Mar 312012
 

Dear Class of 2016:

Congratulations to all of you and welcome! I’m the vice chair of the economics department and looking forward to seeing you here for Dimensions weekend and First Year Orientation. I spent today teaching my seminar on finance and I have a couple of ideas for you to ponder. Look at the enclosed graph. The green line is the yield on the Treasury Inflation Protected Security. The TIPS. This is the yield on the 5 year TIPS. The TIPS pays this rate PLUS the future change in the price level. Thus as an investor you get the real yield on the TIPS (the green line) plus inflation.

What is that enormous spike during the financial crisis? Apparently the market expected deflation (ie inflation would be negative) so in order to hold the TIPS investors demanded 4% figuring that -2% “inflation” would be added to their return. Would it make any sense to expect deflation in the US economy? Couldn’t the Federal Reserve just print more money to cause inflation if it needed to? You have probably heard the terms QE and QE2 meaning quantitative easing. QE and QE2 have a lot to do with this ability to create inflation. Under quantitative easing the Fed has been creating money and buying bonds with it. What does that accomplish? Creating (printing) more money and injecting it into the market keeps interest rates down and tends to increase the price level. This is exactly what the Fed wants to do in this weak economy.

Stranger still, why is the green line below zero now? Its at minus 1%. Why are investors willing to lock in a **negative** real yield on a five year Treasury investment? If banks are paying zero percent, and there is 2 percent inflation, banks are paying -2% in real terms and the TIPS is paying -1% in real terms. Is that the best investors can do and would they be better off putting their money in the stock market and trying to earn a positive real return?

The financial markets are a fascinating part of the economy and our aim is to help you understand these phenomena at a deep level. Each of my students is working on their own research project related to some aspect of asset prices or firm or investor behavior. I hope and suspect that many of you will be economics majors and it will be interesting to see how the world evolves during your time here

Yours truly,

Prof Bruce Sacerdote ’90

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