Slightly left of center economic commentary on news, politics and the economy.

Low interest rates and low inflation at full employment

How low can you go? No… this is not a post about Limbo. It is a post about low interest rates, low inflation, and economic growth.

The question is… Can low inflation stay low as the economy heats up around full employment?

Let’s look at Europe. Low interest rates and falling inflation are not stopping economic growth. Brian Blackstone from the Wall Street Journal wrote about this yesterday.  Here are some selected quotes from his article…

“The super-low inflation rates (in Europe) are the average for the euro zone and are propped up some by higher inflation in Germany (1.04%). Five euro members—Greece, Spain, Cyprus, Portugal and Slovakia—have negative rates.”

“Yet the euro zone’s economic recovery is proceeding faster than expected… And it raises a key question for European policymakers: can economic growth coincide with weak prices? In a recent speech, Jaime Caruana, general manager of the Bank of International Settlements, a consortium of central banks, suggested it can.”

“Still, recent economic reports suggest the euro zone is showing little if any ill effects from low inflation, which has been driven to a large extent by softer food and energy prices. This adds to disposable income and may help consumption…”

” Euro members outside of France and Germany posted their strongest output gain in more than three years, according to the PMI report, despite ultra-low inflation or falling prices.”

The European economy is heating up and inflation is actually still falling. Will inflation keep falling? The long run Fisher effect states…

  • when a central bank’s nominal interest rate is held steady, whether deliberately or not (such as against the zero lower bond), eventually inflation adjusts to the nominal rate in the long run so that the real interest rate returns to its natural level.

Currently, the long run nominal interest rates set by central banks in Europe are below 1% with many at the zero lower bound. According to the Fisher effect, inflation would like to move lower so that the real interest rate rises higher towards its natural level of 1% to 2%.

The long run Fisher equation could look like this when Europe reaches full employment…

Natural real rate of interest (1.0%) = nominal interest rate (0.5%) – expected deflation (-0.5%)

So yes, inflation can keep falling according to the long run Fisher effect. The combination of quickening economic growth and falling inflation makes sense as the Fisher equation finds its long run equilibrium toward the end of a business cycle. The central banks only need to keep their nominal interest rates low.

But there is a risk hiding in the shadows. Again from the article by Brian Blackstone…

“With inflation already so low, an economic shock could push the bloc into more punishing deflation.”

I suppose central bankers will cross that bridge when they get there. In the meantime, low interest rates and falling inflation don’t seem to be a problem, as long as the economy is growing.

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Everything you need to know about Tax Freedom Day®

Monday, April 21, was 2014 Tax Freedom Day®, according to the Tax Foundation. The Tax Foundation is not exactly known for unbiased research, and its promotion of Tax Freedom Day® is no exception.

The Foundation claims that Tax Freedom Day® is “a vivid, calendar-based illustration of the cost of government.” In other words, instead of saying that its analysts expect total taxes in the United States (including social insurance) to reach 30.2% of net national income (NNI) in 2014, they say that Tax Freedom Day® arrives three days later than last year. Precise, huh?

Of course, the word “freedom” tips us off to the fact that the Tax Foundation is actually trying to create an emotional response. Something along the lines of, “Oh boy, after today I’m working for myself rather than the greedy government!” The implication further is that the later Tax Freedom Day® occurs, the worse it is for the country. The thing is, neither of these insinuations is true.

As the Center on Budget and Policy Priorities points out every year, that emotional response, frequently picked up directly by the media, is not true for the vast majority of Americans. As CBPP’s Figure 1 below shows, for the federal portion of taxes, more than 80% of Americans are paying less than the 20.1% federal component of Tax Freedom Day® would suggest. (In addition, the burden of some taxes does not fall on individuals at all.) The Tax Foundation responds that it’s not trying to mislead anyone, it’s just comparing “total U.S. tax collections with total U.S. income.” Of course, if that were all it was really trying to do, it could just say that projected tax collections equal x% of NNI. But no, it trumpets Tax Freedom Day®.

Moreover, a relatively late Tax Freedom Day® is usually a sign that incomes are increasing, so taxes are, too. As the Foundation writes this year,

Tax Freedom Day is three days later than last year due mainly to the country’s continued slow economic recovery, which is expected to boost tax revenue especially from the corporate, payroll, and individual income tax.

