2016, over the 2017-2019 period.

Central banks like these forward measures because they eliminate--or at least diminish--the influence of short-term inflation inflation expectations.

One data source for the construction of such forward measures are surveys of forecasters. The ECB Survey of Professional Forecasters asks participants for their inflation outlook over the next year, the next two years, and the next five years. Using those overlapping horizons one can infer the forward expected inflation rate from this equation:

$$(1+\pi _{0,5}^{e})^{5}=(1+\pi _{0,2}^{e})^{2} (1+\pi _{2,3}^{e})^{3}, $$ where \({\pi}_{n,m}^{e}\) is the annual rate of inflation expected \(n\) years from now, over the next \(m\) years. The forward inflation rate we're interested in is the second term on the right-hand side.

Likewise,
$$(1+\pi _{0,2}^{e})^{2}=(1+\pi _{0,1}^{e}) (1+\pi _{1,1}^{e}), $$ So $$(1+\pi _{0,5}^{e})^{5}=(1+\pi _{0,1}^{e}) (1+\pi _{1,1}^{e}) (1+\pi _{2,3}^{e})^{3} $$ If you estimate the forward expected inflation rates this way and plot the time series, this is what you get:

I am surprised to see that, despite much talk of deflation and falling inflation expectations, the inflation expectations that matter most (the long-run, forward rate, in green) is firmly glued slightly above 2%. The intermediate forward rate (i.e. one-year-forward, one-year-ahead) has declined moderately over the past year from 2% to 1.7%. The only inflation expectation that has dropped dramatically is the short-term rate (inflation expected over the next year), which is now close to 1%, down from 1.5% a year ago, and 1.9% two years ago.

This undermines the case for quantitative easing in Europe. Granted, the ECB might be looking at other measures of inflation expectations (i.e. inflation compensation from nominal and inflation-linked bonds, inflation swap rates, consumer surveys of inflation expectations, etc.) And the ECB might also be worried, besides inflation expectations, about credit growth, output growth, etc.

P.S. By the way, the formulas above were written thanks to the Mathjax tool for Blogger. With Mathjax added to your blog, you can type formulas as you would with LaTex. And if you are not fluent in LaTex, this website is helpful. You just type in your formulas, with the help of some buttons, and it produces the LaTex code for you.

What caught my eye

1. Recessions according to Hayek and Keynes;
2. Network neutrality;
3. Vaccines and autism;
4. Spain issues inflation-linked bonds;
5. The Fed was way off.

1. Reconciling Hayek's and Keynes' views on recessions (NBER working paper). I can't find an ungated version. Please email me if you do.

Abstract: Recessions often happen after periods of rapid accumulation of houses, consumer durables and business capital. This observation has led some economists, most notably Friedrich Hayek, to conclude that recessions mainly reflect periods of needed liquidation resulting from past over-investment. According to the main proponents of this view, government spending should not be used to mitigate such a liquidation process, as doing so would simply result in a needed adjustment being postponed. In contrast, ever since the work of Keynes, many economists have viewed recessions as periods of deficient demand that should be countered by activist fiscal policy. In this paper we reexamine the liquidation perspective of recessions in a setup where prices are flexible but where not all trades are coordinated by centralized markets. We show why and how liquidations can produce periods where the economy functions particularly inefficiently, with many socially desirable trades between individuals remaining unexploited when the economy inherits too many capital goods. In this sense, our model illustrates how liquidations can cause recessions characterized by deficient aggregate demand and accordingly suggests that Keynes' and Hayek's views of recessions may be much more closely linked than previously recognized. In our framework, interventions aimed at stimulating aggregate demand face the trade-off emphasized by Hayek whereby current stimulus mainly postpones the adjustment process and therefore prolongs the recessions. However, when examining this trade-off, we find that some stimulative policies may nevertheless remain desirable even if they postpone a recovery.

2. Everything you need to know about network neutrality, applied to the internet, in 17 easy-to-read cards, from vox.com.

3. Clear, eight-minute review of the evidence (or lack thereof) on the link between autism and vaccines. Thanks to audible.com and upworthy.com.


4. Spain is issuing bonds linked to eurozone inflation, for the first time ever (link to El País article in Spanish, article in English from Bloomberg). A couple of years ago PIMCO published a viewpoint on the eurozone inflation-linked bond market. Market conditions have changed dramatically since then, but it's worth keeping some of PIMCO's concerns in the backs of our minds.

5. John Cochrane re-posts a chart of the Fed's forecasts vs actual growth, by Torsten Slok at Deutsche Bank. If the Fed, employing a flock of highly qualified economists, gets the forecasts so wrong, what's the hope for any individual, somewhat-less-qualified private forecaster?

20130604 Links

1. Canada: energy sector on the East; 2. Inflation expectations in Japan; 3. Dwindling profits in Korea. ********************************************************************************************************************************************************************************************************************************************************************************************************************

1. When I think about Canada's energy sector I think about the west provinces and tar sands. Little did I know that there is a project to build a liquefied natural gas (LNG) plant on the east coast. 

Source: Globe and Mail, accessed on June 3, 2013.

Europe seems eager to jump in to the opportunity of importing natural gas from Canada:

Goldboro signed a multiyear supply agreement with E.ON AG, a publicly traded German company, according to a statement. The deal gives Goldboro an anchor customer, making it easier to attract more business. Companies from India, for example, have been reluctant to sign agreements until infrastructure is in place.

The agreement is a milestone for Canada’s energy industry, with attention surrounding liquefied natural gas shifting to the East Coast from the West Coast, where companies have proposed at least six export projects. On the other side of the Atlantic, it signals how European companies are looking to ease their reliance on Russia’s OAO Gazprom. Indeed, both companies involved in the transaction focused on how their deal is about diversifying supply.

If it takes off, the project would probably put upward pressure on the price of U.S. natural gas.

2. As of April 2013, most Japanese households expected [xls] inflation to be higher than 2% over the next year, and 38% of them expected inflation to be between 2% and 5%, according to a government survey. There has been a large increase in inflation expectations since late 2012. There was another jump in late 2010.

3. Korean companies: dwindling profits. (It is not clear whether the writer is talking about sales or profits. But a fall in sales would be even more negative, in my opinion, than a decrease in profits.) 

Major Korean companies listed on the Korea Exchange are seeing a decline in earnings. For some time even after the global financial crisis, most Korean firms managed to achieve steady profit growth, but that is now over. 

The Korea Listed Companies Association tabulated the first-quarter earnings of 625 listed companies on Sunday and found that the sales of 322 of them or 52 percent fell compared to the same period last year. 

In 2012, only 42 percent saw sales dip. 

The sales of one in every four dropped more than 10 percent this first quarter.
Some 64 percent of all listed companies saw operating profit either decline or swing into the red during the first quarter. Among the top 100 in terms of sales, the proportion rose to a whopping 70 percent.