I'm breaking my recent silence not just to reiterate my previous predictions but also (in one of those slightly snarky, arrogant ways) to propose a solution for those in the future who may be reading this.
First of all, consider this graph:
Regular readers (whoever you people are) will recognise this graph as being part of series of posts I have made in 2011 predicting another economic downturn in 2012. This is based upon a study of Real Ten Year Bond Rates (Bonds minus annual inflation) averaged over a three month period. The methodology I use and historical graphs can be found here. Basically the conclusion I came to was this:
Okay. So that's all that. So now let's assume you're reading from the future and the recession I predicted occurred and thus you feel somewhat interested that someone before the recession predicted it and was able to prove it in an empirical manner based upon data. Either that or you're guffawing at me for getting it wrong. However since I have little to lose and a lot to gain by making this prediction I'm obviously going to go ahead and make it.
Well then. You're from the future. You're now looking back at actions that could've prevented the recession. Had the powers-that-be the knowledge that One Salient Oversight has, what would they have done differently? In other words, what steps could've been taken to avoid the 2012 economic downturn? This is basically the reason for this post.
So in order for the downturn to be potentially avoided, there needed to be a watch placed upon negative real bond rates - in the same way as a watch is placed upon an inverted yield curve. So let's say that occurred. What would've happened?
The statistics show, as I have pointed out above, that June 2011 saw the rates go negative. From the graph above we see that in the six months leading up to that event, the following occurred:
The Euro crisis started in July 2011. A minor event during that time was also the US government debt ceiling crisis, whereby the market began to get riled by chances of a default (which nevertheless didn't affect US government bond yields).
But the stats show that it was inflation which increased, and this occurred between December 2010 and September 2011. So what was it that caused such an increase in consumer prices? Let's look at oil, courtesy of FRED:
There's no doubt that oil was involved in the inflation, however we don't see any real price hit until March 2011 and inflation began growing in December 2010.
So what was it that caused the inflation of 2011 Q1 and Q2?
It was QE2 - the second round of Quantitative Easing.
QE2 was an unconventional form of monetary policy that the Fed under Ben Bernanke introduced in December 2010. It involved creating money by fiat and using it to buy back government bonds. Its purpose was to increase liquidity and act as a loosening of money supply. It was enacted because the limits of conventional monetary policy had been reached, namely that the Federal Reserve Rate was essentially at zero and could not be lowered further.
Thus QE2 was a defacto lowering of interest rates.
There were fears from many, me partly included, that QE2 would result in uncontrollable inflation. This was certainly not the case as inflation since then hasn't been too high. Nevertheless, these were my own views at the time:
As for Quantitative Easing as a policy, I had and still have no real problems with it. In fact I wrote this article at the time in which I propose a more complete form of QE that could potentially replace the use of interest rates in future monetary policy. What I questioned then whether it was needed since prices weren't exactly unstable at the time.
In retrospect, however, it seems that QE2 actively caused the next economic crisis. I didn't know about real ten year bond rates at the time, but now that I do I can see what happened. QE2 pushed inflation up, created negative real ten year bond rates and, as a result, created the trigger for the 2012 downturn.
There's no doubt that many will blame the Eurozone crisis for the 2012 downturn. There's no doubt that it made conditions worse (it probably resulted in a flight to US bonds which, in turn, depressed yields) but the simple fact is that the Eurozone crisis began after rates turned negative. Here is proof:
These are screenshots taken today (2012-02-26) from Bloomberg, showing government bonds in Greece and Italy. The Greek bonds are here. The Italian ones are here.
What these unequivocally shows is that the Euro crisis had begun in July and continued apace as the year progressed. However real 10 year US bonds went negative in June, the month before the crisis began (and remember these are three-month averages). There's obviously going to be arguments as to which was the chicken and which was the egg, but there's no doubt that the problem began in the US before anything bad happened in Europe. In fact I wonder whether we could blame QE2 for the Eurozone crisis too? I'll refrain from that at the moment but I will say that I was never a fan of Europe's lax fiscal attitudes.
There's a number of implications to my argument that QE2 caused the (yet to happen) 2012 downturn.
The first is that price stability is obviously important and that a lid must be kept upon even benign levels of inflation, even in the face of high unemployment and low growth. Because unemployment had gone so high after the 2008 crash, and because GDP had declined so precipitously, the majority view eventually rejected "inflation hawks" like me. The Fed and luminaries like Paul Krugman argued that higher levels of inflation can be sustained because there was so much slack in the economy caused by the GFC. This may have a kernel of truth, but the fact remains that inflation ended up exceeding 10 year bond yields and triggering another downturn. The irony is that policies designed to improve the economy actually ended up making it worse.
