## "EconWeekly" - 5 new articles

### Those shifty inflation expectations

Market-based measures of U.S. inflation expectations plummeted over the last quarter of 2014--which is a concern now that inflation is so low. In particular, two market-based gauges are often quoted: the break-even rate from 5- and 10-year bond yields, and rates from inflation swaps.

Janet Yellen thinks that factors other than inflation expectations may be moving these "inflation compensation" rates (emphasis mine):
There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.
[...]
Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.
Summarizing, Yellen mentions four things that, together or individually, compress "inflation compensation" (the yield charged by investors for bearing both inflation and inflation risk):

1. Oil prices
2. Exchange rate
3. Safe-haven flows
4. Dispersion of inflation expectations

As I said, there might be correlation among those four factors. I would add a fifth item, which is perhaps correlated to "safe-haven" flows: liquidity. As the market in nominal treasuries is deeper than that in TIPS, and investors have a preference for liquidity, a surge of inflows to the dollar may increase the liquidity premium that TIPS must offer, reducing the break-even inflation rate. I wrote about this a long time ago.

Recent developments offer a glaring example of how "inflation compensation" measures can be a noisy gauge of true inflation expectations. See, for instance, these charts:

Source: FRED.

Source: Capital Economics, Global Economic Update, Jan. 27.

Notice the co-movement of the short-term changes of long-term "inflation expectations" and the price of oil. I can't think of a reason why today's changes in the price of oil should affect so much the market's assessment of inflation five years from now, over the following five years. Neither break-even rates nor inflation swap rates seem, then, reliable gauges of inflation expectations.

The Federal Reserve Bank of Cleveland has published for quite some time an estimate of inflation expectations that combines surveys of forecasts with market prices to come up with a (better?) measure of inflation expectations. (The methodology paper is here.)

Below is a chart of the price of Brent, the 5y-5y expected inflation measure from break-even rates, and a 5y-5y estimate from the Cleveland Fed's time series. The Cleveland Fed doesn't give you the 5y-5y forward rate, so I computed the latter with the usual spot-forward formula:

$$(1+\pi _{0,10}^{e})^{10}=(1+\pi _{0,5}^{e})^{5} (1+\pi _{5,5}^{e})^{5},$$ where $${\pi}_{n,m}^{e}$$ is the annual rate of inflation expected $$n$$ years from now, over the next $$m$$ years. The forward inflation rate we're interested in is the second term on the right-hand side.

Up until 2008, the gap between market-based and Cleveland Fed estimates was small and transitory. Then the two diverged, especially after 2010. For a while I was suspicious: the Cleveland Fed's estimates had become more than one percentage point lower than the estimates from break-evens, and the level was persistently close to 1.5%--too low, from a(n admittedly subjective) point of view.

Of late this has changed, as the 5y-5y breakeven has plummeted, but the Cleveland Fed's estimate has not. More importantly, the Cleveland Fed's measure continues to be much less sensitive to the price of oil than the market-based estimate, which is a desirable feature for an estimate of long-term inflation expectations.

Two important questions: Did the market-based estimate of expected inflation become more sensitive to the price of oil after 2008, as the chart suggests? (Beware, the price of oil might be a proxy for something else.) Why?

### Fear depression, not deflation

Following up on a blog post by David Andolfatto, I checked on the deflationary experiences of seven countries during the 19th and 20th centuries.

The mainstream commentary these days is that deflation causes (or at least is associated with) declining real economic activity. Here's an example of this type of narrative:
Plenty of people are alarmed by the prospect of deflation, which can snuff out growth by making consumers reluctant to spend and companies unwilling to invest.
David's main point is that that's not always the case. Both the U.S. after the Civil War, and Japan since 2009, experienced declining price levels, but real GDP per capita rose.

I have put together a dataset of price indexes and growth between 1828 and 2006 for Australia, France, Netherlands, Spain, Sweden, U.S., and U.K. (Many thanks to the sources, especially measuringworth.com, and the International Institute of Social History, for distributing the data for free!)

It's relatively well known that prices were roughly steady in the 19th century, although income per capita rose quite a lot. The inflection point seems to be the Great War, but that's something I learned only after looking at the data.

See these charts and table:

This seems hard to reconcile with the conventional association between "lack of inflation" and "lack of growth."

Taking five-year growth rates, the association between inflation and real growth is hard to spot (the picture is very similar with one-year growth rates):

Finding "big" deflations

Ok, maybe you're thinking: 19th-century deflation was slow and steady. Under that type of deflation, declining prices are presumably expected, which should be less damaging than rapid, unexpected deflation.

