Saturday, March 17, 2012

Inflation Expectations...

...is the current fashion amongst the Eunuchs to satiate and placate the masses with regards to the dangers of inflation and deflation.

And now, they produce the below, a true and instant classic of its kind:

News Release: March 16, 2012
The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.38 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the "break-even" rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium. For more detail, see the links in the See Also box at right.

Estimates are updated once a month, on the release date of the CPI.The methodology used to generate the estimates was changed slightly starting June 15, 2011, and it is documented in this working paper.


Delving into the "paper" mentioned in the last sentence, we find this gem of academic obfuscation and arrogance:

Our model differs because it has four stochastic drivers
yet seven state variables. Three of the state variables in our model are
the short-term real interest rate, expected inflation, and inflation’s “central tendency,”
and they have a large influence on the cross-section of bond yields. However, they play
no direct role in determining bonds’ risk premia. Rather, bond risk premia are completely
determined by four volatility state variables whose dynamics are mixtures of normal and chi
squared innovations that derive from changes in the aforementioned three state variables
plus realized inflation. This de-coupling of the state variables that largely determine the
cross-section of yields versus the state variables that solely determine risk premia allows
for time-varying risk premia that can even change sign.

As a result, the model’s ability to fit the cross-section and time-series of nominal yields exceeds
that of traditional affine models. Because our model better matches the empirical properties of
nominal yields, one may have greater confidence that it provides the correct starting point for
decomposing nominal yields into their real yield, expected inflation, and risk premia parts.


All of this sounds very official and precise, but let us consider what they are saying with respect to this "improved" inflation forecasting technique. They take as a parameter the difference in inflation survey expectations over two time periods. This says much about the sacrosanct status "inflation expectations" has in the Fed. To assert this variable, build a mathematical model that features it, and FIT (with a conceptual crowbar) the model's prediction of expectations to "actual" expectations does not even approach a truly useful gauge of inflation. The question that should be asked is: are expectations of inflation the same thing as inflation itself? Is inflation the kind of thing that is derailed by sanguine expectations, or does it have more clandestine tactics that destroy financial order?

The fact that this paper and its result yell "ALL CLEAR TO DEPLOY MONETARY POLICY" is testimony enough as to its purpose and rigor.

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