The need for price stability even in the aftermath of a damaging recession certainly challenges prevailing views, especially about the nature of inflation. In the logic presented here, 12% bond rates alongside 11% inflation are to be preferred over 2% bond rates alongside 3% inflation. While my own views on inflation are unique and unlikely to be taken seriously by policy makers for some time, what this current situation does show is the need to read more into inflation than merely consumer prices - namely that market investment decisions may be such that even "acceptable" levels of inflation (eg the 4% touted by the Fed and Krugman) may be too high if the market is ploughing too much of its funds into government bonds. Any policy that would've maintained positive real interest rates either on the inflation side (ie not initiating QE2) or on the investment side (eg substantially increasing bond issues to push rates higher) would've been better than what actually transpired.
A second implication involves the behaviour of the Fed. This is not the first time real bond rates have turned negative. the last time it happened was prior to the GFC. It looks like we've been fooled twice by the Fed on this one:
There we have it. The green line tells the story. August 2007 seems to be the key here: despite being faced with an increase in inflation (the blue line), the Fed refuses to increase the Funds rate. Inflation increases, the bond rate falls and suddenly we have negative real bond rates. A recession then hits in late 2008. The same conditions beset the US during the 1970s, though during that period inflation was far higher - as were bond rates. Twice in a row inflation exceeded bond rates and twice these conditions were followed by recessions. This behaviour was stopped, of course, by Paul Volcker and his inflation busting recession of the early 1980s and created the conditions for what is now disparagingly called "the great moderation". Certainly the recessions of the early 90s and early 2000s weren't prevented by positive real interest rates, which indicates that there are more to recessions than simply this particular trigger. Nevertheless it cannot be written off as mere chance that recessions follow negative real bond rates as clearly and as predictably as the negative yield curve.
So will we be fooled again by the Fed even after the 2012 downturn? Only if the new boss is the same as the old boss I suppose.
(By the way, the governor at the Fed in 2007 who made this decision is the same governor now who made the decision again)
As far as unemployment is concerned, I'm not changing my original prediction:
I'll just finish by predicting that this downturn is likely to also change our understanding of the inverted yield curve. With the Federal Funds rate at zero there is no way that the yield curve can invert. (Of course we might be tempted to think that recessions have been solved and that we'll all experience a golden age because zero rates prevent an inverted curve, but recessions are unlikely to worry about things like this). Obviously the only thing that will change the Fed's ZIRP would be an outbreak of uncontrollable inflation. While this is still a possibility my belief is that the yield curve will end up simply becoming a straight horizontal line: Government bond rates will approach zero. This implies a huge flight into government securities, which in turn implies a market correction rivaling and maybe even exceeding that experienced in late 2008. Perhaps the 2012 downturn will be a mixture of both credit crisis and inflation.
Now the reason why I'm talking about the yield curve here is that if there is a recession then the yield curve will invert (ie turn into a horizontal line), and we know there will be a recession because real bond rates are negative, so the yield curve will become horizontal. And that's why I'm going to get my superannuation funds and other savings placed into as conservative a position as possible.
I'll just end with this graph for a laugh:
First of all, consider this graph:
Regular readers (whoever you people are) will recognise this graph as being part of series of posts I have made in 2011 predicting another economic downturn in 2012. This is based upon a study of Real Ten Year Bond Rates (Bonds minus annual inflation) averaged over a three month period. The methodology I use and historical graphs can be found here. Basically the conclusion I came to was this:
While recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession.This conclusion is based upon the fact that every instance of negative real interest rates (which I define here as negative real 10 year bond rates) there is an eventual recession. This occurred in the following periods:
- In March 1957, rates went negative. A recession followed in October 1957. (Rates also went negative during the recession)
- In October 1973, rates went negative. A recession followed in January 1974.
- In November 1978, rates went negative. A recession followed in April 1980.
- In January 2008, rates went negative. A recession followed in April 2008.
- In June 2011, rates went negative. I'm therefore predicting a recession to occur in 2012.
Okay. So that's all that. So now let's assume you're reading from the future and the recession I predicted occurred and thus you feel somewhat interested that someone before the recession predicted it and was able to prove it in an empirical manner based upon data. Either that or you're guffawing at me for getting it wrong. However since I have little to lose and a lot to gain by making this prediction I'm obviously going to go ahead and make it.
Well then. You're from the future. You're now looking back at actions that could've prevented the recession. Had the powers-that-be the knowledge that One Salient Oversight has, what would they have done differently? In other words, what steps could've been taken to avoid the 2012 economic downturn? This is basically the reason for this post.
So in order for the downturn to be potentially avoided, there needed to be a watch placed upon negative real bond rates - in the same way as a watch is placed upon an inverted yield curve. So let's say that occurred. What would've happened?
The statistics show, as I have pointed out above, that June 2011 saw the rates go negative. From the graph above we see that in the six months leading up to that event, the following occurred:
- 10 Year Bond Rates hovered around 3.4%, with a high of 3.58% in February 2011 and a low of 3.17% May 2011.