Despite the dig “slow,” the Foundation is saying that economic recovery boosts tax revenue. Another example should make this clearer. The same document continues, “The latest ever Tax Freedom Day was May 1, 2000, meaning Americans paid 33.0 percent of their total income in taxes.” Horrors! Such confiscatory taxation obviously meant that the economy was in the tank in 2000. You know I’m joking: Actually, the economy was booming and the federal government had a budget surplus. Again, higher incomes and profits boosted tax revenue. Indeed, the economy in 2000 created 2,088,000 jobs, way more than during the entire George W. Bush administration (1,282,000). Maybe the Tax Foundation should pay attention.

This brings me to the ultimate point about Tax Freedom Day®. It’s all there in the ®. As it indicates, Tax Freedom Day® is a trademark registered with the U.S. Patent and Trademark Office. If it were a serious concept, there would be no reason to trademark it at all. What the ® tells us is that Tax Freedom Day® is just a marketing gimmick.

Class dismissed.







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Two ways to Fish with the Fisher Effect

I wrote some 4 days ago about the Thoma/Williamson debate. I thought Stephen Williamson w0n the debate with his views on the Fisher effect, which basically state that keeping the Fed rate low into the long run will create low inflation. The basic principle underlying this view is that the real rate of interest is invariant with monetary policy in the long run.

There was some criticism that I agreed with Mr. Williamson. Now today Noah Smith wrote about the “the Neo-Fisherites”. I consider myself one of them.

There is confusion about how the central bank’s (CB) nominal interest rate affects inflation. There is a short run and there is long run strategy. Noah Smith is referring to the long run strategy to affect the inflation rate.

You might hear someone refer to Canada where they have targeted a 2% inflation rate over 20 years. And with all the ups and downs of the CB rate in Canada, they certainly have achieved a 2% inflation. They were able to do this because they raised the CB rate to lower inflation, and then lowered the CB rate to raise inflation. But now the Fisher effect is telling us that lowering the CB rate will actually lower inflation. That is contrary to what worked for the central bank in Canada.

The key is to separate the Fisher effect into a short run and a long run.

I will make an analogy to two types of fishing to explain the Fisher effect.

1. Chasing Fish

One could catch fish by finding them and then chasing them through the water.

When the CB nominal interest rate adjusts to short run movements in inflation, monetary policy is chasing fish (inflation). The CB nominal rate seeks to move inflation. This is what the central bank in Canada did for 20 years.

2. Waiting for Fish

One could also catch fish by placing the bait at a particular location and then waiting for the fish to come to the bait.

When the CB interest rate stays steady in a long run period and does not adjust to short run movements in inflation, monetary policy is waiting for the fish (inflation) to come to it. The CB nominal rate baits inflation to come to it. The mechanism for this is found in the “long run” Fisher equation…

nominal interest rate = natural real rate + expected inflation (1)

The natural real rate refers to the natural ability of an economy to grow with productivity, capital accumulation and its labor force. So when the natural real rate is understood to be invariant to monetary policy over the long run, the Fisher equation becomes this…

nominal interest rate ≈ expected inflation (2)

In the long run the real interest rate eventually returns to its natural level. So in the long run expected inflation will be…

expected inflation = nominal interest rate – natural real rate (3)

Inflation will adjust to the steady nominal interest rate and the natural real rate in the long run.

The CB nominal interest rates have been low and steady for years waiting for inflation to rise. But instead, inflation has lowered, and the real rate is rising towards its natural level. The CBs are trying their best to chase inflation by the old method, but they cannot chase inflation because they are constrained by the zero lower bound. They end up waiting for inflation to move. But the real effect is that they are bringing inflation to them by waiting so long… equation (2).

This whole issue of the Fisher effect will be huge. The implication is that the Fed rate will have to rise for inflation to rise. And there will be lots of resistance from progressive economists who do not want to raise the Fed rate because they think it would produce a premature recession.

Get ready for the responses to Noah’s post…

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Speeding toward inequality,1266599531,1/stock-photo-speeding-car-on-the-road-shoot-in-this-car-47006323.jpg

If you were a passenger in a car speeding toward a cliff, you would scream at the lunatic driver to steer away or slow down. The car is our economy. The cliff is inequality. Inequality is a disaster for society.

Who is driving the car? A combination of government policies and business institutions are steering the car toward inequality. We see low taxes on the rich and norms for higher and higher CEO pay. We see the real wage struggling behind productivity. Changing these policies would steer us away from inequality.

What has been making the economy go so fast toward inequality in these last 2 years? … Monetary policy is the engine of the economy. When you push down on the gas pedal (interest rates), the car (the economy) goes faster. The speed at which we are generating inequality is largely based on monetary policy. And our long run aggressive monetary policy is speeding toward inequality.

