Theory #1: Break-Even Rates Provide “Deflation Warning”

Bloomberg is sounding a Deflation Warning as 2-Year Break-Even Rates Go Negative.

Break-even rates are the difference between treasuries and the same-duration Treasury Inflation-Protected Securities (TIPS). The break-even rate turned negative yesterday for the first time since 2009.

In theory, break-even rates reflect investors’ expectations for inflation over the life of the securities.

When break-even rates are negative, it’s an indication investors expect price deflation for the duration, in this case for two years.

From Bloomberg …

The drop in the break-even rate followed a Labor Department report yesterday that showed consumer prices dropped 0.3 percent in November, the most in almost six years, on tumbling energy prices. Principal and interest payments on Treasury Inflation Protected Securities are indexed to changes in the consumer price index, so a lower than forecast CPI diminishes the value of projected future payments from TIPS.

The break-even rate dropped to negative 0.035 percent yesterday. The difference was 0.024 percent today.

The negative break-even rate represents “an uncertainty premium that maybe oil could fall to $40 a barrel,” said Donald Ellenberger, who oversees about $10 billion as head of multi-sector strategies at Federated Investors in Pittsburgh. “The shortest-term TIPS are very influenced by the direction of the consumer price index. It’s telling you inflation on the short-end could turn negative.”

Fed Chair Janet Yellen downplayed the notion at the press conference after the conclusion of yesterday’s two-day policy meeting. Falling break-even rates may represent a decline in the inflation premium risk or the range of inflation outcomes investors are taking into consideration, she said. One of the justifications for the Fed to raise rates for the first time since 2006 is to keep consumer price increases from getting out of control.

Out of Control Consumer Prices?

Color me extremely skeptical regarding out of control consumer prices. In fact, I side with this headline: Krugman, Fighting Consensus, Says 2015 Fed Rate Increase Is Unlikely.

Paul Krugman, challenging the consensus of economists and the Federal Reserve’s forecasts, said policy makers are unlikely to raise interest rates in 2015 as they struggle to spur inflation amid sluggish global economic growth.

“When push comes to shove they’re going to look and say: ‘It’s a pretty weak world economy out there, we don’t see any inflation, and the risk if we raise rates and it turns out we were mistaken is just so huge’,” the 2008 Nobel laureate said in Dubai. “It’s certainly a real possibility that they’ll go ahead and do it, but probably not, and for what it’s worth I and others are trying to bully them into not doing it.”

Agreement With Krugman

Aside from that last sentence, I am in general agreement with Krugman.

Please read carefully. Although I endorse Krugman’s belief about how the Fed will react, I do not endorse the policy itself.

Krugman precisely summed up how economic illiterates at the Fed think (and that is how Krugman, thinks as well).

No bullying by Krugman is needed. The Fed already thinks like he does.

Jean-Claude Yellen

Please consider Krugman’s December 10th column Jean-Claude Yellen.

In his post, Krugman says Jean-Claude Trichet’s decision to raise rates in Europe in 2011 “a big mistake“, just as the Swedish Riksbank’s early rate hike was a “mistake“, just as Japan’s rate hike in 2000 was a “mistake“.

The notion that a quarter-point hike caused Europe’s problem is absurd. Moreover, I propose Krugman understands just that.

Keynesian or Austrian theory aside, the notion that one interest rate can serve the likes of widely differing fiscal policies in Germany, France, Spain, Ireland, Grecee, etc. is preposterous. Krugman has to know that!

If I am wrong, and Krugman cares to disagree, then I welcome the rationale.

Krugman continues …

Suppose, on the other hand, that the Fed raises rates, and it turns out that it should have waited. This could all too easily prove disastrous. The economy could slide into a low-inflation trap in which zero interest rates aren’t low enough to achieve escape — which has happened in Japan and is pretty clearly happening in the euro area.

Yes Japan is in a trap, and the reason is Japan did precisely what Krugman wanted – wasted money on inane projects to “stimulate” the economy!

Reasonable people would intuitively understand that as soon as stimulus was removed, the recovery would end too (over and over and over again).

