The Fed: A Pollyanna on Inflation

I’m late to this item, but from what I can tell, it went relatively unnoticed upon despite its seeming importance.

The Wall Street Journal’s Greg Ip, in “Fed Officials Downplay TIPS Inflation Signal,” makes the case that the Fed is whistling in the dark as far as inflation is concerned. He takes their optimism at face value, as in that they have somehow talked themselves into it. Other explanations are possible. For instance, it could be that the Fed knows full well that its policy options are lousy, it feels it has to keep the liquidity spigot on full even though it knows full well that will probably lead to inflation worries down the road. But acknowledging inflation risks would probably feed them, so denial, even if it risks the Fed’s credibility, is the wiser course of action.

What makes this post intriguing is that Ip is widely believed to have a special standing with the Fed; they call him when they want to convey a message not through official channels (for example, correcting misunderstandings of Fed pronouncements). So conversely, even though this is a blog post, one would think that the Fed probably pays more attention to Ip than most reporters and commentators.

Thus, this post has particular significance, While Ip is going on Fed statements, he’s a particularly well informed Fed watcher. And in a rather anodyne fashion, he’s telling his best source that he thinks they are smoking something awfully potent.

From the Wall Street Journal’s Economics Blog:
Inflation wa

rning signs are popping out all over. One of the more alarming is in the market for Treasury inflation-protected securities, known as TIPS.

Ever since Federal Reserve Chairman Ben Bernanke signaled in early January he was subordinating the fight against inflation to the fight against recession, the spread between TIPS and regular (nominal) Treasurys has widened. That breakeven is an indication of the inflation rate bond investors expect to prevail over the maturity of the bond.

Yesterday, the 10-year breakeven hit 2.5%, the highest since August, 2006, while the five-year spread hit 2.58%, according to Anthony Crescenzi of Miller Tabak & Co. Indeed, he notes that on some TIPS, the yield is actually negative, meaning investors assume that after inflation, they will lose money owning the nominal bond.

But top Fed officials are playing down the importance of this signal. “Does this rise in [breakevens] indicate that long-run inflation expectations have risen by a similar amount?” Governor Frederic Mishkin asked in a speech yesterday. “My best guess is that much of the rise in inflation compensation reflects other factors.”

Specifically, Mr. Mishkin and other officials note the peculiar fact that the inflation rate implied by breakevens more than five years from now has risen more than the implied inflation rate just four years from now. According to Macroeconomic Advisers, the implied inflation rate in the year 2012 rose 0.25 percentage points between Jan. 9 and Feb. 28, while the implied inflation rate in 2017 rose 0.38 points. This doesn’t make a lot of sense: if investors really think the Fed has gone soft on inflation, why would that be more pronounced in 2017 than in 2012?

Mr. Mishkin says it’s because the breakeven doesn’t represent just expected inflation, but compensation for other factors including uncertainty about inflation. By this reckoning, if investors have the same forecast for inflation but less confidence in that forecast, they will pay extra (i.e. accept a lower TIPS yield) for insurance against inflation. This is true even if there’s an equal chance of it coming in lower as higher than expected. Mr. Mishkin noted the same thing happened in 2003 and 2004 when the fear was deflation. Increased inflation uncertainty could explain the greater increase in breakevens nine years from now vs. four years from now. Mr. Mishkin says that interpretation is supported by recent surveys of economists that found only a marginal increase in expected inflation but increased uncertainty about the trajectory of inflation.

Brian Sack of Macroeconomic Advisers thinks the Fed should not take so much comfort in this explanation. First, even just looking four years from now, there’s been a large increased in breakevens since early January, compelling evidence of more inflation concern. Second, “it is not clear that the [Fed] should be dismissive of the rise in breakevens even if it is driven by the inflation risk premium rather than inflation expectations. A credible central bank should not only keep inflation expectations low and steady, but it should also prevent investors from pricing in substantial upside inflation risks.”

More noteworthy is that senior Fed officials have tended in the last month to look at every inflation warning as a glass half full. Surveys of consumers and professional forecasters both show an increase in expected inflation; but senior Fed officials focus on the small magnitude of the increases rather than the fact of them, and note that these measures remain within the range of recent years. The rise in core inflation (which excludes food and energy) is attributed primarily to pass-through of energy prices and unsustained drops in certain categories earlier last year, with the implication that both effects are temporary. The rise in commodity prices is seen either as a reflection of global growth or speculation rather than an endogenous response to expected inflation. Similarly, the fall in the dollar is attributed to differential growth rates and interest rates between the U.S. and its trading partners. Core inflation measured by the price index of personal consumption expenditures has been above the 1.5% to 2% range of Federal Open Market Committee definitions of price stability for three months now. Mr. Bernanke noted both data points in his testimony to Congress last week but did not connect them. Blogger Tim Duy says, “What is clear is that the Fed remains eager to dismiss any inconvenient information.”

To be sure, the Fed has good, fundamental reasons to be optimistic on inflation, perhaps most important the fact that a recession, if it happens, will do a lot to contain wage and price gains. Credit market conditions are worse than ever. “It is increasingly obvious that the Fed is in a no-win situation,” writes Mr. Duy. “The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970’s type of environment.”

Note to Duy: we don’t need a deteriorating labor market to keep wages in check. Labor (and that includes overworked white collar workers ex investment bankers) have had no bargaining power even in a growing economy. We may be going down the Japan path, of low growth and deteriorating real wages, albeit at a higher rate of inflation.

Print Friendly, PDF & Email


  1. doc holiday

    President Bush is working to prevent a recession, but the group of advisers meant to help him achieve this vital goal is woefully understaffed. In fact, the three-member Council of Economic Advisers is limping by with just a single adviser.