- Annual inflation in that period averaged 2.4%, with annual rates increasing steadily each month from 1.1% in November 2010 to 3.1% in May 2011
The Euro crisis started in July 2011. A minor event during that time was also the US government debt ceiling crisis, whereby the market began to get riled by chances of a default (which nevertheless didn't affect US government bond yields).
But the stats show that it was inflation which increased, and this occurred between December 2010 and September 2011. So what was it that caused such an increase in consumer prices? Let's look at oil, courtesy of FRED:
There's no doubt that oil was involved in the inflation, however we don't see any real price hit until March 2011 and inflation began growing in December 2010.
So what was it that caused the inflation of 2011 Q1 and Q2?
It was QE2 - the second round of Quantitative Easing.
QE2 was an unconventional form of monetary policy that the Fed under Ben Bernanke introduced in December 2010. It involved creating money by fiat and using it to buy back government bonds. Its purpose was to increase liquidity and act as a loosening of money supply. It was enacted because the limits of conventional monetary policy had been reached, namely that the Federal Reserve Rate was essentially at zero and could not be lowered further.
Thus QE2 was a defacto lowering of interest rates.
There were fears from many, me partly included, that QE2 would result in uncontrollable inflation. This was certainly not the case as inflation since then hasn't been too high. Nevertheless, these were my own views at the time:
(All) this goes back to whether the money supply should be increased. While US inflation is low (currently 1.14%, year on year) deflation is hardly a problem just yet. Deflation hit the US economy very hard in late 2008 when the credit crisis hit, but since then prices have stabilised somewhat. Paul Krugman and others would argue that the US should actually target 4% inflation as a goal rather than as a limit, in which case Bernanke's policy is heading in the right direction. Interest rates have certainly bottomed out, but where is the deflation that can't be influenced by conventional monetary policy?To be fair, at that time I was not seeing QE2 and the resulting inflation as a way of creating another recession. That was because my study of real ten year bond rates and their historical relationships to recessions had not yet been realised. I did point out that the Fed's dual mandate was problematic (I believed then, and still do now, that central banks should focus solely upon price stability, while governments should focus upon policies to encourage economic growth. This is an increasingly unfashionable belief in this day and age, though).
And this therefore calls to question the reason for quantitative easing. Is Bernanke aiming to stimulate the US economy or is he simply trying to maintain price stability? If it were the latter, then Bernanke is crazy since the US doesn't have a problem with price stability at the moment (unless you adhere to absolute price stability like I do, of course, but that's another topic!), which means that QE2, as an inflationary policy, is being implemented when prices are not in danger of deflating. This can only mean that Bernanke is aiming to stimulate the US economy, and this is problematic.
As for Quantitative Easing as a policy, I had and still have no real problems with it. In fact I wrote this article at the time in which I propose a more complete form of QE that could potentially replace the use of interest rates in future monetary policy. What I questioned then whether it was needed since prices weren't exactly unstable at the time.
In retrospect, however, it seems that QE2 actively caused the next economic crisis. I didn't know about real ten year bond rates at the time, but now that I do I can see what happened. QE2 pushed inflation up, created negative real ten year bond rates and, as a result, created the trigger for the 2012 downturn.
There's no doubt that many will blame the Eurozone crisis for the 2012 downturn. There's no doubt that it made conditions worse (it probably resulted in a flight to US bonds which, in turn, depressed yields) but the simple fact is that the Eurozone crisis began after rates turned negative. Here is proof:
These are screenshots taken today (2012-02-26) from Bloomberg, showing government bonds in Greece and Italy. The Greek bonds are here. The Italian ones are here.
What these unequivocally shows is that the Euro crisis had begun in July and continued apace as the year progressed. However real 10 year US bonds went negative in June, the month before the crisis began (and remember these are three-month averages). There's obviously going to be arguments as to which was the chicken and which was the egg, but there's no doubt that the problem began in the US before anything bad happened in Europe. In fact I wonder whether we could blame QE2 for the Eurozone crisis too? I'll refrain from that at the moment but I will say that I was never a fan of Europe's lax fiscal attitudes.
There's a number of implications to my argument that QE2 caused the (yet to happen) 2012 downturn.
The first is that price stability is obviously important and that a lid must be kept upon even benign levels of inflation, even in the face of high unemployment and low growth. Because unemployment had gone so high after the 2008 crash, and because GDP had declined so precipitously, the majority view eventually rejected "inflation hawks" like me. The Fed and luminaries like Paul Krugman argued that higher levels of inflation can be sustained because there was so much slack in the economy caused by the GFC. This may have a kernel of truth, but the fact remains that inflation ended up exceeding 10 year bond yields and triggering another downturn. The irony is that policies designed to improve the economy actually ended up making it worse.
