Dressed Up Delusions Of Bad Math: The False Term Premium Inflation Promise

Deconstructing long-term interests may seem like a purely academic exercise. This is certainly how Economists treat it, coming at them using their statistical models. The goal is always to properly interpret these most basic of economic, financial, and monetary fundamentals so as to understand where everything that matters stands.

Getting this wrong is the difference between night and day; between driving a car with perfect vision or attempting to do so with a blindfold on.

In the latter case, you might be able to “sense” where you’re headed for a few minutes (seconds) before being rudely shown how much of a mistake it would’ve been to ever have tried.

Ever since Irving Fisher wrote The Rate of Interest in 1907, it’s been widely accepted how changes in nominal bond yields like those on US Treasuries come from two sources: changes in real rates plus changes in expected inflation. This kind of Fisherian deconstruction or decomposition has been examined thoroughly by Economists over the century in between.

The problem, from their point of view, is how do we know which is what and then quantify all for each? It’s not as if bond investors get together and describe these discrete breakdowns to the world for publication in the next day’s Wall Street Journal (for those who remember having to look up securities prices in a physical newspaper). In lieu of that or mind reading, econometrics created a regression analysis purporting to accomplish something close to this objective.

Right from the start, you can see where this just goes wrong. The Federal Reserve Bank of New York publishes daily data derived from one widely recognized model of yield decomposition. The branch’s “ACM Model” (which stands for its authors: Tobias Adrian, Richard K. Crump, Benjamin Mills, and Emanuel Moench) combines the real interest rate with inflation expectations via an affine methodology:

The term premium estimates that we present are obtained from a five-factor, no-arbitrage term structure model…Our model belongs to the affine class of term structure models which characterize yields as linear functions of a set of pricing factors.

As such, it only runs into big trouble. To figure out what the market must be thinking in terms of inflation and underlying fundamentals, linear functions of a set of pricing factors is a purposefully vague term for winging it but making it look scientific because…math.

What that has meant, by and large, is that Economists following this approach have fooled themselves especially in the post-crisis era at every step and stage along the way.

Let me show you exactly what I mean:

I like to use a conceptual model where the expected path of short-term rates isn’t lumped together with expected future inflation (as I’ll get to below) because there are certainly times when those things might (and have) diverge(d). What this econometric modeling does is combine these two factors as their view of inflation plus real rates and then merely compare those calculations to the market yield of long-term rates (of whichever maturity; I’m going to use the 10-year here).

In other words, this thing about “term premiums” is that they are nothing other than a remainder after all the estimating is done elsewhere. That’s it. Therefore, this puts total emphasis on the ability of Economists to properly calculate the blue stuff. Yeah.

Because they believe QE works (even though their own studies can’t really describe how or why), and that it eventually leads a recessionary economy into recovery, what is supposed to happen is that long-term bond yields rise due to the market believing those same things: inflation and real rates will absolutely go higher as they always would whenever legitimate business opportunities pick up creating full employment which then leads to tighter price conditions (labor and consumer prices).

Following especially the introductions of QE3 and then QE4 in late 2012, by mid-2013 with the unemployment rate dropping rapidly the modeled calculations all changed in this way. In FRBNY’s numbers, shown below, you can see how the models shift upward when QE was tapered in December 2013 and then kept following that rising path even though mere weeks later long-term bond yields reversed course.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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