To which I reply: But slow-and-steady is the kind of deflation that we're contemplating these days, right?

How about abrupt, big deflations? I don't know of a definition of "big" deflation, but I think most people have the American Great Depression in mind.

The U.S. price index bottomed in 1933, at which time the five-year, annualized inflation rate was -5.4%. So I have looked for deflations of this size across countries. When I find one, for a given country, I rule that a "big" deflation episode occurred, starting with the first year in which one-year inflation was negative, and ending with the first year in which prices rose (even if the five-year inflation rate was no longer below -5%). If the string of price declines is interrupted for only one year, I consider the episode of deflation was unbroken; if the string stops for two or more years (and five-year inflation eventually falls below -5%), then a new episode begins.

Using this admittedly ad hoc process, I find the following episodes of "big" deflation:

The table shows that, for example, Australian prices fell at a compounded rate of 3.6% a year between 1836 and 1851, for a total decline of 43%. Real GDP per capita went up by 5% a year.

Except for the deflations in the late 1920/early 1930s, output per capita didn't fall during deflations! It has been possible, and in fact frequent, to have rising real economic activity and falling prices, even with rapid deflation.

At the very least, I think we should agree that not all deflations are created equal. Only a small minority is associated with persistently declining real activity. And those experiences, over the last two centuries, have all happened during a peculiar period (the Great Depression).

What really hurts, then, is not deflation, but a depression, which is not what most people expect for the years ahead.

Data sources:

Real GDP per capita growth:

Inflation:

Australia: Diane Hutchinson
France: CGEDD
Netherlands: International Institute of Social History
Spain: Rafael Barquín Gil, Esmeralda Ballesteros, and Jordi Maluquer de Motes.
Sweden: Riksbank
United States: Lawrence H. Officer and Samuel H. Williamson
United Kingdom: Gregory Clark

### Is Greece's debt really so unsustainable? Yes, it is.

Lorenzo Bini Smaghi, former member of the executive board of the ECB, writes for the Financial Times that Greece's debt might be sustainable.

One of the points he makes is
...the sustainability of the debt depends on the dynamics over time rather than on the overall level. A high debt-to-GDP ratio can be more sustainable than a lower one, if the former component is expected to stabilise and fall over time, while the latter continues to grow unabated. In fact, the sustainability of the debt is inversely related with the level of interest rate paid on the debt, and positively related to the expected growth rate of the economy and the primary budget balance which has been achieved.
I can't argue with that.

He makes assumptions for the four variables that pin down the dynamics of the debt-to-GDP ratio, and concludes that Greece could reduce its debt burden by 40% of GDP by 2019.

I am shocked. If there was one thing I thought I knew about the Greek crisis, it's that Greece's debt is on an explosive path, under any realistic scenario for the relevant variables. But since a simple computation, in this case, can clarify a lot, I decided to check.

The sovereign debt-to-GDP ratio is governed by the familiar GIDDY equation:

$$D_t = (1+y-g-i) D_{t-1} + d_t$$
where $$g$$ is the growth rate of real GDP; $$i$$ is the inflation rate; $$D_t$$ is the debt ratio at time $$t$$; $$d_t$$ is the deficit, as a ratio to GDP; and $$y$$ is the average interest rate on the debt (yield).

(I'm assuming all debt is in denominated in domestic currency,  in this case euros, so I can ignore changes in the exchange rate.)

Bini Smaghi draws his debt projections out to 2019, although he's not explicit about his assumptions year by year. Suppose, he says, that Greece grows 3% a year through 2019; it runs a primary fiscal surplus of 4.1% of GDP every year (as Bini Smaghi says Greece will do in 2015); and the average interest rate on debt is 4% (Bini Smaghi assumes 4%, because "official creditors have accepted a reduction of the interest rate on their loans to levels comparable to those of the best eurozone borrowers").

It's not clear whether his growth assumption is real or nominal. However, the debt reduction is way too small if his assumption is for nominal GDP. Let's be generous, then, and suppose he's talking about real GDP, and add an inflation rate of 3% a year through 2019.

With all that in place, I get numbers close to Bini Smaghi's. The debt ratio goes down about seven points in 2015, just like he says, and we get to a level of 138.5%, not too far from his claim of 135%.

(You can plug in your own assumptions in this tool by the Financial Times and the IMF. Beware, though, that this calculator assumes the starting debt ratio, in 2014, is 164%, whereas I started with 175%.)

I checked the IMF's projections, as a benchmark, and it turns out he may have been using the IMF's projections all along! The WEO database shows a debt ratio of 174% in 2014, which goes down to 135% by 2019, just like Bini Smaghi says. The primary balance is 3.5% in 2015, and north of 4% after that. Real GDP growth never falls under 3% after 2015, and inflation gradually soars from 0.4% this year, to 1.75% in 2019.