The need for price stability even in the aftermath of a damaging recession certainly challenges prevailing views, especially about the nature of inflation. In the logic presented here, 12% bond rates alongside 11% inflation are to be preferred over 2% bond rates alongside 3% inflation. While my own views on inflation are unique and unlikely to be taken seriously by policy makers for some time, what this current situation does show is the need to read more into inflation than merely consumer prices - namely that market investment decisions may be such that even "acceptable" levels of inflation (eg the 4% touted by the Fed and Krugman) may be too high if the market is ploughing too much of its funds into government bonds. Any policy that would've maintained positive real interest rates either on the inflation side (ie not initiating QE2) or on the investment side (eg substantially increasing bond issues to push rates higher) would've been better than what actually transpired.
A second implication involves the behaviour of the Fed. This is not the first time real bond rates have turned negative. the last time it happened was prior to the GFC. It looks like we've been fooled twice by the Fed on this one:
There we have it. The green line tells the story. August 2007 seems to be the key here: despite being faced with an increase in inflation (the blue line), the Fed refuses to increase the Funds rate. Inflation increases, the bond rate falls and suddenly we have negative real bond rates. A recession then hits in late 2008. The same conditions beset the US during the 1970s, though during that period inflation was far higher - as were bond rates. Twice in a row inflation exceeded bond rates and twice these conditions were followed by recessions. This behaviour was stopped, of course, by Paul Volcker and his inflation busting recession of the early 1980s and created the conditions for what is now disparagingly called "the great moderation". Certainly the recessions of the early 90s and early 2000s weren't prevented by positive real interest rates, which indicates that there are more to recessions than simply this particular trigger. Nevertheless it cannot be written off as mere chance that recessions follow negative real bond rates as clearly and as predictably as the negative yield curve.
So will we be fooled again by the Fed even after the 2012 downturn? Only if the new boss is the same as the old boss I suppose.
(By the way, the governor at the Fed in 2007 who made this decision is the same governor now who made the decision again)
As far as unemployment is concerned, I'm not changing my original prediction:
Unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.You can imagine what this will do to US government debt.
I'll just finish by predicting that this downturn is likely to also change our understanding of the inverted yield curve. With the Federal Funds rate at zero there is no way that the yield curve can invert. (Of course we might be tempted to think that recessions have been solved and that we'll all experience a golden age because zero rates prevent an inverted curve, but recessions are unlikely to worry about things like this). Obviously the only thing that will change the Fed's ZIRP would be an outbreak of uncontrollable inflation. While this is still a possibility my belief is that the yield curve will end up simply becoming a straight horizontal line: Government bond rates will approach zero. This implies a huge flight into government securities, which in turn implies a market correction rivaling and maybe even exceeding that experienced in late 2008. Perhaps the 2012 downturn will be a mixture of both credit crisis and inflation.
Now the reason why I'm talking about the yield curve here is that if there is a recession then the yield curve will invert (ie turn into a horizontal line), and we know there will be a recession because real bond rates are negative, so the yield curve will become horizontal. And that's why I'm going to get my superannuation funds and other savings placed into as conservative a position as possible.
I'll just end with this graph for a laugh:
5 comments:
A word about inflation and deflation: should they be viewed as analog or digital quantities? Will our understanding of them differ between one and the other?
So, if the price of apples, say, is viewed as as analog quantity, you would check the flyers and see the drop from $1 a pound to 87 cents a pound -- deflation as I normally think of it.
But suppose the label price stays at $1 (because there's only so cheap you can grow apples) but the number of apples sold decreases? Digitally, the apple market has deflated. In a field of ones and zeros, the ones are still entire, but there are fewer of them.
In a large market like the US you could, I think, get quite a lot of digital deflation without it being obvious.
Of course the same goes for INflation: the prices stay the same but the little yellow market basket gets smaller.
Now, back to reading your post in detail. It's 5:45 am here, so I need to take another run at it.
Noni
There's no doubt that inflation has lots of causes. My own study of inflation and comparing it to increases in the money supply show occasional times of connection (ie an increase in one leads to an increase in another) but many other times when it doesn't connect.
I'm still trying to understand your digital/analog comparison, but prices have a lot to do with supply issues as well. Prices for individual goods and services increase or decrease depending upon supply and demand issues. Thus it is entirely possible to have increased demand and increased supply with low inflation, while decreasing demand and decreasing supply can be accompanied by higher inflation.
I think the rules we put into place regarding things like inflation should actually be more like guidelines... there is a relationship most of the time, but at other times there are other factors involved.
This is actually why I included the graph on oil prices, just so I could involve it in my argument and say "yeah it may have some impact, but the real deal was QE2".
I would be much more interested in that last graph if it was a graph of the price of gas compared to average US wages.
I would be much more interested in that last graph if it was a graph of the price of gas compared to average US wages.
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