Wednesday, September 21, 2011

When bad men combine, the good must associate

It seems as though good men today are silent, weak and divided, while evil men are full of sound and fury. Rick Perry is the only important politician today who understands macroeconomics. Before you laugh, hear me out:

1) Governor Perry believes that the Fed can create as much inflation as it wants to, whether or not we are at the "zero bound"
2) Governor Perry believes that this inflation will have real consequences
3) Governor Perry believes that the real consequences of increasing inflation will be to increase output and employment

The only difference between us is that I think these (particularly the last) are good things. Governor Perry is trying to unseat an incumbent president and doesn't give a damn about the public good, therefore he has warned/threatened the Fed to leave things as they are and to continue strangling the economy with tight money.

Meanwhile, Mitt Romney and the Democrats are bumbling idiots who think money is easy because interest rates are low. I may be wrong about Romney; he may simply be holding his tongue for fear of angering the Republican mob. There is no explanation for the silence of Democrats on monetary policy other than pure, unfettered stupidity however. They are 12 months away from losing the presidency due to poor economic performance, and anybody with eyes can see what the problem is. First up, the all-too-familiar TIPS spread timeseries along with the SPX (edit: please see note at the end of the post for data sources):

Okay,  straightforward enough. The general story is clear: when monetary policy is functioning well, equities (as a proxy for expected future NGDP) aren't particularly sensitive to expected inflation. "Something bad happened" in late 2008, and expected inflation and NGDP dropped off a cliff. Since then, the Fed has run a tight money policy, constraining NGDP expectations, and turning equities markets into the correlation one monsters we see today. But anybody paying attention has already figured out this much, and as a quant I want more detail. 

If you want to see how bad things have gotten, you can use the beta of equities vs TIPS spreads. Loosely speaking, this beta is the amount the SPX is expected to increase for a 1% increase in TIPS spreads. If beta equals 10, then the Fed can increase equities prices by 10% by driving up the TIPS spread by 1%. Technically, I am computing the moving ratio of 6 month covariance(TIPS spread, SPX) to 6 month variance(TIPS spread) on a 1 week sampling frequency. 

Now, a well-functioning monetary policy shouldn't have a beta below 0 or above 5 against 5yr TIPS spreads (depending on your discounting any of the numbers in that range are "ideal", meaning that real variables will be independent of inflation expectations). Well, let's see what's actually happening:

Good God! The data's a bit noisy, but according to my read of this, the Fed is massively constraining real activity through its insane tight money policy. A 1% increase in inflation for 5 years (total increase in expected price level of 5%) is expected to lead to ~20% higher nominal output (integrated over time). That means that we get at least 3% real growth for 1% inflation. I want Obama to lose come Nov 2012 as much as anybody working on Wall Street because I think he's mucked around on the AS side of the equation enough to do real damage, but I'm not willing to cut off my nose to spite my face with more unnecessary AD-induced doldrums.

Note on data sources: for 5 year tips spread I used the data on For the SPX closes I used^GSPC+Historical+Prices. The TIPS spread overstates expected inflation, and does so more when inflation expectations are close to 0 because of the embedded optionality inside TIPS. However, I know of no publicly available data which would correct this bias (either by providing implied vol of inflation or by directly giving prices of delta one instruments like inflation swaps).