the inflation monster

From a recent Economist article (02/07/2009) that depicts the increasing volatility in long-term inflation expectations:

As volatility has subsided in equities, it has popped up elsewhere. Interest-rate swaps allow investors and borrowers to switch from a fixed rate to a floating, or variable, rate and vice versa. You can buy an option to take part in a swap, a contract dubbed a “swaption”. The implied volatility of these contracts has shot up in recent months, indicating that investors are uncertain about long-term interest rates. With good reason: ten-year Treasury bond yields have veered between just over 2% and almost 4% since December. Although many countries are experiencing mild deflation, investors fret. David Woo of Barclays Capital says investors worry about the inflationary impact of fiscal deficits and quantitative easing. “Every European client asks in each meeting about inflation,” says Jan Loeys of JPMorgan. They are clearly acting to protect themselves.

Here we have the funny situation of clients protecting themselves against themselves.

Inflation can occur due to a variety of reasons. As the circulation speed and volume of money increases without a corresponding increase in the production of goods, prices of goods will naturally up. In other words, money will become less valuable. This is the classical explanation of inflation. The post-modern explanations are less intuitive. Nevertheless the underlying psychological mechanism behind them is pretty straight forward: Fear is contagious and collective worry can turn into a self-fulfilling prophecy. In other words, inflation expectations are as important as the inflation itself. For example, if each "European client" sells fixed-rate government bonds and takes measures to protect itself against a possible severe inflation, then the market indicators will adjust accordingly. These expectations may in turn spread into the non-financial markets as investment funds flock into commodity futures in the hope of hedging themselves against inflation. Once the oil prices take off, the inflation monster will be unleashed. (Note that there are numerous pathways through which expectations can influence the outcome. This example represents only one of them.)

Question 1: Why would spot oil prices increase when investment funds flock into the oil futures markets? Is the oil price not determined by the physical supply and demand conditions?

Oil futures are used by investors for a variety of purposes. They are usually conceived as a good hedge against inflation and against fluctuations in the value of US dollar. They are also bought by managers who would like to diversify their portfolios by adding in an exposure to commodities.

The resulting demand is not related to physical oil demand at all. Instead of correcting the order-flow-driven price hikes in the futures markets, the physical traders may simply succumb to the expectations indicated by these hikes.

There can not be any arbitrage opportunities between the spot and future prices.(Otherwise the law of one price is broken.) This is essentially the only constraint on the evolution of the two prices. Which price drives the other is not pre-determined. For example, spot market may instantenously absorb all indications given by the futures market. In that case, spot prices will move along with the future prices towards an arbitrage-free equilibrium without any occurrence of physical arbitrage. The alignment can also happen in a more balanced fashion. For example, the movement in the futures market may be transmitted to the spot market via physical arbitrages. In that case, spot and future prices will both move towards each other.

Last year's commodity bubble was probably fuelled by alignments of the first kind. On the other hand, it is pretty certain that last week's $3 surge in Brent Oil future prices was entirely due to the long positions taken by a single rogue trader. (I wonder how spot prices would have responded if the rogue transactions had gone unnoticed in the midst of a large inflow of momentum trades and the rogue trader had never been caught.)

Question 2: If the nature of inflation is so twisted, why do central banks bother with inflation targeting policies? How can they ever make credible commitments to maintain price stability if the monetary policy tools at their disposal are only partly capable of taming the inflation monster?

The magic word here is "credible".

Military commanders galvanize their soldiers and win wars that they would otherwise not be able to win. Religious leaders make their followers believe in things that are not empirically verifiable. Hypnotists can literally paralyse the limbs of their subjects. This mysterious art of influence is hard to master. However, once mastered, it can be very very powerful.

Ben Bernanke explains why central banks need to make use of this art for the successful execution of monetary policies:

In the 1960s, many economists were greatly interested in adapting sophisticated mathematical techniques developed by engineers for controlling missiles and rockets to the problem of controlling the economy. At the time, this adaptation of so-called stochastic optimal control methods to economic policymaking seemed natural; for like a ballistic missile, an economy may be viewed as a complicated dynamic system that must be kept on course, despite continuous buffeting by unpredictable forces.

Unfortunately, macroeconomic policy turned out not to be rocket science! The problem lay in a crucial difference between a missile and an economy--which is that, unlike the people who make up an economy, the components of a missile do not try to understand and anticipate the forces being applied to them. Hence, although a given propulsive force always has the same, predictable effect on a ballistic missile, a given policy action--say, a 25-basis-point cut in the federal funds rate--can have very different effects on the economy, depending (for example) on what the private sector infers from that action about likely future policy actions, about the information that may have induced the policymaker to act, about the policymaker's objectives in taking the action, and so on. Thus, taking the "right" policy action--in this case, changing the federal funds rate by the right amount at the right time--is a necessary but not sufficient condition for getting the desired economic response. Most inflation-targeting central banks have found that effective communication policies are a useful way, in effect, to make the private sector a partner in the policymaking process. To the extent that it can explain its general approach, clarify its plans and objectives, and provide its assessment of the likely evolution of the economy, the central bank should be able to reduce uncertainty, focus and stabilize private-sector expectations, and--with intelligence, luck, and persistence--develop public support for its approach to policymaking.

Of course, as has often been pointed out, actions speak louder than words; and declarations by the central bank will have modest and diminishing value if they are not clear, coherent, and--most important--credible, in the sense of being consistently backed up by action. But agreeing that words must be consistently backed by actions is not the same as saying that words have no value. In the extreme, I suppose a central bank could run a "Marcel Marceau" monetary policy, allowing its actions to convey all its intended meaning. But common sense suggests that the best option is to combine actions with words--to take clear, purposeful, and appropriately timed policy actions that are supported by coherent explanation and helpful guidance about the future.

The central bank will try to impress the crowd by occasionally whipping the inflation monster. The hope is that everyone will be convinced that the bank can control the monster even in case things get really out of hand. And the irony, of course, is that the crowd has greater power over this monster than the bank does.

The monster partly dwells in the mind of the crowd and its lifeblood is the aggregate fear. The central bank puts on a show that is sort of like fireworks. People forget their miserable conditions when they see colourful sparkles lightening up the sky. Similarly, people forget their own fears, when they see a villain suffering. Here the villain is the whipped monster and the illusion is that the monster is not audience.

Finally I would like to quote Emanuel Derman's blog post titled "Do Keynesians Laugh When They Tickle Themselves?" (12/02/2009). It is a variation on the same theme that is touched upon by Bernanke. It is also the most original comment I have read on the "stimulation debate":

When the government throws money at the populace, and keeps describing it as a Hail Mary pass they regret they have to make, it must vitiate the effect of the stimulus itself. The first time Keynesianism was used, it was a surprise move to a nation that wasn't an expert on economic theory; the second time around, everyone knows what is supposed to happen, and that can't be good. In human affairs, history matters. Penicillin works even if they tell you they're going to give it to you, maybe even better. But people's minds are different from people's bodies. Is a stimulus so stimulating when they keep telling you they are going to stimulate you? Can you get excited when everyone around you is watching to see how excited you get?

P.S. Targeting price stability is not equivalent to popping asset and commodity bubbles as they arise. Firstly, central banks are often incapable of distinguishing bubbles from price movements that are driven by fundamentals. Secondly, bubbles may be occurring outside the set of goods that are included in the formula which is used for price level calculation.