The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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August 26, 2006

A Laffer Critic With Critcism I Criticize

At disco-tech.org (hat tip, The Capital Speculator), Arthur Laffer comes under fire from fellow traveler Bret Swanson for his defense-of-the-Fed opinion piece in Thursday's Wall Street Journal.  I'm not one to dive into family disputes, but there is at least one contention to which I feel a response is needed.  Swanson writes:

-- Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.

I don't think there is any way to draw that conclusion.  When monetary policymakers think about inflation expectations, the focus is almost always on long-term expectations -- the assumption being that the central bank has only modest control over inflation on a year-to-year basis. Since Treasury Inflation Protected Securities were introduced in 1997, it is just not possible to determine whether they have been good predictors at the relevant 5 to 10 year horizon.

Of course, the argument works both ways.  Though I tend to agree with the sentiments expressed by Ryan DeJarnette (thanks again, TCS)...

Mr. Laffer explains inflation is under control when looking at the TIPS spread, or the difference in yields on TIPS and the 10-year bond. This spread tells you the market, which is the most efficient and effective entity when it comes to valuation and prediction, expects 10 year inflation rates around 2.5% a year...

... the claim that the TIPS market is giving us the "the most efficient and effective" estimate of inflation expectations, and hence inflation, is still largely an article of faith.  Though there are several reasons that the simple TIPS spread might not be an unbiased predictor of inflation -- because of differentials in liquidity, for example -- trusting in this market measure of expectations is a leap I'm willing to take.


August 26, 2006 in Inflation | Permalink


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Just an argument against Tips.

While using tips shows no recent decline in real bond yields other measures of inflation and inflation expectations do show a drop in real bond yields. But we are also starting to see monetary velocity for botn M2 and zero maturity money rise and that is what you should expect to see when real yields drop significantly below 4%.

A form of indirect evidence that the tips inflation estimate may not be accurate.

Posted by: spencer | August 27, 2006 at 04:31 PM

The measure could potentially have lots of distortions. But seems to be getting better as time goes by and the outstanding increases... See the link for a study on Canadian data.


Posted by: Frederic Dion | August 27, 2006 at 06:23 PM

TIPS track CPI expectations, not inflation expecations.

Posted by: Matt | August 28, 2006 at 03:50 PM

I'd say that the TIPS spread is an unbiased predictor of future inflation in much the same way that long-term interest rates are unbiased predictors of future short-term interest rates. Both represent the market's best estimate at a given point in time. However, both inflation and short-term interest rates are impacted by so many factors that its unlikely anything is going to be a particularly good predictor of the future.

Posted by: Tom Graff | August 28, 2006 at 05:47 PM

Matt -- fair enough.

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