For example, quoted bid-ask spreads, after widening sharply during the financial crisis, subsequently narrowed and have remained stable at pre-crisis levels since 2010. (Exhibit 1) Other measures paint a more mixed picture. While order book depth is appreciably lower now than in 2012 and 2013, it is much higher than during the financial crisis, and does not appear to be unusually low by historical standards. (Exhibit 2) Similarly, the price impact of trades appears to have risen a bit since the October 15 flash rally indicating some deterioration of liquidity, but is still not high relative to its longer-run experience. (Exhibit 3) Average trade sizes have followed a similar pattern to the order book depth and have recently declined somewhat. (Exhibit 4) Another way to assess liquidity conditions is through the potential impact on Treasury yields. If liquidity had deteriorated markedly, then we would expect to see larger deviations of actual yields compared to the yields predicted by an empirically fitted yield curve. If liquidity were more costly, the deviations of actual yields from fitted yields would increase because the costs of arbitrage to eliminate those divergences would be higher. During the financial crisis, for example, there was a sharp deterioration in liquidity, which was associated with a sharp rise in some measures of yield curve fitting errors to a peak of about 20 basis points. This compares to less than 2 basis points prior to the crisis. In contrast, yield curve fitting errors have been low and stable recently and not outside historical norms.
Despite current low rates, I still often hear people say that higher inflation is just around the corner. I confess that I am somewhat exasperated by these repeated warnings given our current environment of very low inflation. Many times, the strongest concerns are expressed by folks who said the same thing back in 2009 and then in 2010 and, well, you get the picture. OK, five years later we still need to carefully assess this very serious question. Let me offer five reasons why I still see the economic environment as pointing to below-target inflation for several years. First, many commentators see rising commodity prices as a harbinger of rising inflation pressures. Certainly, back in 2008 and 2010 there were instances when energy and commodity prices rose to high levels. This put pressure on inflation and also reduced aggregate demand. There is a lot of evidence that these types of relative price increases result in only transitory increases in consumer price levels. 6 At the moment, even these transitory upward pressures are absent, and the current weak state of global demand contributes to downward pressures. Until something unexpected, and frankly positive, happens with the world economy, commodity prices seem like an even more unlikely propellant for strongly rising inflation than they usually would be. Second, some say a classic warning sign of inflation is the enormous size of the Fed’s balance sheet and the greater than $ trillion of excess reserves sitting on commercial banks’ books.