Everybody knows that share prices are more volatile than observed economic fundamentals. What’s not so well appreciated, however, is that a similar thing is true of bonds and inflation.
Next week, all eyes will be on Wednesday’s US CPI numbers for any sign of a rise in inflation. Recent history, however, suggests that investors are more jumpy about this than they need to be.
A simple statistic tells us this. Since data began in 2003, the volatility of monthly changes in the five-year breakeven inflation rate (the gap between yields on Treasury bonds and their inflation-proofed counterparts) has been more than twice as high as the volatility of changes in actual five-year inflation. In particular, inflation expectations have been more cyclical than actual inflation: they plummeted in 2008 and rose in the subsequent recovery whilst actual inflation was more stable,
Excess volatility, then, isn’t confined to the stock market. We see a similar thing in bond markets.
One reason for this might be that, as Yale University’s Ulrike Malmendier has shown, our attitudes to the economy are shaped by what happened in our formative years. Those of us who grew up in the 70s and 80s think it normal for inflation to zoom up and down. That colours our attitude to inflation now.
This might be exacerbated by our economic training. The dominant theory of inflation is that it will take off once the economy reaches full capacity. Milton Friedman warned in his famous address to the American Economic Association in 1968 that any attempt to keep unemployment below its “natural” rate would lead not just to rising inflation but to accelerating inflation. That might have been a good description of the economy in the 70s and 80s. In recent years, though, what’s striking about inflation is just how stable it has been.
Even those who believe inflation will remain stable, however, cannot do much to stabilise the market’s inflation expectations. Doing so requires you to bet against the market – to bet that inflation expectations will rise when they are low and fall when they are high. This, however, is dangerous. Just as cheap shares can get even cheaper, thereby inflicting losses upon value investors, so a high inflation expectation can get even higher. Back in 2006, Insead’s Bernard Dumas pointed out that rational investors can do little about excess share price volatility. A similar thing is true of excess volatility in inflation expectations.
Although individual investors can do little about volatile inflation expectations, the Fed – in theory – could do. It could lean against changes in expectations by cutting rates a lot when they fall and raising them a lot when they rise.
Doing this, however, has a big and obvious drawback: it would generate instability in the real economy. One other thing economists and central bankers learned from Friedman’s address is the desirability of “avoiding wide swings” in policy – which is why the Fed has for a long time spoken of only “gradual increases” in interest rates.
Inflation, the real economy and interest rates are more stable than the market’s expectations of them. And this might well remain the case.
