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July 26, 2005


Rob Read

Your assuming that a recession will lower inflation.


Yes Rob - this assumption is what I meant by a "standard macroeconomic model." It's a variant of the old Phillips curve, whereby the output gap leads to changes in inflation.
Personally, I think this is questionable in the short-term. There are loads of reasons why inflation would be slow to fall in a recession, and might even rise - counter-cyclical mark-ups and the like - but it would be soooo 1980s to rehearse them. It seems consistent with the data and with short-term price stickiness that, in the longer-run, recessions do indeed reduce inflation. And this is what matters for longer-dated bonds. So this story still holds, I think.

Rob Read

In a recession is caused by protectionism i.e. the ending of the massive Chinese deflationary effect that was cancelling out the huge inflationary pressure caused by the large Adiabatic expansion of money. Then the result will be massive inflation.

Of course, Chinese economic growth is causing inflation in commodities, but due to low wages in China, deflation in more-finished goods.

Mark T

Greenspan's point was that the long standing relationship between the yield curve and subsequent output has become increasingly weak (see recent work done by Fed Bank of Cleveland for example)and yet the imbedded assumption in most work is that the long term relationship is stationary - indeed in the ever optimistic (for them) bond markets it is almost an article of faith. While not evoking the foreign central banks reasoning, there does seem to be a demand for long term "risk free" investments from overseas investors at a rate below that dictated by models of the US economy, as well as an ongoing carry trade that appears to persist until the curve is almost entirely flat.

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