Monthly Archives: October 2014

Cliff Asness provides a qualified defense of a 2010 letter to Ben Bernanke he endorsed, warning that further QE would “risk currency debasement and inflation”. The piece boils down to the clash between priors that have not come to pass and observed reality. In theory, this is a fair defense: elevated risk of hyperinflation, if accompanied with a similar increase in risk of forever deflation wouldn’t alter the long-term expectation. Paul Krugman responds that Asness fundamentally misunderstood monetary theory – that when short-maturity debt substitutes perfectly for cash, an increase in money cannot increase prices.

That’s not necessarily sufficient. Expected inflation of 2% can be sustained if the entire market believes that inflation will, indeed, be between 1.5% and 2.5%. It would also be sustained if half the market thought inflation would average -2% and the other half thought it would hit 6% – except the Fed’s expected loss function is higher in any scenario of the latter world.

So the question we need to ask is whether the market price of inflation risk beyond some threshold increased because of quantitative easing. And because of the exciting market of inflation floors and caps, we can actually answer that question. Before we answer this question, it’s worth qualifying the value of this analysis, and explaining the nature of the market.

An inflation cap is effectively an out of the money call option struck at some inflation rate for some maturity. Normalizing the payoff at $1 per point, the we can denote this as C(10%, 5) = max{n – 10, 0} where n is the average inflation over 5 years. Then, at every moment in time, we can not just identify the expectation of inflation over a time period, but the probability density function thereof.

Various options pricing frameworks can be used to determine the implied PDF, though I think the partial derivative method using a forward measure is the most common. (This just means future cash flows are discounted by the yield curve of a well-traded bond, instead of a risk-free rate that you don’t know in advance).

Unfortunately, comparing the market for inflation caps with the TIPS (a standard estimate of inflation expectations) is tricky, since it’s far less liquid, and incredible new (introduced, conveniently, around 2008). Therefore, we need some sort of sanity check that the values generated from this data make sense without making huge adjustments for liquidity and risk premia. Looking for an answer, I came across a paper by Yuriy Kitsul and Jonathan Wright at the Fed that exploits a quirk in the TIPS payoff mechanism to see how well it matches the options data.

While you normally think that it’s only possible to infer an expectation from the TIPS breakeven, under reasonable assumptions, it’s actually possible to figure out the market’s expectation that there will be deflation (a cap of 0%) over some time period. The asymmetry that TIPS must payoff its entire nominal face value, even if there is substantial deflation, means that TIPS is actually a compound security: long pure TIPS and long a 0% inflation cap.

Therefore, we can compare the explicit inflation caps implied probability of deflation with the TIPS implied probability of deflation. And what researchers find is even if they don’t match perfectly, they are almost perfectly correlated suggesting that even if the level of the inflation caps market is distorted by liquidity concerns, the dynamics thereof are legitimate.

And now we can answer the question at hand: did the risk of high inflation increase after the Fed engaged in QE2? (Note this establishes a correlation, not causation). Per Kitsul and Wright:

Deflation Inflation

And you see two very interesting trends: the probability of high inflation (that above 6%, which is the largest traded strike) sharply increased over the latter half of 2010 and early 2011, the time period over which the effects of QE2 were priced in. This is a general trend across all maturities. While the 3, 5, and 10 year option follow a similar path afterwards, the 1-year cap is much more volatile (largely because immediate sentiments are more acute). Still, you see the probability of high inflation pic up through 2012, as QE3 is expanded.

The takeaway message from this is hard to parse. This market doesn’t exist in the United States before 2008, and isn’t liquid till a bit after that, so it’s tough to compare this with normal times. While the sharp increase in the probability of high inflation would seem to corroborate the Hoover Institution letter, that wouldn’t mean much if it simply implied a return to normalcy. That’s just a question we’ll have to leave for a later day.

What about the probability of deflation? We’ll the interesting point is that for the three higher maturity options, the probability for high inflation and probability of deflation were increasing at the same time. This was a time of relatively anchored 5 year implied inflation, but the underlying dynamics were much more explosive, as can be seen in the above charts.

The punctuated volatility of immediate, deflationary threat is interesting. Moving away from changes for a second, the risk of deflation was consistently higher than that of inflation (though we shouldn’t take this too seriously given liquidity issues) – but only over the span of one year. Over ten years, the likelihood of high inflation was much higher than that of deflation.