    The reason: a lingering impasse between Senate Democrats and the Bush administration regarding the choice of nominees.

    Some economists worry the impasse could affect the administration’s ability to respond to the economic downturn. “By not confirming the appointments, the Senate is acting to deprive the White House of some of the best economic advice available,” a former chairman of the CEA, Gregory Mankiw of Harvard University, said.

    For more than six months, the president has been unable to fill the vacancies because top Democrats are refusing to approve his nominees until the White House agrees to the Democrats’ choices for vacancies at the Securities and Exchange Commission.

    With the deadlock now dragging into March, the administration’s chances of being able to fully staff the current CEA are dwindling. Already, one of Mr. Bush’s nominees, Dennis Carlton of the University of Chicago, has taken his name out of the running. He had been waiting since August to be considered by the Senate.

    The remaining nominee, Donald Marron, also of the University of Chicago, is awaiting “an up or down vote,” as the administration searches for a nominee to replace Mr. Carlton, a White House spokeswoman, Emily Lawrimore, said.

    That leaves the CEA with just one top-ranking member, its chairman, Edward Lazear. With the White House rushing to respond to an economic downturn, the chairman is “spread way too thin,” a former CEA member, Andrew Samwick of Dartmouth College, said.

    Also See: President Bush’s decision to elevate three former administration economic advisers to the Federal Reserve Board prompted questions yesterday about whether they would be able to steer the economy independently of the White House they have served.
    “This is inevitably going to create the impression that the board is more political than in the past,” Schlesinger said. “This creates more of a burden on Bernanke and company to prove they’re not taking their cues from [White House Deputy Chief of Staff] Karl Rove.”
    Warsh, 35, who has served on Bush’s National Economic Council for the past four years, is a special assistant to the president for economic policy.

  2. doc holiday

    I think I just put 2=2 together:

    Here is my theory as to why Ferguson resigned and then why the youngster Warsh was pushed into place; I think Bush was going to fill a vacancy with a Warsh appointment, but then as soon as Ferguson relaized how utterly stupid that would be, he resigned, and forced Bush’s hand. In that regard, I count Ferguson as an American Hero and Patriot, because his action has exposed the level of collusion and politics within The Fed!:

    1. Roger W. Ferguson, Jr., submitted his resignation Wednesday as Vice Chairman and as a member of the Board of Governors of the Federal Reserve System, effective April 28, 2006.
    Ferguson, who has been a member of the Board since November 5, 1997, submitted his letter of resignation to President Bush. He will not attend the March 27-28 meeting of the Federal Open Market Committee.

    2. President Bush’s decision to elevate three former administration economic advisers to the Federal Reserve Board prompted questions yesterday about whether they would be able to steer the economy independently of the White House they have served.
    “This is inevitably going to create the impression that the board is more political than in the past,” Schlesinger said. “This creates more of a burden on Bernanke and company to prove they’re not taking their cues from [White House Deputy Chief of Staff] Karl Rove.”
    Warsh, 35, who has served on Bush’s National Economic Council for the past four years, is a special assistant to the president for economic policy.

  3. Yves Smith


    I know Ferguson distantly. He and I overlapped at McKinsey. My impression is that he believed he had a shot at being the Fed chair. Even though he is a capable enough individual, I don’t think that had a snowball’s chance in hell of ever happening. His academic credentials were no where near as good as Bernanke’s, and he hadn’t held an important role in the banking industry to give him the street cred to compensate.

    And people who’ve held top-level roles at the Fed get very nice consolation prizes in the form of well paid jobs in finance land.

  4. Anonymous

    Clearly, the Senate’s refusal to approve these Bush appointments is entirely a function of following Grover Norquist’s advice: They are shrinking the CEA so that it can drown in a bathtub.

  5. Anonymous

    I was hoping that Ip would get to run this piece in the paper so it would get more play, b/c I like you, couldn’t agree more about its importance. The Fed has told us over and over that what they really care about is inflation expectations, and if they became unmoored, then it would react appropriately. What we are learning is that it is not market based or survey based expectations that will cause the Fed to act, but rather their own personal expectations of what inflation will be. Great.

  6. doc holiday


    I agree that Ferguson was not the person to replace Greenspan, but I do wonder about the possibility of him not wanting to be a babysitter for Warsh and the other kids there. That said, it was probably the smartest thing for him to walk away from the position he had.

    I really want to start a Warsh Watch Blog, because he seems totally un-qualified to be in the position that Bush gave him. I did a Google today and he is nowhere in the news, and as I recall, he has never written a thing of value, but Im sure in this day and age, someone will help him with that and get his resume looking better (soon) and add more meat, more filler and thus offer hope that he plays some part in reality.

    I imagine he will be giving some speeches to high school kids that are pondering whether or not to take AP History. I also anticipate that he will be under the wing of someone for many years and God willing removed by the next president for cause.

    He should resign this afternoon actually and go play tennis on his own dime, as taxpayers are all ready on the hook for too many abusive boondoggles!

  7. Lune

    doc holiday,

    I’m not sure if you mean to imply that it’s the Democrats’ fault for the understaffing of the CEA. To spin it the other way, the President is showing that he’s more interested in keeping democratic nominees off the SEC and thereby protecting his Wall St. buddies than in getting the advice he needs to deal with a tanking economy.

    The truth is that both parties (the Pres. and the Senate) are being hard-nosed about this. After all, if the president really wanted his economic advisors, he just has to compromise on th SEC, right? Why shouldn’t the democrats press that advantage?

  8. doc


    Im hoping every politician up for election/ or not is replaced by anyone that has some integrity; aint gonna happen though…

  9. Anonymous

    I am surprisingly unconcerned that, due to a standoff with the Democrats, Bush will only have one adviser to help him fail to deal with the current economic crisis.

Comments are closed.