08 October 2010

Reading The Bond Market

One of the really fundamental insights of economics is that the actions of people in markets often provide more accurate and honest assessments of their beliefs than what they say that they believe. One bit of information that is relevant to everyone who charges interest in dollar denominated amounts is the anticipated inflation rate, which affects the real return associated with every interest rate.

A clever way to infer market expectations about future inflation rates is to compare the interest rates of Treasury bonds, and inflation indexed Treasury bonds of different maturities, both of which are determined by auction in the bond market by highly trained financial professionals with lots of money at stake in their decisions.

For example, the interest rate spreads imply that bond traders think that there is a slightly greater than 25% chance that there will be deflation in the time period from April 15, 2010 to April 15, 2015.

In contrast, professional economists who do forecasts are much less likely to think that there is much of a chance of deflation.

In the recent Survey of Professional Forecasters, economists were asked to give their subjective probability of deflation during the next year. Specifically, they were asked about the chances that the quarterly consumer price index excluding food and energy (core CPI) will decline in 2011. According to the respondents, the probability of core CPI deflation in 2011 was only 2 percent.

Yes, the time periods don't match up, but the general conclusion holds true. Indeed, historically, deflation over a five year period is much less likely than deflation over a fifteen month time period in a period.

Economic theory would suggest that we are more likely to be right if we trust the bond traders rather than the professional forecasters.


Maju said...

What about Japan? As reference I mean. I was looking for historical examples of deflation and the closest you get to modern US (and generic Western) reality is Japan in the 1990s and beyond.

As in the USA today, Japanese deflationary decade happened in response to a bubble, with decreasing demand (because of population aging), with loads of toxic assets and imported cheap products from abroad (China specially). The conditions are similar.

Just wondering because I'm not familiar at all with the concept of deflation, as it has been absent from our reality for many decades, since the gold pattern was dropped.

Andrew Oh-Willeke said...
This comment has been removed by the author.
Andrew Oh-Willeke said...
This comment has been removed by the author.
Andrew Oh-Willeke said...

Japan is widely looked to as a reference, most recently by Krugman.

If you compare Japan not to the entire United States, but to a particular real estate market like that of California, the comparison is even stronger.

Of course, there are lots of ways to find differences if you want as well. Japan has then and still has very low levels of consumer debt (most Japanese don't even have the very short term credit that Americans do between writing checks and having checks paid), while U.S. consumer debt is sky high. The U.S. population is aging less rapidly than just about any other first world economy out there, in part, because it is renewing itself through immigration. Japan's boom prior to the 1990s was longer and had fewer interruptions than the runup to the U.S. driven financial crisis. Japan's society is far more egalitarian in terms of wealth distribution than that of the United States, despite the fact that the class divisions in that society are more publicly acknowledged. The percentage of people in the U.S. involved in the stock markets, at least indirectly, and the size of the U.S. equities markets, is far larger than it is in Japan. Wages in Japan are far less sticking than those in the U.S. because so much of a worker's total compensation comes in the form of an annual bonus whose amount is based on the company's profitability, meaning that Japanese companies can bend far more rather than breaking and being force to reorganize themselves. The list could go on.

There is also a great deal of academic dispute over whether it is deflation per se, even slight deflation that is the source of the problem, or whether it is simply a symptom of other things that were wrong with the economy at the times when it has been observed. The eve of the U.S. Great Depression looked a lot like the eve of the financial crisis in the U.S. in many important ways and on balance, I'm inclined to think that it is a better analogy despite being remote in time. The U.S. economy, pre-recession looked more like the U.S. economy of the late 1920s than it did like the Japanese economy of the 1980s.