What we can learn from the deflation PDFs is that long-term deflation was never a concern in the US (it would be interesting to conduct a similar analysis on the UK and EU, something I’d be happy to do if anyone knows where this option pricing data is – help!) The immediate dynamics are a whole different game. QE2 seems to drastically reduce the chance of deflation, to basically nil, but this isn’t persistent and there’s a lot of volatility. Though it does look as if QE3 was responsible for the death blow, with the likelihood around 10% by the time purchases peaked at $85 billion.

So where does this bring us on Krugman v. Asness?

An important argument the money manager made in his essay is that this question may be decisively settled for the short-run, but we still haven’t successfully exited from this period of weird, unconventional policy regime: the risk of inflation still exists seems to be the message. Markets agree with this: with the 10-year inflation cap probability of high inflation nearing its peak. That said, there’s a good chance, that 2008-2010 represented the trough of high inflation probability – the increases afterwards seem to be a return to normal more than anything else. A 20% chance of inflation above 6% isn’t too bad – and it’s important to keep in mind that the levels of this market are probably biased by selection, risk, and liquidity.

More importantly, the probability of deflation, and variability thereof, moderated. But here’s the end result:


The probability that we’re going to have 2% inflation over the long-run decreased from around 70% in 2010 to 40% in 2012. There’s been a marked increase in the standard deviation of the PDF, which is cause for concern.

Again, I don’t want to put too much stock in these numbers – until we have reads from more normal times (again, anyone, data? I would love to replicate this for 2014 USA, or Europe).

These numbers neither provide a roaring endorsement for QE nor one for some crazy increase in the risk of inflation. While you can defend your use of the word “risk” against failed expectations – there’s a distribution, after all – it’s hard to protest when the increase in risk itself, as priced by the market, has been so modest.

That said, the QE can’t increase inflation in a liquidity trap argument is also unconvincing. There’s little theoretical reason to believe that once the growth rate picks up and overnight bonds are once-again priced at a discount, the exit from unprecedented stimulus wouldn’t cause inflation to increase as the monetary transmission mechanism kicks in, and the money multiplier roars back to life. There is good reason to think that this isn’t going to cause any hyperinflation (not the least that the Fed wouldn’t let it), and “debasement” was certainly too alarming a description.

This letter suffers more from some of its signatories, like Niall Ferguson, who go on to defend its claims with dubious nonsense from Shadowstats than pure content it self. It was wrong, but derivatives markets suggest that inflation risk has increased.

The big departure I’d take is in arguing this increase wasn’t enough to flush out the debt overhang. Though, one ought to ask, whether a better way to get there was moving the distribution to the right, or increase its standard deviation.

Tyler Cowen links to Scott Sumner’s skeptical notes on secular stagnation. As frequent readers know, I’ve been very skeptical in the past myself, but I think the argument has a lot more merit than Sumner gives credit for – i.e. that this is an open question that economists can more decisively accept or reject in ten years.


It seems to me that the Krugman/Summers view has three big problems:

1. The standard textbook model says demand shocks have cyclical effects, and that after wages and prices adjust the economy self-corrects back to the natural rate after a few years. Even if it takes 10 years, it would not explain the longer-term stagnation that they believe is occurring.

2. Krugman might respond to the first point by saying we should dump the new Keynesian model and go back to the old Keynesian unemployment equilibrium model. But even that won’t work, as the old Keynesian model used unemployment as the mechanism for the transmission of demand shocks to low output. If you showed Keynes the US unemployment data since 2009, with the unemployment rate dropping from 10% to 6.1%, he would have assumed that we had had fast growth. If you then told him RGDP growth had averaged just over 2%, he would have had no explanation. That’s a supply-side problem. And it’s even worse in Britain, where job growth has been stronger than in the US, and RGDP growth has been weaker. The eurozone also suffers from this problem.

The truth is that we have three problems:

1. A demand-side (unemployment) problem that was severe in 2009, and (in the US) has been gradually improving since.

2. Slow growth in the working-age population.

3. Supply-side problems ranging from increasing worker disability to slower productivity growth

Only the last two can explain the slowing long run trend rate of RGDP growth, as well as the low real interest rates on 30 year T-bonds.

Both (1) and (2) don’t get to the heart of what Krugman/Summers believe and are implicitly embedded with false assumptions. The “standard textbook model” is a nebulous concept. Even within many of the workhorse, New Keynesian, models the economy will not return to full employment without some external push if the natural rate to which it must correct is below 0%. This is very different from the old Keynesian permanent slump, which suggested that if wages are flexible, downward adjustment would further increase the real interest rate and tempt a vicious, deflationary cycle.

