A frequent counterargument to the notion that current Federal Reserve policy is inflationary centers on two market indicators: TIPS spreads and the yield on long-term Treasuries. Neither suggests that inflation is a problem. But it is also true that the yield on the former (TIPS, or Treasury Inflation-Protected Securities) moves in concert with a lagging government inflation indicator (the consumer price index), while the latter has, with good reason, always been slow to price in inflationary pressures.
To gauge this pressure, a logical place to look is long-maturity Treasuries. Since these pay out in dollars, it makes sense that their yields would rise if the dollar were losing value. What is omitted here is the fact that yields on Treasuries factor in past, present, and future assumptions about what the Federal Reserve will do.
While the dollar’s fall against gold accelerated in the aftermath of Bretton Woods in August 1971, long-term Treasury yields remained mostly stable through all of 1972. Price controls are said to have been a factor then, but most important were market expectations that a return to fixed exchange rates was imminent.
The dollar/gold price hit a high of $850 in February 1980, yet despite the fact that this price was soon cut in half, markets were slow to attach lower yields to Treasuries throughout the 1980s and ’90s. Memories of the inflationary mistakes made in the 1970s were arguably too fresh.
Moving to today, while gold is up 135 percent in dollars since 2001, there hasn’t been a significant jump in long-term yields commensurate with the dollar’s fall. Investors today are arguably pricing in deflationary Fed policy from not long ago (1997-2001), not to mention the likelihood that the Fed’s memory is sensitive enough such that no 1970’s redux will be countenanced. In the book he co-authored with Robert Keleher, Monetary Policy, A Market Price Approach, former Fed vice-chairman Manuel Johnson noted that dollar weakness can at times play into bond strength if the currency weakness is thought to be ephemeral.
Also, Treasuries in particular are thought to be safe havens in times of uncertainty, and with fear of terror strikes acting as an ever-present market risk, yields are presumably lower as a result.
Regarding TIPS, these offer a variable interest rate tied to the CPI, with the coupon rising if the CPI does. While TIPS are traded in open markets, the rate offered is based on a flawed government measure of prices. TIPS price in market reaction to the federal government’s manipulation of what it deems inflation.
The CPI measure of inflation presents many problems, not least the measure of “rent” on living space in times of inflation. Real estate itself has traditionally rallied amidst falling currencies, something Ludwig von Mises referred to as a “flight to the real.” Conversely, rents are said to fall amidst property rallies; meaning a major CPI input puts downward pressure on the government’s measure of inflation, often when inflation is most prevalent.
It’s also true that prices are “sticky.” Whereas commodity prices adjust daily to changes in the dollar’s value, regular goods prices are often tied to long-term leases and contracts that create the illusion of stability. The happy reality that citizens of nations such as China and India are joining the worldwide labor pool and expanding the range of products available at lower prices would also put downward pressure on prices tracked by the federal government. Furthermore, with the variety and quality of software, cars, and shoes continuously evolving, do measures like the CPI tell us much at all?
Not really. Prices are supposed to change regularly, as consumers and businesses “vote” on what is and is not useful and valuable to them. As Nathan Lewis wrote in Hard Money, price changes organize “the market economy,” and as such, the goal of stable prices is a “nonsensical goal.” TIPS incorporate changes in what Lewis refers to as a “statistical abstraction,” one that greatly lags real indicators of a currency’s true value. For the Fed to target the CPI is for it to distort the very price signals necessary for the smooth functioning of the economy.
When it comes to keeping inflation and deflation at bay, the goal should be to maintain currency, rather than price, stability. Commodities tell us with great immediacy about changes in the value of currencies. They’re also the most reliable indicator of existing inflationary pressures. Indeed, according to Johnson and Keleher, a 1987 study by the Federal Reserve Board found that a commodity index predicted all but 1 of 29 inflationary turning points over a sixty-seven year period.
Though the dollar has rallied alongside stocks since the Fed’s pause on August 8, commodities from copper to oil to gold are presently well past their ten-year averages. Naysayers about inflation often point to strong “real” GDP growth and retail sales to say we’re not inflating, but it should be noted that “real” GDP and retail sales were very strong in the inflationary 1970s; the weak dollar driving up the former and the latter as dollar holders chose to spend money that was losing value.
– John Tamny is writer in Washington, D.C. He can be reached at jtamny@yahoo.com.