Great expectations

The big day is finally here, and while this may not be the biggest payroll number since FOREVAH, it's nevertheless still pretty important.  With the market now pricing something like a 2/3 probability of a December hike from the Fed, there's a fair amount of "gamma" around this figure that move those probabilities a fair amount in either direction.   Given the recent fixed income sell-off and the fact we're closer to 100% than zero, markets are probably a bit more vulnerable to a figure that would argue in favour of no move.

Of course, given the Fed's apparent desire to nudge rates higher, the bar for maintaining rate hike momentum is probably lower than it was a few months ago.   Nevertheless, markets have a funny way of upsetting the apple cart on payroll data, so while your author was gnashing his teeth a bit yesterday to see the eurodollar curve continue to weaken and steepen, he appreciates the importance of sticking to the discipline of a process.

As for the figure itself, his model is, for once, quite upbeat, looking for an above consensus reading of 198k.  Should that figure come to pass with reasonable peripherals, you'd have to think it would take something pretty special to defer a December hike, particularly given the possibility that October's employment figure may suffer some distortions from the hurricane about to lay into Florida and the southeast.

In the comments section yesterday a reader asked what would happen if/when the core PCE deflator reaches 2% y/y.  Barring a meltdown in labour or financial markets, it's a given that the Fed would raise rates some more; the question is by how much.  Being the academics they are, the core of the FOMC would of course do more than simply look at the spot level of inflation.   They'd also consider the forecast outlook and other factors, among them the trajectory of inflation expectations.

Expectations are an important part of academic economists' understanding of inflation dynamics, and the FOMC was famously concerned around mid-year when expectations declined.   In defining "inflation expectations", let's dispense with both TIPS breakevens, which reflect market liquidity dynamics more than legitimate inflation forecasts, and short-run expectations, which in the US are dominated by trends in gasoline prices.   Fortunately, the University of Michigan surveys consumers on their expectations for inflation over the next five years.   You can see the downtick of the last few years that has alarmed the Fed.

As a reminder, the Fisher equality states that Rr = Rn -  i, where

Rr = the real rate

Rn = the nominal rate

i = inflation.

In modern policy circles, this can be reformulated such that

Rr = the natural real rate of interest, which can evolve over time

Rn = the optimal policy rate

i - inflation expectations.

The distinction between orthodoxy and neo-Fisherism is that the latter assumes that the real rate is largely fixed, so that changes in the nominal policy rate impact inflation expectations.  The orthodox crowd believe that that the policy rate must move in response to changes in the real rate to maintain steady inflation expectations.    This is why the shift lower in the latter has been so troublesome for the Fed.

Apparently left unasked is what actually drives inflation expectations?  Obviously, historical inflation plays a large part in shaping the public's expectation of future price shifts.   The chart below illustrates the entire history of the Michigan 5 year expectations series alongside the trailing 5 year headline CPI rate.

As you can see, trailing inflation generally tracks expectations reasonably well, though the experience of the late 70's/early 80's suggests that expectations move more quickly than the trailing data when there is a sharp change in the delta of inflation.  Still, it's notable that expectations have remained fairly steady despite a fairly sharp move lower in long-term inflation averages since the crisis.

For fun, Macro Man decided to build a simple little model based on the Fisher equation to explain the level of inflation expectations.  Note that he regressed levels rather than changes, given that high frequency oscillations in the series are in many cases driven by short term factors such as oil.  The explanatory variables employed were the trailing CPI average in the chart above and the nominal/real T bill yields used in last week's savings rate post.    Note that these were spot rates, not long term averages.  The fit of the model using the entire data set as in-sample is really quite good, with an R-squared of 0.89; the result and summary statistics are laid out below.

What Macro Man found really interesting about this is that the coefficients for the nominal and real yields were virtually identical.  The negative coefficient for the real yield is as the orthodox crew would have it, lower real yields raise inflation expectations, higher yields lower them.   On the other hand, the neo-Fisherians score a point with the positive coefficient of the nominal yield, which says that all being equal a lower rates would reduce expectations.

Of course, as always it is difficult to attribute causality in a simple regression.  Still, the fact that nominal and real yields appear to impact/are impacted by inflation expectations by a similar magnitude is another reason to be skeptical of the apparent fetishization of R* in some policy circles.
For fun, Macro Man ran regressions with smaller sample windows:  1990-2007, and 2000 to the present.    The results are set out below.

 
What's interesting is that the two regressions with the best long-term fit both suggest that inflation expectations should be lower than they are currently.  On the other hand, the model that takes much of its sample from the post-crisis ZIRP period gives almost no weight to interest rates in shaping expectations (how could it?  Rates were stuck near zero for seven years!), which means that it is a very poor fit in prior eras.

Given how low inflation has been since the peak in the summer of '08 and how interest rates were pegged at zero for so long, the question the Fed should have been asking is not "why are inflation expectations falling", but rather "why are they so high?"