And any economist with an ounce of common sense would understand that the buildup of debt would require lower and lower interest rates to service! The alleged “trap” happens precisely because central bank fools fight short-term imbalances, creating long-term problems in the wake.

I don’t think the Fed will hike, but they sure as hell should have long ago. Repetitive bubbles of increasing magnitude bring upon the very thing Krugman rails about!

I will expound more on rate hikes and inflation in a bit, but for now let’s continue with more of Krugman’s rant this time in block quotes because of the length

My guess — and it’s only that — is that they [the Fed] have, maybe without knowing it, been bludgeoned into submission by the constant attacks on easy money. Every day the financial press, many of the blogs, cable financial news, etc., are full of people warning that the Fed’s low-rate policy is distorting markets, building up inflationary pressure, endangering financials stability. Hard-money arguments, no matter how ludicrous, get respectful attention; condemnations of the Fed are constant. If I were a Fed official, I suspect that I would often find myself wishing that the bludgeoning would just stop, at least for a while — and perhaps begin looking for an opportunity to prove that I’m not an inflationary money-printer, that I can take away punchbowls too.

But the objective case for a rate hike just isn’t there. The risks of premature tightening are huge, and should not be taken until we have a truly solid recovery that includes strong wage gains and inflation clearly on track to rise above target. We don’t have any of that, and if the Fed acts nonetheless, it has the makings of tragedy.

Objective Case

Krugman does not see the “objective case” for rate hikes for the simple reason he is totally clueless about what constitutes inflation!

That assertion brings up my point of view …

Inflation is Nearly Everywhere You Look

Inflation is not quite everywhere, just nearly everywhere. Looking for price deflation? Yes, you can find it in the price of gasoline.

And across the board there is little CPI inflation, nor will there be any time soon. And on those scores I am in complete agreement with Krugman!

But that’s not what inflation is really about. Inflation is really about the expansion of money supply and credit. When those soar, so does “real” inflation.

Any realistic look shows there is inflation in home prices (not in the CPI), sovereign bond prices (not in the CPI), equity prices (not in the CPI), student loans (not in the CPI), junk bond prices at amazingly low yields (not in the CPI), tuition (underrepresented in the CPI for many), and healthcare costs (underrepresented in the CPI in general).

Break-Even Theory Irrelevant

The break-even rate theory warns about consumer prices. That theory may or may not be correct. I think the theory is accurate, but it matters not given all the things it totally or partially ignores. Break-even theory is totally irrelevant “at best”, but more likely counterproductive.

In contrast, asset bubble breakages are relevant. And the Fed just blew the second or third biggest asset bubble in history following the advice of Krugman.

Now Krugman wants to bully the Fed into halting the hikes. The irony is that it’s already far too late to hike. The bubbles have been blown. By definition they will pop. And when they pop economic illiterates like Krugman will say “I told you so” while blaming the Fed for irrelevant actions like rates hikes of 0.25%.

Economic Illiterates Caused the Problems

Economic illiterates at central banks following horrible advice from fellow economic illiterates like Krugman are the ones who caused the problem in Europe, in Japan, and in the US.

Opposite Extreme Illiterates Make Krugman Look Good

Unfortunately, economic illiterates of the opposite extreme, people like Peter Schiff, John Williams, etc., have been screaming about the blow-up of the US dollar and/or hyperinflation for so long they actually make Krugman’s theories look reasonable by comparison (at least for now).

Deflation Will Return

Credit deflation (and that’s what’s important) will return (fueled by a decline in asset prices). Policies espoused by Krugman and enacted by central banks will be the cause.

Asset Deflation vs. Consumer Price Deflation

For more on asset deflation (the real concern) vs. consumer price deflation (a welcome event), please see …

I particularly would like to see Paul Krugman answer my Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit”.

I even challenge Krugman to a debate, with proceeds going to charity. I doubt Krugman will respond for the simple reason I will be a far more formidable challenge than the hyperinflationists who have been as wrong as he is.

Mike “Mish” Shedlock