After falling for three days straight, Treasury yields increased again yesterday. This coincides with two consecutive days of bad inflation news from the Bureau of Labor Statistics: both producer and consumer prices are again rising rapidly, with the former at 22.6 percent year to year, and the latter at 6.2 percent.
The yield increases were sharp, given that they happened from one day to the next:
- The 30-year bond rising from 1.83 percent on Tuesday to 1.92 on Wednesday,
- the 20-year bond rising from 1.86 to 1.96 percent,
- the 10-year note rising from 1.46 to 1.56 percent,
- the 7-year note rising from 1.32 to 1.45 percent, and
- the 5-year note rising from 1.08 to 1.23 percent.
These increases are all expectable given rising inflation.
There is also a moment of sell-off on the market: when the yields dropped, prices of the securities increases, which allowed speculators to sell at a profit. However, speculation only has temporary effects on the market; once the sell-offs have been completed the yields on Treasury securities will follow the trend of longer-term investor confidence.
This confidence is clearly unsatisfied with the inflation numbers that came out this week. The market has also, rightly, interpreted the Fed’s early-launch tapering of its accommodative monetary policy as a sign that the central bank harbors a genuine worry about inflation. When investors start demanding higher yield to protect them against inflation, interest rates can climb to levels unknown to most Americans alive today. During the stagflation era, inflation and interest rates rose in tandem:
- In 1977 inflation (measured as CPI) was 6.5 percent; the weighted average Treasury yield in September that year was a hair below at 6.47 percent;
- In 1978 inflation was 7.6 percent, with the weighted yield average at 7.4 percent;
- In 1979 inflation had reached 11.2 percent and yields had climbed to 8.6 percent;
- In 1980 inflation reached 13.6 percent while yields averaged 9.64 percent;
- In 1981 inflation was beginning to subside, falling to 10.35 percent, but yields still rose, reaching 12.5 percent.
We have three lessons to learn from the stagflation era, the first being that stagflation actually can happen. It is, in fact, happening as we speak. With the October inflation numbers out, there is no denying anymore that our economy, with GDP growth reverting back to its long-term, almost-stagnant normal and a labor market stubbornly stuck at subpar capacity, is following the same stagflation path as it did in the late 1970s.
The second reason to learn from the stagflation era is that inflation takes on a momentum of its own. Officials from the Federal Reserve have mentioned this mechanism several times in recent months, with focus on expectations: when people expect inflation to rise, they will act as if inflation is going to rise – and in fact make the rise in inflation either happen, or happen more forcefully than it otherwise would.
What the Fed officials have not explained is how those expectations translate into actual inflation numbers. The key here is product pricing. Under normal circumstances businesses review and adjust their consumer prices twice per year. This is an average number, cutting across the economy; actual price-review intervals vary from market to market, from industry to industry. That said, with a six-month benchmark interval, we have a periodicity for inflation that is relatively restrictive, in other words does not allow prices to take any leaps over the course of a year. With long intervals between price adjustments, you would scare buyers off if you suddenly marked up your prices by any significant amount.
If, on the other hand, you shorten your price-review periods, you can still mark up prices by the same small amount, but get a higher annual outcome. Figure 1 illustrates how the speeding-up of the price-review frequency rapidly increases inflation. Suppose the price of a product is $10 in December, and during the following year the price setter changes the price by one percent every six months. The outcome is a 2.01 percent inflation rate measured December to December. Suppose instead that he changes his prices every three months, again by one percent each time. The outcome is now a 4.06 percent annual inflation rate:
If prices are raised every month, still by one percent each time, the annual inflation rate ends up being 12.7 percent.
We don’t need large price hikes per se to cause inflation, but they obviously have a similar effect. Businesses are sometimes bound by contractual agreements as to how much, and how often, they can adjust their prices, but contracts often come with clauses that allow flexibility under adverse circumstances. This in turn means that businesses who are not used to making significant price changes can resort to somewhat disruptive pricing practices when inflation first hits: price changes may be more drastic than what may actually be needed, leading to subsequent adjustments.
At this point, with pricing behavior that seems to be looking for its footing in a high-inflation environment, many consumers will experience a substantially higher rate of uncertainty as to what their near-term finances will look like. Households may know their paychecks, but if their expenses vary by a lot more than they are used to, they mimic the over-reactive behavior of businesses. As I found in the empirical section of my doctoral thesis a long time ago – published in 2002 by a reputable international academic publisher – price uncertainty has a significantly negative effect on consumer spending.
In fact, it is better if inflation is high and stable than if it changes considerably from one month to the next. I made this point in my thesis, causing quite a bit of debate at the defense, but I stand by my results. They have also been verified later and are not too hard to see in regularly published macroeconomic data.
This means, plainly, that as we now see inflation not only at high levels, but rising from month to month – the October CPI number was 0.83 percentage points higher than it was in September – we can expect consumers to exhibit bearish spending behavior. Bluntly: they will spend less and save more.
Initially, more of their expenses will go onto their credit cards. This has become a consumer practice that is both a blessing and a curse: when you compensate for short-term cash flow strains by accumulating debt, you get through the rough patch on the hopes that you can successfully deal with the debt later. However, if the rough patch lasts longer than expected, the blessing turns into a curse.
We likely will not see an uncertainty-driven drop in consumer spending this holiday season. Households have fairly strong savings and household credit costs remain relatively low. The problems come when interest rates start rising generally and therefore drive up the cost of household credit. Squeezed by inflation on one hand and rising interest rates on the other, households will have to run down their savings balances to weather the storm.
The problem with a saved dollar is that you can only spend it once. At some point, inflation and rising interest rates will take their toll on economic activity. Expect the first quarter of next year to be bad, both in terms of GDP growth and for the labor market.
But will interest rates rise? Yes, they will. As mentioned earlier, demand for higher yields on Treasury debt will inevitably follow in the footsteps of inflation. When Treasury yields rise, other interest rates will follow, from mortgages to credit cards.