IMF's projections (WEO Oct. 2014)
2015 2016 2017 2018 2019
Real GDP growth, % 2.9 3.7 3.5 3.3 3.6
Inflation (GDP deflator), % 0.4 1.1 1.3 1.4 1.8
Primary fiscal balance (% of GDP) 3.0 4.5 4.5 4.2 4.2
Debt (% of GDP) 171 161 152 145 135

Lo and behold, however, the heroic assumptions. Three to three-and-a-half percent real growth, year in year out, through 2019? Primary surpluses above 3% for five years in a row? Are we talking about a fiscally hyper-disciplined, pro growth economy? Or are we talking about Greece?

I'm sorry, Mr. Bini Smaghi and economists at the IMF, but these are science-fiction numbers.

Suppose instead that nominal growth (real growth + inflation) is 3%, primary surpluses average 2%, and the cost of debt stays at 4%. (Still generous projections for a country with Greece's situation and track record.) The debt ratio then declines by a modest 1.3% of GDP over five years, to 173.7%.

Bini Smaghi makes a second point in his column: Greece is unlikely to default because its debt is largely held by the EFSF and it has a long average maturity. Refinancing risk, he says, is much lower than for other eurozone countries that borrow in the market.

But he's addressing two different questions here. One is whether Greece's debt is sustainable. The most likely answer is "no," based on realistic assumptions. The other question is whether Greece will default in the short term. Not necessarily (assuming there were no elections soon). A country can be insolvent in the long term and, yet, thanks to temporary arrangements, be able to service its debt in the short term. There is no doubt that Greece's cost of debt would not be 4% today, if it weren't for the EFSF. And Greece's fiscal balance would not be a surplus of 4% if it weren't for pressure from the troika. Greece is on life support, and current conditions will not, and should not, apply in the long term.

### Dominant and contrarian visions of 2015

It's that time of the year when seemingly every economist in the private sector puts together an economic outlook for the year ahead. I'm not foolhardy enough to make predictions, or even to pretend my crystal ball is less cloudy than others'. I'm writing this post because I am bothered by the extreme prevalence of some "consensus views." For example: the narrative of divergence between the U.S. and the eurozone. Or the widely shared belief that Syriza will lead Greece out of the eurozone.

I have put together a list of (what I see as) dominant views--it's not fair to call them "consensus"--, as well as possible alternative scenarios that don't get as much attention as they should. Time will tell.