Monetary policy mostly depends upon the wealth effect to boost demand. Yes, the Federal Reserve has programs to direct liquidity into communities, but the larger impact of monetary policy is still the wealth effect through QE and the zero lower bound Fed rate. Productive investment is muted due to low labor consumption power. The wealth effect is a fast track to inequality when the economy is being steered toward inequality. If the economy was being steered toward a healthy balance between labor and capital, monetary policy would be benefiting broader society.

Words from Jeffrey Snider at Alhambra Investment Partners.

“That is because the “wealth” effect has nothing to do with wealth at all, rather it is properly defined as an inflation/credit system. Thus any relationship between asset inflation and consumer spending is indirect.”

“… we need to stop focusing on monetarism and credit, and instead allow direct economic expansion through the wages of actual capitalism. This convoluted monetarist system is simply too inefficient to sustain and nurture long-term economic success.”

If the government is unable to tax the rich.. if businesses are unable to raise labor’s real wages faster than productivity growth… if business is unable to lower CEO pay… if off-shore tax havens are not controlled… in essence, if the economy cannot steer away from inequality, can central banks at least slow down the speed at which we head toward inequality?

Society needs time to form a proper response to growing inequality.

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Are Markets Better Described as Robust than Efficient?

by J Tzimeskes  

Are Markets Better Described as Robust than Efficient?

Something that I think all of us with private sector jobs experience in our day to day lives is just how incompetent a large number of private businesses are. These may be our customers, suppliers, or another division. Yet, somehow, these businesses thrive despite not really having a good grasp of basic administrative procedures, financing, or sometimes even customer service.

Despite this, we often write and speak of private sector actors as if they are brilliant and efficient individually, despite the experiences of our everyday lives.* We simply assume as a result of mere market success that a business or individual has ability and competence. This isn’t surprising, the just world hypothesis is a powerful cognitive bias which leads us to believe that the system as a whole must be more just than what our individual experiences would lead us to conclude. However, there is no property of the market system which should lead to this belief.

What’s more notable is how little this impacts how we think about the market system as a whole. After all, given an immortal, perfectly rational, and omniscient central planner even the worst designed communist system would work beautifully. What’s remarkable about the market system is that it should lead to ever increasing levels of productivity and efficiency even if the individual actors are all completely incompetent. Competition and creative destruction should lead businesses to be ever better even if they only differ due to random variation alone.

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Bifurcated Monetary expansion and low inflation…

Low inflation continues to be a concern in Europe and the US, especially in Europe. Central bankers project that inflation will rise as the economy gets closer and closer to full employment. Yet, what is behind low inflation?

I refer to the work of Michael Pettis who is a professor of finance at Guanghua School of Management at Peking University in Beijing. He puts low inflation in China within the context of financial repression.

“…why is it that what seemed by most measures to be an extraordinary surge in money creation did not also result in significant wage and consumer price inflation?

The answer, I will argue, has to do with the nature of money growth in financially repressed economies. Because the Chinese financial system is so severely repressed, money growth in China cannot be compared to money growth in a market-based financial system. Monetary growth is effectively bifurcated and affects producers and consumers in very different ways.

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Reader comments on monetary policy and inequality

I posted a question to our readers…

How should monetary policy change if reducing inequality was seen as the most important priority?

An assessment of the comments…

The real issue of monetary policy’s effect on inequality its purpose to generate a “wealth effect” which will increase spending. A few things were said about the wealth effect.

Dannyb2b: “The central bank needs to be reformed. No reforms, no solution IMO. The fed just needs to be tweaked so that it interacts with different counterparties… Buying assets through OMO’s or QE is very uneven or imbalanced because it works through increasing wealth of existing asset holders and assets are concentrated. Asset holders have a lower MPC than broader public so the effect is limited… The solution I see is to create a wealth effect that affects all people by transferring new assets (money) to all when targeting inflation or growth or whatever. Average people have a higher MPC meaning less money needs to be expanded to realize changes in gdp or inflation.”

He is explaining the problem with monetary policy creating inequality. It is true that the wealth effect has helped the economy recover through increased consumption. However, consumption by capital income is at a very level while consumption by labor is very low. So consumption by the rich, which is created by the wealth effect, is being praised as a success of monetary policy. Yet, the resultant inequality is becoming a side effect greater than the original disease. (source for increasing capital consumption)

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China’s Place in the Global Economy

by Joseph Joyce (is a Professor of Economics at Wellesley College and the Faculty Director of the Madeleine Korbel Albright Institute for Global Affairs and maintains his blog at Capital Ebbs and Flows)

China’s Place in the Global Economy

Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

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