Fear not, Brave Sentinels of Reflation

My friend and sparring partner, David Glasner, over at Uneasy Money is sounding the alarum regarding the recent correction in 1 year implied breakeven rates, which have recently turned negative.  He views this as reflecting what he sees as the Fed’s abdication of responsibility, and a sign that Bernanke is leading us to disaster.

Might I point out first of all that the one year sector of the TIP curve from which this rate is calculated is hardly the most liquid or heavily traded (since most investors, when they think about protection from inflation, are looking to the distant future, rather than to a horizon that can be more easily forecasted).  We have only two bonds of this maturity – the 0.625 TIIs of April 2013, and the 1.875s of 7/13; and in general one should note that the yields on particular securities are always subject to distortion by questions of idiosyncratic supply and demand, such that only two securities of approximately this maturity will not give us a good picture of the general state of expectations.

This being noted, the key point is that 1 year inflation expectations and implied breakeven rates are heavily influenced by commodity prices given their innate volatility, and not just their direct impact on the CPI (via gasoline, and food), but also their indirect influence via influencing producer costs in ways that may ultimately be reflected in the CPI.

If, as I understand he thinks, it was wrong for central banks to panic over the influence of commodity prices on the CPI as crude went ballistic into the summer of 2008, then it is wrong to panic now about the mechanical impact of falling energy prices on CPI over the next year.

What we have is to a large extent good deflation resulting from a calming of turmoil in the Middle East, the diminishing prospect of an Israeli strike on Iran, a switch from crude oil to highly abundant domestically-produced natural gas and the still-neglected prospect of a massive increase in supply of crude oil from shale oil – in the US, and elsewhere.  Serious people are now openly discussing the possibility of North America (ie including Canada) becoming self-sufficient in energy production, something that should certainly change the geopolitical map, in ultimately a positive direction.

We have also a shift in the commodity intensity of growth in China – there are only so many empty cities you can build, as well as a slowdown.  This may well presage some adversity ahead for commodity producers (I wrote a year ago about the likely challenges that Latin America would face as commodity prices sold off), but for commodity consumers, the commonsensical view is correct, rather than that of the sophisters and economists – in other words cheaper gasoline is a good thing, and will continue to boost real consumer incomes and confidence.

Here is a chart showing 1 year breakevens and crude prices on the same chart:

 

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Now, correlation is not causation.  One could make the argument that some great deflationary wave is causing both a collapse in commodity prices, and a collapse in breakevens, and will ultimately lead to the kind of growth-deflationary horror that he implicitly thinks starts to become likely.   But if making this argument one would need to address competing explanations, such as the points I make above.  One would also need to bet one’s credibility to back this view.  If it turns out that in the US there is no such collapse in growth, then one must be prepared publicly to admit that one was wrong, and that one must therefore revisit one’s framework.

Speaking of track record, I did write on 31st March – as crude prices and breakeven inflation expectations were close to their highs that I expected just these events to happen:

http://cantillonblog.com/?p=905

“I am not in the very near term concerned about breakeven expectations and headline inflation becoming unhinged since I expect crude and related energy prices to come down sharply, pushing down headline inflation.  Although this will impact shorter-dated breakevens most heavily, it will tend to weigh on the back end of the curve too”.

So far I have been proven right.  I wonder if I will be right about my conclusion in that piece:

“Longer-term though I rather think that the inflation hawks will turn out to be right.  I shall make a note in my diary for April 2015 and we shall see whether Dr Krugman’s dismissal of inflationary concerns turns out as well as his cheering-on of the inflation of a bubble in housing.”

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