Relevant and even prescient commentary on news, politics and the economy.

The Fed’s attempt to assuage inflation fears that don’t need assuaging

by Rebecca

There is no shortage of speeches by US central bankers these days. The following is an excerpt from a NY Times article that highlights the debate among key Fed officials about the speed and method of stimulus withdrawal once the decision to exit has been made:

Mr. Bernanke and other officials want to see evidence that the economic recovery is self-sustaining, strong enough to generate jobs without the crutch of extremely low interest rates.

But Mr. Warsh, as a Fed governor, has begun arguing that the central bank cannot afford to wait for irrefutable evidence of a solid expansion. Mr. Warsh recently argued that the Fed should take at least some of its cue from stock prices and other financial indicators, which turn around earlier and more quickly than the underlying economy.

Mr. Warsh and some other Fed officials also argue that when the time does come to change gears, the central bank may have to raise rates almost as fast as it slashed them when the crisis began.

We are far from seeing “irrefutable evidence of a solid expansion”. This debate is likely confusing the public more than anything else, or as my title puts it: the Fed is attempting to assuage inflation fears that don’t need assuaging. There is simply no measured inflation concern at this time, not even over the next ten years.

The chart illustrates the 30-day moving average of expected inflation for the next 5, 7, 10, and 20 years. Expected inflation, roughly speaking, is the nominal Treasury Security rate minus the associated Treasury Inflation-Protected Security (TIPS) rate, the real rate of return or the break-even rate. Technically this break-even rate is not a perfect measure of inflation expectations; but it’s close and measured daily (see this SF Fed article for more on TIPS).

The “inflation problem” is way overstated in the media. Roughly speaking, markets have priced in just 1.3% annual inflation each year over the next five years, 2% over the next ten years.

By giving speech after speech (Bernanke’s latest), the Fed is attempting to keep inflation expectations in check. However, the Fed is walking a fine line between alleviating concerns about long-term inflation prospects and overemphasizing the short-term disinflation (deflation) risks.

Rebecca Wilder

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The Fed called a mulligan

by Rebecca

Ex post, it is obvious that the Fed was way too tight in the second half of 2008. To be sure, the FOMC was actively engaged in its standard easing policies; however, the Fed got the Treasury to aid in its sterilization efforts, and later the Fed fast-tracked the interest on reserves (IOR) program (originally set for an October 1, 2011 start). The Fed was misguided in its sterilization efforts, as aggregate demand was already collapsing.

Something was afoot well before the collapse of Lehman Brothers. David Beckworth at Macro and Other Market Musings backs up Scott Sumner’s (TheMoneyIllusion blog) theories with an intuitive analysis using the equation of exchange (MV = PY):

Below is a table with the results in annualized values (Click to enlarge):

This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other.

… (And a little later)

Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

This line research essentially posits that the Fed got it terribly wrong in the second half of 2008. As David shows in the table above, the velocity of money was dropping with households clinging to cash under heightened economic uncertainty.

If this theory is true, then one could view the $300 billion Treasury buyback program (see the NY Fed’s Q&A here) as the Fed’s equivalent of “calling a mulligan” in an attempt to take back its sterilization efforts in 2008.

The $300 billion buyback of Treasuries will restock about 75% of the Fed’s Treasury holdings (focused in notes and bonds rather than bills, but there is a contemporaneous objective to pull long rates down) that dwindled previous to the onset of the SFP account. Unfortunately, though, it was already too late.

(The Treasury issued short-term notes and deposited the proceeds with the Fed in order to aid in the Fed’s sterilization efforts – see an old post of mine for a more thorough explanation of the SFP, or the Supplementary Financing Program.)

Another event recently occurred that would support the view that the FOMC is backpedaling: the Treasury’s Supplementary Financing Program (SFP) is going bye bye.

The Treasury started this week to unwind its account with the Fed (the SFP listed on the liabilities side of the Fed balance sheet). This is almost surely going to end up as excess reserve balances in the banking institution, as the Fed is unlikely to sterilize these flows. (Note that one could see if the Fed was sterilizing the flows if its Treasury holdings started to fall again.)

