How afraid should we be about inflation? Via a nice post from Ezra Klein, I see Daniel Gross has a Slate column parsing the arguments between Paul Krugman and Niall Ferguson. Krugman wrote a column last week suggesting the inflation scare was in part a Republican conspiracy, and Ferguson devoted an FT column to settling a debate he had with Krugman on a panel in New York. (Yikes.) What's the controversy? From Gross:
In a nutshell, Ferguson and his allies believe that the rising bond yields prove that markets are worried about the inflation that will inevitably result from the fiscal policies of the Obama administration and the Fed. Given the large deficits and rising concerns about the viability of Social Security and Medicare, Ferguson writes, "It is hardly surprising, then, that the bond market is quailing." [...]
Krugman and his fellow travelers couldn't disagree more. Far from being a sign of failure and impending disaster, they say, the rising bond yields actually signal success and impending improvement. Government bonds were so low last December because the world's investors were totally freaked out about risk. They sold everything--U.S. stocks, emerging market government bonds, corporate bonds in Europe, Indian stocks--and parked their cash in the safest, most liquid investment around: U.S. government bonds. In the months since then, as the stimulus and bailouts have helped stabilize the economy, investors have started to relax. [...] This line of argument makes sense, especially when you look at a very long-term chart of the 30-year bonds, which shows just how much of an aberration the December 2008 lows were.
Here is the chart Gross has in mind:
(The current yield does look less worrying in context, though a Fergusonian [?] would respond by saying it's the rate of increase and not the level that has them worried.)
But a related question is whether this is all political: Are inflation Cassandras parsing the bond-market in search of reasons to criticize Obama and the Fed? Dan Gross says yes. But since I haven't yet developed the ability to see into Niall Ferguson's brain, I'll just say zthat I've been thinking a lot about this penultimate paragraph from Gross:
Finally, the notion that the market is telling us something -- anything -- ultimately rests on the erroneous assumption that financial markets represent the collective wisdom of rational actors processing information efficiently. There are plenty of cool-minded forward-thinking investors in the markets. But there are also a lot of lunatics, fools, sharks, widows and orphans, government actors with ulterior motives, algorithmic traders, greedy speculators, and whack jobs. The markets resemble the Star Wars bar scene more than they do the economics faculty lounge at Princeton.
So here's a question for the weekend: Why should we care if the bond market is rational? Of crucial importance for predicting inflation are present inflationary expectations: If there is a widespread fear of future inflation, workers in the present should demand higher wages in their contracts, which in turn will lead to higher prices, which in turn will lead to ... inflation. (James Kwak had a good explanation of inflationary expectations a while back, and the Federal Reserve Bank of San Fransisco has a good explanation of how this is measured through the bond market here.)
But I don't think the Fed cares why anyone has these expectations. You can fill the bond market with all the goofy people in the world. If the goofy people think long-term inflation is coming, it'll affect long-term inflation. Paul Krugman says we have nothing to fear but the fear of inflation. But isn't the fear of inflation, er, worth fearing?
A final question, of course, is why we should believe the faculty lounge at Princeon doesn't resemble the Star Wars bar scene.
Photo of violence in the Princeton faculty lounge from Wikimedia.
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