At disco-tech.org (hat tip, The Capital Speculator), Arthur Laffer comes under fire from fellow traveler Bret Swanson for his defense-of-the-Fed opinion piece in Thursday's Wall Street Journal. I'm not one to dive into family disputes, but there is at least one contention to which I feel a response is needed. Swanson writes:
-- Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.
I don't think there is any way to draw that conclusion. When monetary policymakers think about inflation expectations, the focus is almost always on long-term expectations -- the assumption being that the central bank has only modest control over inflation on a year-to-year basis. Since Treasury Inflation Protected Securities were introduced in 1997, it is just not possible to determine whether they have been good predictors at the relevant 5 to 10 year horizon.
Of course, the argument works both ways. Though I tend to agree with the sentiments expressed by Ryan DeJarnette (thanks again, TCS)...
Mr. Laffer explains inflation is under control when looking at the TIPS spread, or the difference in yields on TIPS and the 10-year bond. This spread tells you the market, which is the most efficient and effective entity when it comes to valuation and prediction, expects 10 year inflation rates around 2.5% a year...
... the claim that the TIPS market is giving us the "the most efficient and effective" estimate of inflation expectations, and hence inflation, is still largely an article of faith. Though there are several reasons that the simple TIPS spread might not be an unbiased predictor of inflation -- because of differentials in liquidity, for example -- trusting in this market measure of expectations is a leap I'm willing to take.