Dominant view Contrarian view Dark-horse view
U.S. dollar Fed raises rates, and the U.S. economy outperforms that of the eurozone, Japan, and emerging markets, leading to a big appreciation of the U.S. dollar relative to most currencies. Grexit and the failure of Abenomics add more fuel to the run-up of the dollar. The eurozone's economy performs better in 2015 than in 2014, the ECB delivers little or no QE, and Japan's growth and inflation turn out higher than expected. The dollar depreciates from the level of late 2014.
Monetary policy Divergence between Fed, on one side, and BoJ and ECB on the other. Tightening begins in the U.S., whereas ECB and BoJ commit to zero interest rates for the foreseeable future. Rapid disinflation lifts real interest rates. The Fed turns more dovish, and policy rates rise less than anticipated, supporting asset prices. Faster-than-expected growth, and recovering oil prices change the Fed's inflation outlook, prompting aggressive tightening.
Inflation Inflation stays low in most countries. In the U.S., core inflation remains stable, then rises, as labor market tightens. Eurozone enters deflation, briefly, before base effect of low oil prices is phased out. U.S. core inflation falls, scaring the Fed into postponing interest rate hikes. Eurozone falls into deflation, which proves to be more persistent than anticipated. "Japanization" narrative becomes mainstream. Oil price rebound puts disinflation behind, at least for now.
U.S. bonds Long-term interest rates rise, in anticipation of the Fed's tightening "in mid-2015". The yield curve flattens, due to low expectations for medium-term growth and inflation. Slow growth and ultra-low inflation push long-term yields even lower. Monetary policy tightening happens faster than expected. Growth surprises on the upside. Long-term yields rise sharply. The yield curve steepens despite Fed's tightening.
U.S. equities Gradual withdrawal of Fed support + Pick-up in economic growth = Elevated profits and valuations persist --> Positive returns, but lower than in 2014. The Fed is even more cautious than expected, and puts off interest rate hikes, perhaps due to ultra-low inflation. Investor enthusiasm turns into mania. IPOs and M&A activity bubble up. Valuations approach those of the late 1990s, raising the risk of a crash in the short term. Fundamentals of 2009-2014 bull market prove fragile. Faster-than-expected monetary tightening crushes equities.
Oil Plentiful supply and sluggish demand keep prices in $50-$80 range. Disruptions to supply in MENA push prices back up to the $90-$120 range. Recession in China pushes price under \$50 for several months.
China Soft landing, with bumps. "Lowflation" persists, pernicious deflation is avoided. Excess capacity is worked out slowly; government doesn't need to officially bail out the financial sector. Slowdown escapes Beijing's control. Sharp recession and deflation set in, but government steps in to save the day, nationalizing several financial entities. Commodities plunge, several countries in Latin America enter recession, financial crises engulf a few EMs. Volatility spikes in all the world's main financial centers. China's slowdown proves temporary. GDP growth rebounds north of 8%. Commodity prices rebound.
Japan Fresh monetary stimulus succeeds at first. Yen depreciates, Japanese firms gain market share and increase profits. Core inflation remains positive, but eventually starts falling again, prompting the gov't to provide, eventually, more stimulus. New round of monetary stimulus fails to keep inflation up. Deflation returns, spurring the gov't to provide new stimulus, soon. Domestic demand, inflation expectations, inflation grow faster, setting off a "virtuous cycle" that leaves deflation behind forever. Abe's third arrow gets implemented, raising potential growth.
India Lower commodity prices boost economy and improve fiscal position. Modi pushes through reforms, lifting potential growth and dampening core inflation. Equity bull market continues. Global environment supports Indian growth, but Modi can't push reform as quickly as expected, due to internal political obstacles. Equities lose some steam, but there is no collapse. Rupee sell-off triggered by rising U.S. interest rates, contagion from Russian crisis to other EMs, etc. Foreign exchange reserves shrink precipitously, financial crisis looms.
Russia Recession deepens. External debt crisis looms, but is narrowly avoided. Short-lived dip. Growth resumes thanks to rebound of oil price. Persistently lower oil prices push Russia into full-blown external debt crisis. Banks fail. IMF comes to the rescue.
Greece Syriza wins the Jan. 25 elections, or gets enough seats to form a coalition led by Syriza. Greece requests a debt restructuring (i.e. partial default), which the troika rejects. Grexit. Syriza wins the Jan. 25 elections, but doesn't obtain majority. They call new elections. By then (March), Greeks get scared out of leaving the euro. Syriza loses votes in the second election. A coalition of moderate parties forms, and in the nick of time Greece commits to reform in exchange for more time and money from troika. Greece stays in. Syriza gets crushed in the polls, and stays out of gov't. ND forms a coalition. Stability returns, for now.

### 2014 in review: "conventional wisdom" predictions that did happen, and fears that didn't materialize

Things that Conventional Wisdom got right about 2014:

1. The Fed tapered asset purchases and ended the quantitative easing program by October.

2. China staged a soft landing, holding growth above 7%.

3. The eurozone's recovery from the recession was slow and uneven. (Here I must say, however, that the majority was positively surprised by Spain's growth, and disappointed by Italy's and France's).

4. Commodity prices, overall, didn't rise.

5. It was a year of "sluggish growth," in the aggregate.

6. Inflation was lower than it's generally been over the past 30 years, especially in mature economies.

8. The U.S. dollar appreciated against the other major currencies.

9. Japanese inflation accelerated. (Although it's not clear whether Conventional Wisdom was factoring in the effect of the consumption tax hike. Excluding the higher tax rate, inflation was actually down.)

10. A really big iPhone arrived.

Surprises, and fears that didn't materialize:

1. There was no military confrontation between China and any of its neighbors in the South China Sea.

2. Russia annexed Crimea and almost went to war with Ukraine.

3. The Bank of Japan launched another wave of quantitative easing.

4. Oil prices fell far more than most people expected in the second half of 2014.

5. The Bank of England didn't raise interest rates, despite public utterances by governor Carney near the end of 2013.

6. None of the Fragile Five--nor, for that matter, any major emerging country'-had a financial crisis
(I exclude Venezuela and Argentina, who were already crumbling in 2013, and are not among the largest emerging markets anyway). Russia has come close, but if a crisis unravels it will be already 2015.

7. Housing bubbles didn't implode, neither in Asia nor in Latin America, Scandinavia, Canada, or Australia.

8. The U.S. unemployment rate dipped below 6%.

9. U.S. long-term interest rates (the ten-year government yield, for example) didn't rise. In fact, they fell.

10. Brazil lost "its" World Cup in the most crushing way, and Spain didn't make it past the preliminary phase.