Let's get all of those worries about inflation in perspective

Hat tip the Guardian data blog.

Update. Krugman's take is here. The one line summary: does the big inflation scare make any sense? Basically, no.

What I don't understand about the DMO

FT alphaville has a post on the DMO at the tail end of last week, setting out the auction catalogue for the next quarter and setting out progress to date. It includes this summary of the year so far:This squares with my understanding that the DMO has a policy to keep index linked issuance at less than 20% of the total. My question is why. There is massive demand for long-dated linkers from pension funds and life insurers. Given the need to sell a lot - really a lot - of gilts next year, why is the DMO not giving the market what it actually wants to buy?

A short note on the yield of inflation-linked bonds

Some people recently seem confused by the yield of some inflation linked bonds. Here's the scoop.

1. Some, but not all, inflation linked bonds are floored at zero inflation on principal. That is, you cannot get less than the face value back. TIPS, for instance, have this feature.

(2. There is a more extreme form of flooring where the coupon is floored at the stated real yield on the face, so for instance if you hold a 2.5% real yield bond where the face has accrued to $1M, then you will always get a coupon of at least $25,000. This form of floor is rare, so I will ignore it.)

3. This means that in effect these floored bonds are a pure inflation-linked bond together with a floor. The strike of the floor depends on inflation to date. To see this, suppose we have an old TIPS. Experienced inflation over its life will have inflated its market price way above par. Thus inflation has to be highly negative for the floor to be worth anything. For a newly issued TIPS, on the other hand, the floor is much closer to the money.

4. When inflation was expected to be 3 or 4% a year, this didn't really matter much. But with deflation expected in 2009 by some, you really need to adjust the yield of short dated newly issued floored bonds by the value of the embedded inflation floor, as this floor is now quite valuable.

5. This is in theory a simple option adjusted spread problem. I say in theory because in some markets - the UK is a good example - there is an oversupply of inflation caps which means that market quoted inflation volatilities are not reliable. But this isn't an issue for TIPS. Simply [;-)] go to your friendly broker, get a quote for the correct strike inflation floor, back out the vol, then use this to option adjust the spread of your bond.

No arbitrage requires arbitrageurs

No arbitrage conditions are not natural laws. You can only rely on them if there are enough arbitrageurs around to keep the markets in line. At the moment, that isn't true in many settings. John Dizard points out an example from the Tips market:

seven-year Tips bonds are asset swapping at 130 basis points over Libor

As Dizard says, this is partly because the Tips are illiquid and hard to finance (and thus to leverage), and partly because there is not enough risk capital around:

The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds. The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry, and then were sold off by merciless prime brokers.

Dismally bad

Larry Elliott in the Guardian has an article encouraging the Bank of England to cut rates. Larry is harsh with the Bank, accusing them of being asleep at the wheel, and he presents as evidence the Bank's 2007 CPI prediction:This shows a zero chance of inflation reaching 5% in 2008. If we now turn to the latest report, we find:In other words, current CPI over 5% and likely to stay there for six months. For me this is not proof of the Bank's guilt: this is just proof of how utterly unscientific economics is. After all, the Bank of England staff are neither ignorant nor lazy. They will have applied reasonable econometric tools in reasonable ways to get the first chart. The fact that reality turned out not just different from their prediction but completely outside the error bars simply shows that far too often when tested against reality, economics fails dismally.

Update. See here for a comprehensive account of the failure of economics. Or at least its failure to be funny.

Trichet on asset price bubbles

Jean-Claude Trichet made a speech in 2005 on Asset Price Bubbles and Monetary Policy. The full text is here. A few points leap out at me. Firstly Trichet raises the question as to whether there is such a thing as an asset price bubble:

I believe the NASDAQ valuation of the late 1990s was not excessive... [I] tend to believe that occasionally we observe behavioural patterns in financial markets, which can even be perfectly compatible with rationality from an individual investor’s perspective, but nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental values, until the fragile edifice crumbles.