I guess that the real question is: where would we be now if the Fed had pushed harder on the money supply in 2008? I imagine that Angry Bear readers have many thoughts on this.

Rebecca Wilder

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The Fed’s moving target: NAIRU

by Rebecca

Neal Soss and Henry Mo at Credit Suisse published a very interesting article, “Where is full employment in a more volatile macroeconomy?”, where they argue that the natural (long run) rate of unemployment may be shifting (they do this by showing that the Beveridge curve, which plots the the job vacancy rate against the unemployment rate, is shifting upward). I cannot provide a link, but here are their conclusions pertaining to monetary policy:

In the case of rising NAIRU [RW: this is the rate of unemployment that does not grow inflation, often called the long-run rate] and higher economic volatility, the monetary policy implication is complicated.

On the one hand, a higher NAIRU suggests that it would require a strong and prolonged recovery for the unemployment rate to return to the level attained in the past two decades. This scenario argues for a long period of low interest rates, because the economy’s structure will make it harder to get unemployment back to the low levels of recent business expansions.

On the other hand, a higher NAIRU suggests higher inflation pressure, as the output gap is smaller than otherwise would be the case. In other words, the Fed would have to normalize its policy stance sooner than would have been the case warranted by a stable NAIRU.

The burden of this is likely to be several years of quite low short-term interest rates by any modern standard other than the zero-ish levels of today. Even if the NAIRU is deteriorating, it is likely to be several years before the economy generates enough of a drop in unemployment to get to the new NAIRU, presumably above the levels of the last 20 years but surely below the current 9.7% unemployment rate. Between now and then, high unemployment is likely to remain the focus of policy attention. Labor market policies, such as job retraining for the unemployed, to improve the inflation unemployment trade-off, would make the central bank’s job a lot easier as that longer-run unfolds.

Basically, if the long-run level of unemployment, which the Fed targets implicitly under their dual mandate (maximum sustainable employment and stable prices), is changing then the Fed’s job becomes that much more difficult. Policy is only as good as the model’s calibration: they need to confidently estimate and target a level of employment that may be very much in flux. A simple Taylor Rule estimation illustrates this point.

Note: The Taylor Rule is a policy rule that relates the federal funds target to inflation and the output gap: roughly speaking, as inflation rises relative to the output gap, the Fed should tighten (raise its target); and as the output gap rises relative to inflation, then Fed should ease (lower its target). I estimate the relationship, and you can view my data here, and Wells Fargo’s forecast here.

On one hand, the CBO projects that NAIRU is 4.8%. In this case, the Taylor Rule policy drops the fed funds target to -4.6% by the end of the year. Put it this way: the output gap is so big that policy is very, very aggressive but bound by zero.

On the other hand, if NAIRU has shifted to something more like 6% – this is roughly its level in the 1980’s – then the policy prescription is less aggressive. The output gap remains wide, but the implied target rises to -3% rather than almost -5% – still negative, but suggestive of a more benign policy strategy. Inflation pressures would start to build earlier than under the 4.8% case.

This complexity has been documented by the Fed in the minutes of their August 2009 meeting:

Though recent data indicated that the pace at which employment was declining had slowed appreciably, job losses remained sizable. Moreover, long-term unemployment and permanent separations continued to rise, suggesting possible problems of skill loss and a need for labor reallocation that could slow recovery in employment as the economy begins to expand.

Note: this not the same thing as a jobless recovery – the unemployment rate may very well fall with economic growth (no jobless recovery), but then settle at a structurally higher level.

Rebecca Wilder

P.S. I will not be able to respond to comments until tomorrow.

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Policy and housing: someone’s gotta give!

by Rebecca

Housing demand is being propped up by government subsidies and low mortgage rates, and the level of supply is held back by low prices. Right now, the housing market is a complicated hodgepodge of policy, foreclosures, and very weary potential home-buyers.

Home sales are stabilizing; home building is stabilizing; and home prices (might be) stabilizing – the chart to the left illustrates a positive trend in sales away from distressed and first-time home-buyers, the targets of policy, according to the NAR. But what would the housing market look like if the massive policy expired this year? Not good, and it will.

