Policymakers at the Federal Reserve and other central banks continually face the “Goldilocks” question—is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation; survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.
This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.
People’s expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.
Let’s start by simply isolating and identifying some of the salient concepts and important points, then, we’ll work through an analysis.
From paragraph one:
*Real Interest Rates
*Expected Inflation
*TIPS securities
*Survey measures of expected inflation
*Nominal Interest Rates
*Economic Theory
All of these appear in paragraph one. None are defined, explained, or expanded upon. So let’s initially do just that.
The Natural Rate of Interest is when you measure the interest rate in the following manner. I lend you a bag of coal, weighing 100Kg, you return to me in 1 year a bag of coal weighing 100Kg + an additional bag of coal weighing 10Kg. The natural rate interest rate = 10%
The natural rate of interest is vitally important in determining the Real Rate of Interest, or, the inflation adjusted rate of interest. Thus when economists talk about observing the real interest rate, and then look at financial products that depict money rates of interest, it implies that they either know, or have a very good idea of what the natural rate of interest actually is. How exactly do they do this?
Expected inflation – is by definition, the future. How many people do you know, that can predict the future? Expected inflation is therefore a guess. Events have a horrible penchent for making guesses look ill-informed.
When we look at the timeframes involved, the whole experiment becomes even less realistic, 1 month to 30 years. Thirty years, get a grip chaps. Thirty years ago, in 1979 yields were 10.3%, rising to 14%+ in 1981, to drop year-on-year thereafter. Had anyone predicted, or indicated an expectation then, the prices would have been heavily bid-up, but no, they continued to fall into 1981.
Expectations are measured by surveys. These surveys are then tortured via statistical methods to yield the data that will be acted upon. Statistics and Financial Markets are mutually exclusive. Statistics have only a very limited application within Financial Markets, as has been demonstrated cycle-after-cycle.
Google Trends probably provides as good a gauge of expectations in survey form as you’re likely to find.
Nominal, or unadjusted for inflation, interest rates. Pretty self-explanatory, we’ll return to this a little later.
TIPS, US Treasury Bills/Notes/Bonds that reset Par values to adjust for CPI inflation, there are a few problems, but these will be considered later.
Economic theory, the biggie. Not detailed is which theory the authors are utilising, there are after all numerous, all with a variety of titles. The most prevalent are the followers of Paul Samuelson. Now, the authors may not actually be using these theories, rather some others, but for the moment, we’ll go with Paul Samuelson for the reason that he developed econometrics, the mathematical perversion of economics and due to paragraph #2.
Paragraph number two, introduces us to the rational man, also known as homo economicus. This theory has been thoroughly refuted through the work of Daniel Kahneman
Thus we can already see that this new model is running into numerous problems and we haven’t even made paragraph three yet.