`Excessive' is a difficult word and I can see why Trichet is cautious about using it. But certainly the fair value of debt securities is the result of many phenomena including funding premiums and liquidity premiums as well as long term default rates. Their spread can tighten leading to asset price growth if funding is cheap and liquidity is plentiful without this necessarily being irrational.

The problem knowing how much is too much means that Trichet is cautious about the possibility of identifying an asset price bubble:

I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not.

He suggests one definition of a bubble:

[There is] a warning signal when both the credit-to-income ratio and real aggregate asset prices simultaneously deviate from their trends by 4 percentage points and 40% respectively.

I agree, but I would have thought that liquidity and/or funding premiums and the availability of credit would also provide helpful warning signals. As Trichet says:

A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.

Interestingly (for 2005) Trichet points out the positive feedback in a bubble pricking of collateral:

A negative shock is likely to have a larger effect than a positive one. The reasons are that credit constraints can depend on the value of collateral and that in case of a financial crisis the whole financial intermediation process can in the worst case completely fail.

After those insights the conclusions are depressing:

With regard to the optimal monetary policy response to asset price bubbles, I would argue that its informational requirements and its possible – and difficult to assess – side-effects are in reality very onerous. Empirical evidence confirms the link between money and credit developments and asset price booms. Thus, a comprehensive monetary analysis will detect those risks to medium and long-run price stability...

I fully advocate the transparency of a central bank’s assessment of risks to financial stability and of its strategic thinking on asset price bubbles and monetary policy. The fact that our monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain circumstances, provide early information on developing financial instability is an important element in this endeavour.

In other words we will try to tell you when a bubble is inflating but, beyond targeting inflation, there is little we are going to do about it. And M. Trichet did indeed keep to the second part of that promise.

All Inflation's Little Parts

A wonderful graphic from the NYT illustrates the US inflation basket. The original interactive version is here: the static version is below.
(Click for a larger version.)

Will inflation be targeted?

Central banks have over the last few years been either rather successful at inflation targeting or rather lucky that inflation has remained low (but positive). FT alphaville cites some research from Morgan Stanley questioning whether this happy state will persist.

For me there are two parts to this question. Does inflation targeting work? And if it does, will central banks actually practice it?

On the first certainly when inflation has been rising in the major economies recently raising rates seems to have reined in inflation. However we have not really seriously flirted with a deflationary environment so the evidence concerning raising a too-low inflation rate is scanty. But that was definitely an issue in Japan: with rates close to zero they had nowhere to go if the only policy tool is control of the short rate. The efficacy of targeting therefore gets a 'not proven' from me.

The second point is more problematic. The FED, for instance, seems to have abandoned inflation targeting entirely in order to protect the financial system. When you consider the manipulation of the inflation index in the US (the official inflation figure is now known to some as 'inflation ex-inflation' - see here for an independent calculation) this response becomes even more troubling. So it seems that central banks will target inflation only if there is not something more important they need to use short rates for.

Three balls in Frankfurt and New York: a Decade of Deflation?

The FT has a story reminding us that the FED is currently playing a game of 'go on, I'll trust you, how much do you want for that?' that would shame a small town pawn shop.

The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.

The ECB has similar tactics:

Eurozone banks increased sharply their use of mortgage-backed debt and similar structured bonds last year in order to raise money from the European Central Bank, helping to avoid liquidity problems in financial markets.

The volume of asset-backed securities pledged as collateral in ECB market operations to provide funding to banks reached €215bn ($315bn) by the end of last September, the bank said in data released on Thursday.

It is worth remembering that this massive liquifaction of the banking system was one of the key features of Japanese economic policy during the decade of deflation. The central banks are playing a very dangerous game here and it cannot last for many more months without addicting the banks to cheap funds and very low liquidity premiums - an addiction the Japanese example shows is very difficult to recover from.

Update.Credit slips has an interesting if perhaps overly bearish macroeconomic perspective on the potential for an extended period of deflation.

Wearing a cap

Further to the discussion on Saturday, here are some more thoughts on risks in pensions and who should bear them.

Pensions are complicated things. Consider a typical defined benefit scheme. Here the pensioner has a right to a certain level of pension - often index linked - and the employer has an obligation to provide it. The pension is simply collateral against that obligation.