Some points on the housing market:

  1. Subsidies are set to expire. If the Fed continues to buy its average of $105 billion in GSE-backed MBS per month (see the NY Fed’s website for weekly updates), it will max out the announced $1.25 trillion in four months. The $8,000 tax credit for first-time home-buyers expires at the end of this year. The Fed’s Treasury buyback program will run its course by October.
  2. There are several home price indices out there, each painting a slightly different picture of the level and trend in aggregate home values (see AB post).
  3. The foreclosure modifications program is holding off some foreclosures; but the program is no match for market forces.
  4. There is a large shadow inventory out there – potential sellers that are reluctant or unwilling (TIME calls some of these sellers “accidental landlords”) to relinquish home ownership at current prices. However, if home values continue to take baby steps forward, shadow sellers (new supply) will emerge.
  5. There is a bimodal distribution of sales across the high-end and low-end housing markets. Low-end sales are hot, while the upper end is not.

The housing market still has a long, long way to go before unsubsidized demand equals supply at a price that doesn’t exacerbate foreclosures – strategic or otherwise. With virtually all of the subsidies expiring within four months, it’s hard to believe that policymakers won’t give.

So who’s gonna cry uncle? My bet’s on the Fed, as it lacks does not require Congressional approval. Some Fed officials even tout that the MBS program should be scaled back; that’s ridiculous, given points 1. through 5. above. I agree with Daniel Indiviglio at the Atlantic: the Fed is more likely to increase its MBS purchase program, rather than to curtail or even adhere to the current limit.

By the way, the Fed and the Treasury have successfully dropped mortgage spreads to 2006 levels, even lower on the 30-yr; but it took an accumulation of $1 trillion in MBS to date to do that.

Rebecca Wilder

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Flow of Funds Accounts: some are deleveraging, while others are not

by Rebecca

The Federal Reserve released its quarterly Flow of Funds Accounts, and the message is crystal clear: the private sector is dropping debt burden, while the public sector is growing it.

Quarterly private sector debt growth, households + nonfinancial business + finance, has been slowing or negative since the second half of 2007. In contrast, federal and state and local governments are selling debt like it’s going out of style, with 28.2% and 8.3% annualized debt growth in the second quarter of 2009.

It is no secret that the private sector is unwinding debt, but to what end? 100% of income? – 110%? – Or 65%?

According to Reuven Glick and Kevin J. Lansing at the San Francisco Fed, Japanese households dropped their debt burden to 95% of disposable income. If US households were to follow a similar path, then the debt cycle would be complete in 2018. An excerpt from the article:

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

There is deleveraging still left in the pipeline, but one cannot say that the Japanese experience foretells the path of US debt. The economic agents, their propensities to save, and underlying economic fundamentals are different: 100% debt to disposable income in Japan may not be the equilibrium level in the US. Unfortunately, though, nobody can tell you what the level is…just something less than 125%.

The path of saving (paying down debt)

The US economy has suffered a precipitous drop in consumer demand, as the marginal saving rate surged. Going forward, higher saving (the average saving rate) does not preclude income and economic growth per se, but increasing saving (the marginal saving effect) can.

As wealth effect ratios stabilize – the chart to the left features the wealth effect as household net worth/personal disposable income – I believe that household saving will stabilize and consumer spending will grow with income.

Admittedly, though, the lag structure of the recent anomalous wealth effect is not known, and the strong marginal effect on saving might continue (i.e., the saving rate grows, as in the San Francisco Fed paper). To be sure, the labor market has dropped wage growth to record lows (see Mark Thoma’s post here), and Q2 ’09 annual disposable income growth was negative (a first since 1951). Not good for contemporaneous saving and spending growth.

The next four quarters, or the early period of recovery, will be critical in setting the stage for income growth. The recovery is expected to be weak, with the consensus GDP growth forecast around 2.4% in Q4 2009. But given the precipitous decline in output, even a 5% annualized quarterly growth rate during the early recovery would be rather “weak”. There’s room for an upside surprise as financial and housing markets stabilize.