Krugman has definitely agreed before that to the extent that falling prices are expected to be temporary, they can also be expansionary.

More importantly, disregarding the fact that a fall in unemployment to 6.1% doesn’t adequately capture the whole labor market, if you showed Keynes a chart of US unemployment since 2007, he wouldn’t have expected rapid growth if you also told him inflation has consistently been well-below its long-term average every year thereof. Sumner’s suggestion that productivity growth is to blame (while perhaps true) does nothing to change the fact that, if anything, declining supply-side fundamentals should have increased the price level.

In fact, that’s specifically the conundrum that secular stagnation attempts to address. It’s not a comment on the financial crisis and recession as much as a meditation on the decade that preceded it. How could a rapid increase in wealth, credit creation, construction, government spending, and accommodative monetary policy not result in above-average inflation?

John Taylor loves pointing out that the housing bubble was caused by discretionary policy that deviated from his eponymous rule. Not only does that ignore the fact that the target FFR pretty much followed the implied Taylor Rule if one looked at the Fed’s inflation forecast instead of current inflation (which is both noisy and laggy), but also assumes that the equilibrium rate of interest was constant over this period. That deviation from Taylor’s version of the Taylor Rule begat a housing bubble , and not any inflationary pressures suggests this is false.

So if you told Keynes that the unemployment rate had been cut in half without any associated increase in inflation, he’d probably ask you to look at a different metric.

More peculiarly, Sumner seems to be missing the Krugman/Summers point entirely by prescribing policies that they would both advocate:

I mentioned that there was a third problem with the Krugman/Summers view. They favor big government Keynesian demand-side remedies for what they see as a sort of permanent liquidity trap. This fits with the newly fashionable anti-neoliberal views on the left. Thomas Piketty’s new book made the wildly implausible claim that neoliberal reforms had not helped countries like Britain. However the countries least likely to be mentioned in discussion of “The Great Stagnation” are precisely those countries that have pretty good supply-side fundamentals, and/or relatively small government. Here’s the Heritage Foundation’s list of the top 10 countries for Economic Freedom […]

Now I don’t want to oversell this list. Many of the top 6 countries have fast population growth. It’s hard for any country to completely overcome the slowdown in the rate of global productivity growth. But I think any fair observer would note that (with the exception of Ireland) the “usual suspects” in the stagnation discussion (Japan, the US, Britain, the 18 eurozone members, etc) are conspicuously missing from that list. And while Ireland undoubtedly was hammered by a big demand shock, their RGDP rose 7.7% over the past 12 months, a rate the US could only dream about. So while the top ten countries are not perfect (Denmark’s performance has been mediocre) they’ve clearly done better than most developed countries. That doesn’t provide much support for the progressives’ claim that the eurozone is doing really poorly because while they have the biggest governments on Earth, their governments need to be even bigger to overcome the Great Stagnation.

There’s pretty much nothing exclusive in those two paragraphs with what Summers and Krugman believe, except perhaps for any credibility assigned to the Heritage Foundation. If you read Summers’ introduction to the definitive ebook on the subject, he notes the following as some of the most promising avenues out of secular stagnation:

  • “Removing barriers for labor mobility between firms by trimming down employment protection legislation.”
  • “Increasing incentives for low-skilled workers to participate on the labor market.”
  • “Simplifying procedures for starting up businesses.”
  • “Applying anti-monopoly policies to reduce the profit margins in new IT industries”.

In fact, the central thrust of the secular stagnation argument is that falling productivity growth, a chief determinant of the prevailing natural interest rate, has fallen to a point where there is a vicious cycle between lower potential growth and lower actual growth.

The comments on the Eurozone are also tough to confirm. While Germany was definitely the success story of the decade, it worked largely because the rest of the world was able and willing to absorb its excess savings, thereby masking instability in the periphery. Instead, the real question is why did the periphery grow so slowly, despite a rapid inflow of capital from Germany and subsequent fall in borrowing rates.

The German model, by the unfortunate but inevitable requirement that international assets and international liabilities must sum to zero, could not have been applied everywhere to similar effect.

This post mischaracterizes what progressives actually believe. The conversation on secular stagnation most certainly does not, at least by itself, advocate “anti-neoliberal” viewpoints. If anything, this is a much stronger case for supply-side reforms than the Reaganites were ever able to produce in the 80s.