Good news on bond market inflation


A “Now Hiring” sign at TJ Maxx in Annapolis, Maryland on Monday. The Fed has done precisely what it is supposed to do, by allowing the American economy of sticky prices, wages and debt to quickly return not just to full employment, but to the correct version of full employment – the one that has workers who work in sectors producing products for which there is real and fundamental demand – after a shock. AFP

As of May 6, the bond market expected US consumer price inflation to average 2.5% within five to ten years. This is the rate of inflation needed to equalize the returns of indexed and non-indexed US Treasury securities. And given that CPI inflation is above the rate associated with the implicit price deflator for personal consumption expenditure, I consider this 2.5% five-year forward five-year rate to be the price 2% from the US Federal Reserve. deflator inflation target.

So what would it take to bring the economy back to the Fed’s target inflation rate? Given that the five-year equilibrium rate at the May 6 close was 3.22%, the implicit expectation is that inflation will exceed the Fed’s target by 3.6 percentage points over the next five years. If this does not remove the inflation anchor from the economy, a deviation of this magnitude would be an extremely small price to pay for the rapid recovery from the pandemic-induced recession. If the recovery brings the structural economic transformation we need, the rise in inflation we have experienced will have been well worth it.

As a result, it seems to me that the Fed should take a victory lap. It did precisely what it was supposed to do, by allowing America’s economy of sticky prices, wages and debt to quickly return not just to full employment, but to the right version of full employment – one that has workers who work in sectors producing products for which there is real and fundamental demand – after a shock. And it did so without disrupting confidence in the monetary system and its stability.

So why does the very sharp Kenneth Rogoff of Harvard University claim that “things are out of control?” would think the only way to describe the situation is as a case of “control”.

Rogoff clarifies that there are “a lot of uncertainties” and that he “is not going to say that I know exactly what to do”. But his observation that inflation is “out of control” makes sense only to the extent that he is prepared to declare that the bond market and its implicit expectations are wrong. Only then could the expected move in Fed policy lead to inflation well above 3.22% over the next five years, and average inflation well above 2.5% d here five to 10 years.

Of course, that could happen. The economy is a surprising place, and our models and forecasts are ultimately just ill-informed guesses. The Fed could have to change course substantially. He may have to send the US economy into a substantial recession with significantly higher-than-expected interest rates to bring inflation back to its medium-term target of five to ten years.

For Rogoff’s own implicit forecast to come to fruition, workers and bosses would have to conclude wage negotiations that assume inflation well above 3.2% for the next five years and well above 2.5% for the next five years. . Moreover, these inflationary wage negotiations would have to be locked in by contracts and institutional arrangements that would make it difficult to revise them downwards if they were found to have overstated actual inflation. For workers and bosses to do this, they would have to be convinced enough that bond traders are irrationally Panglossian – that they are inflation doves despite evidence to the contrary.

Is there any reason to think that bond traders are irrational panglossian inflation doves? Is there any reason to think that workers and bosses now believe that bond traders are irrational doves of Panglossian inflation?

I don’t see any.

In our modern economy, a spike in inflation is a peculiar expectation-driven process. This requires a vicious circle in which high inflation expectations lead to actions that then validate those expectations – with higher wages leading to higher consumer prices which in turn lead to higher wage demands, to infinity. For that to happen, the expectation of high inflation has to come from somewhere, and right now it’s not obvious.

Yes, more negative supply shocks could occur in our future. The Covid-19 virus still has the potential to mutate and confront us with dangerous and disruptive new strains. Other disruptions could come from an expansion of Russian President Vladimir Putin’s war on Ukraine or an economically catastrophic interplay of new virus variants and China’s zero Covid policy. These types of developments could push inflation out of control.

But the fact that such risks exist does not mean that we should live as if they have already happened, and thus ignore the world as it is now.


J Bradford DeLong, former Deputy Assistant Secretary of the US Treasury, is a professor of economics at the University of California, Berkeley and a research associate at the National Bureau of Economic Research


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