Rebecca Wilder (if you are interested, I listed additional Flow of Funds charts here)

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Central bankers: slow to acknowledge the start; quick to declare the end

by Rebecca Wilder

There is always an agenda when a central banker declares the recession is over – and Bernanke is no different. The following facts remain: US GDP contracted at a 1% annualized pace in the second quarter of 2009 (its fourth consecutive drop), industrial output grew just two consecutive months after declining every month (except one) since January 2008, employment is still falling, retail sales are improving somewhat, and real personal income has formed no discernible upward trend.

In that light, the most accurate description of Bernanke’s declaration is that he “thinks” the recession is over, rather than it “is” over. His strategic announcement plays on market expectations to the upside, just as announcing that the recession is underway would play on expectations to the downside.

Are central bankers generally more apt to declare the end of a recession sooner that the beginning? I bet that they are. Will an AB reader do a little investigative reporting to find the first time that Bernanke acknowledged the onset of the 07-09 recession? My money’s on 12/08, the date when the NBER declared it as such and a year after it began.

To his credit, much of Bernanke’s Brookings address was spent highlighting the weak recovery that is expected. Bernanke is brilliant and surrounds himself with likewise brilliant economists – but data is data; and he sees what I see, which is a murky bottom and expected positive growth.

The charts below illustrate the key monthly macroeconomic variables used by the National Bureau of Economic Research to date the recession peak and trough by month: real income (I use personal income through July), employment (through August), industrial production (through August), and wholesale-retail sales (through August).

George Cooper is on to something in his book “The Origin of Financial Crises” (highly recommended). He criticizes central banking for adhering to efficient markets thinking, which leads to lax policy on the upside of the business cycle, i.e., allowing aggregate demand to outpace underlying fundamentals, and overly aggressive policy on the way down.

In this light, central bankers might be quicker to face the end of the recession and slower to conclude the onset of one. It is akin to policy mistakes being made on the way up and a triumph on the way down.

Rebecca Wilder

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A housing bubble illustration

by Rebecca

Yesterday’s post on the Australian economy sparked some discussion of its housing market. I agree – Australia’s bubble is large relative to that in the US (interestingly enough) and Canada.

The chart illustrates the price to rent ratio in Australia, Canada, France, Ireland, the UK, and the US, which measures the trade-off between owning and renting. Across country, the housing indices are not perfectly comparable – for example, Statistics Canada measures the value of new homes, while the S&P/Case-Shiller index measures repeat sales of existing homes. Furthermore, countries often measure the owner-equivalent rents differently. Nevertheless, the trends are meaningful.

Australia’s bubble was (is) big, and relative to rents, home values recently turned upward. According to Steve Keen (thank you reader VtCodger for the link), government subsidies provided households the incentive to leverage up their balance sheets while the private business sector deleveraged. Basically, the crash is yet to come.

The recent uptick in the Australian price-rent ratio, i.e., jump in housing prices relative to rents, is interesting. Notice the same is happening in the UK and Ireland; however in their cases, seriously weak economic conditions are dragging down the CPI housing index (the denominator). (In the UK, prices are likewise rising, but rents are falling faster.) As rents slide, so too will the relative attractiveness of home ownership.

I expect that the same will happen in the US. In Q2 2009, the S&P/Case-Shiller home price index grew 1.4%, faster than did the owner-occupied rents index in the CPI. Owner-occupied housing (see CPI table here) inflation slowed dramatically in Q2; and given the long lag on core price fluctuations, there is a very good chance that it turns negative.

Rebecca Wilder

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Australia…escaped a total meltdown, but still far from healthy

by Rebecca

Australia is another on the short list of countries that “escaped recession” (another is Poland, which I wrote about earlier). As much of the developed world struggles with job loss and weak economic groundwork, Australia managed to push through the global meltdown with just one quarter of negative growth, -2.8% annualized growth in the fourth quarter of 2008. Since then, GDP in the first and second quarters of 2009 grew at an annualized pace of 1.6% and 2.5%, respectively. (Note: the chart on the left illustrates growth over the year, rather than annualized.)

To what does Australia owe this honor? Net exports and policy. First, while most of the developed world saw export demand plummet – in the US, exports dropped at an annualized rate of 29.9% and 5.0% in the first and second quarters of 2009, respectively – Australia, with its high concentration of primary products exports (foods, fuels, minerals, etc.), benefited from positive real export growth of 8.2% and 3.9% (annualized rates) during the first and second quarters of 2009. Imports fell even faster, and net exports picked up the slack for the huge drag on GDP coming from inventories and investment.