The first risk, then, is that the employer cannot meet that obligation, typically because they have defaulted, and the pension fund is not adequate. It is this risk that pensions protection legislation is meant to address.

The second risk is that the fund is not judged be adequate to meet the employer's liability, causing the need to 'top up' the fund. I say 'is not judged to be' rather than 'is not' because the law requires an assessment of the future likelihood of adequacy to be made rather than a spot assessment. Ignoring for a moment the veracity of the assessment - which is questionable - let's look at how a fund might fail to be sufficient to meet an employer's liabilities.

There are two moving parts here: the fund assets, and the fund liabilities. Funds are typically invested in some or all of corporate bonds, equities, and inflation linked bonds, plus perhaps other asset classes. Therefore they are typically:

• Short credit spreads (if credit spreads increase, the fund loses money on a MTM basis);
  
• Short nominal rates (because if rates increase, fixed rate bonds are worth less);
  
• Long equities; and
  
• Long CPI inflation (to the extent that they hold inflation-linked assets).
  

On the liability side the fund is:

• Short longevity (if people live longer it has to pay a pension for longer and hence loses money);
  
• Short wage inflation (if final salaries increase, so do pensions);
  
• Short CPI inflation (if inflation increases, so do index-linked pensions);
  
• Long nominal rates (because future liabilities are discounted back to today along some interest rate curve).
  

The risk is then that the spread assets - liabilities goes negative. In a DB scheme then the employer has to top up a fund if this spread falls beneath some threshold value, and hence they are short an option on the spread. In a defined contribution ('DC') scheme the pensioner bears all the risk and hence they are short this complicated spread cap: if their funds don't meet their pension expectations, then they have to find the cash for their retirement from somewhere else.

The details of the cap in any particular situation of course depend on how funds are invested, but typically it will have some elements of equity risk, interest rate risk, corporate credit spread risk, and both wage and CPI inflation risk, together with the risk of the comovement of these factors (which you can simplistically think of as correlation risk). Given it is a very long dated instrument - perhaps as much as ninety years for someone entering the workforce now - and very complicated, it is hardly a surprise that it is difficult to know what it is worth.

Note in particular that because we have a long-dated problem, the details of the dynamics of each component of the spread are crucial. It might be reasonable to assume that some of them, such as corporate credit spreads, are mean reverting. This makes the problem easier. For others, notably inflation and equity returns, there seems no reason at all to assume long term mean reversion. This means there is an awful lot of model risk in pensions analysis.

Some dimensions of pensions risk can be minimised: for instance if the scheme holds inflation linked gilts then it can hedged inflation risk and bears no equity risk. However it still have longevity risk, and (absent a liquid longevity swap market anyway) contingent inflation risk (since if longevity increases the fund is mismatched on the duration of its assets vs. its liabilities and hence has inflation term structure risk). Moreover, of course, a low risk pension fund has to be much more comprehensively funded than one that is taking market risk in multiple dimensions (equities, corporate credit, property, alternative investments, ...) Finally note that longevity risk is remarked considerably less often than other risk components so it is less visible - but that does not mean that it is not there.

The key policy question, then, in pension is who should bear the risk of underfunding, i.e. who should write the spread cap. Recently, there has been a suggestion that rather than one party bearing all of the risk as in current DB and DC schemes, perhaps it should be shared between employers, employees, perhaps with a far out of the money state backstop*. (See here for a further discussion.)

This is certainly a policy option that could be considered. Pensions policy is bedeviled by a failure to address risk issues openly, not least because most pensioners do not want to face the harsh reality that either a pension has significant risk or it is extremely costly to fund. Education is needed to address this point. Once we are ready for the debate, though, I would suggest there is room for a creative sharing of risk. There are no easy options here, not least because of the considerable uncertainty in estimating the size of the risk. But the problem is hard enough without artificially restricting the domain of possible solutions.

*One issue not addressed here is the use of DC schemes to reduce employer contributions. DC does not imply lesser employer contributions and legislation could (and probably should) stop employers using DC as a way of reducing their funding obligations.