Scott Sumner’s last few posts have been a tour de force. I didn’t need any convincing that Fed policy was too tight in late 2008, but this was based mainly on intuition and being a CNBC/Bloomberg junkie.
From my window it looked as if liquidity demand was spiking and there was a flight to quality that needed to be counterbalanced. Scott gets there a slightly different route but we both freaked out about the following chart.
Unlike Scott, I have hard time interpreting this as a collapse in five year inflation expectations. To be sure, that’s part of it. There was little question late last year that the CPI was about to turn negative on year-on-year basis and that any upward inflation adjustments bond holders had from the last few years would vanish.
However, I see this as accounting for, something less than 150 basis points of movement. Maybe far less, but 150 looks to me like an upper bound.
I am not sure this distinction has a whole lot of importance, however. An unanswered spike in liquidity demand is going to lead to a reduction in investment – cash will dominate capital as the marginal savings instrument whether it is because the cost of holding cash is rapidly falling or the uncertainty surrounding capital is rising.To the extent this is the case, the Fed cannot ignoring warning signs like this.
Furthermore, why is the TIPS yield above zero when the unemployment rate is 10.2%? At this point does it look like all the slack will be run out of the economy in five years, that we will be back at 4% unemployment by then? If not, then why should there be a productive alternative to capital investment that yields a guaranteed real return over the next five years?
Doesn’t this imply that monetary policy is still too tight?