Friday, May 31, 2013

A Fourth Category

Paul Krugman list 3 possible reasons for the recent rise in bond yields based on what happens in currency and stock markets. If rising yields are combined with falling stock prices and a weaker dollar, then it reflects debt fears, if it is combined with falling stock prices and a stronger dollar then it reflects belief that the Fed will reduce its "quantitative easing", if it is combined with rising stock prices and a stronger dollar then it reflects optimism about the economy.

Krugman is actually basically right in his analysis of these three scenarios, though technically the last scenario could reflect simply optimism about profits, which is not necessarily the same thing as optimism about the economy.

However, Krugman left out a fourth category, namely the possible increase in yields combined with higher stock prices and a weaker dollar. That would be the result if inflation expectations increased while investors didn't believe that this increase in price inflation would cause the Fed to tighten policy. This is certainly a possible scenario, for example if Krugman, or someone with his views, became Fed chairman. I'll let you decide whether this was why he neglected to discuss this possibility

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