In 2008, 14.6% of Australia’s exports went to China, whose economy, as we all know, is faring much better than previously expected. And in July, Australia’s exports remained strong to China, growing 4.6% over the month.

Likewise, the Australian government underpinned the economy with huge fiscal stimulus, around $42 billion AUD or 3.5% of GDP, and robust expansionary monetary policy, cutting its cash rate 400 bps to 3.0%. The stimulus firmed household spending’s contribution to GDP growth above zero.

Australia escaped the recession, but it is not immune. Last week, the OECD released its updated forecast, which includes estimate of potential GDP. Although stimulus and exports kept Australia afloat, production remains well below the OECD’s estimates of potential output. And well, so does the rest of the world.

Against this backdrop, Poland really does shine.

Rebecca Wilder

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Weekend charts: the destruction of the "goods-producing" payroll


The BLS establishment survey (nonfarm payroll) reports that the accumulated job loss since December 2007 is 5.02% (almost 7 million jobs), blowing the total job loss of the previous “biggie” recessions, the 73-75 and 81-82 recessions, out of the water by 2.5% and 2%, respectively. There’s no question that it has been bad, with almost every industry slashing payroll.

The chart illustrates the total accumulated job loss across the major industries spanning December 2007 to August 2009 (nonfarm payroll listed here). Assuming that the recession is over (the consensus and key indicators seem to indicate that a business cycle trough has been found), then there are just two men left standing (adding jobs over the cycle), education and health services and government (barely). Even the historical job anchors , other services, professional and business services, and financial activities, are down between 1.8 and 8%! The job loss is broad and deep.

However, the industry contributions to total job loss show that the job destruction is heavily weighted in manufacturing and construction, which account for roughly half of the total drop in nonfarm payroll (-2.5% of the total -5%). But manufacturing and construction hold just a 16% share of the entire payroll.

Productivity numbers, i.e., growing amid record output loss, would suggest (even manufacturing productivity saw growth in Q2 2009) that factories are running on skeleton crews, which is efficient given the drop in demand. And a resumption of aggregate demand may be partially satisfied by adding hours, but that will only go so far. Firms will need to hire, and hire soon after demand starts to grow again.

Rebecca Wilder

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The pre-labor report labor reports


Let’s investigate these pre-BLS reports.

There are many job reports out there, but here are some of the biggies that come out right before the official government BLS employment situation (not a coincidence).

  • Monster Employment Index (not seasonally adjusted) – an index geared toward online recruiting trends.
  • Challenger job cuts (not seasonally adjusted) – follows announced layoffs at large companies.
  • The ADP report (seasonally adjusted) – estimates private nonfarm payroll using their payroll data (very different from the BLS survey methodology).
  • WANTED Technologies report (no information on seasonal adjustments on the website, but it must be, right?) – estimates total nonfarm payroll (private plus public) using “hiring demand data” stemming from online job boards.

Well, they are all generally trending in the positive direction – i.e., the “it’s getting worse less quickly” story. This is consistent with the BLS report. The trend is about all that they can match, the level value seems more like a hit or miss to me. (Note: except for the Challenger cuts, all of this data has been revised). Correction: Just heard from Charles Thibault over at WANTED – he says: “We do not ‘revise’ forecasts ex-post like ADP”. Will update if that changes. RW: Maybe there’s something to this one.

But I am a skeptical as to the exact value added from these reports. Although the ADP report does not explicitly claim this, I imagine that they do like the idea that markets generally use their number as an indicator of the upcoming BLS report on Friday.

WANTED Technologies is explicit in their claim to forecast the BLS report more consistently than does the “consensus”. And furthermore, they present a root mean square error of their forecast (a measure of how close the forecast comes to the actual data) as something below that of the BLS (see Table at the bottom of their methodology page). I am not quite clear on how they calculate the error, since they revise their data as does the ADP (again, correction: according to WANTED, they do not revise their forecast ex post, and the MSE comparison may be quite meaningful).

This gets me back to my first point, what is the value added of these pre-labor labor reports? I always thought that the various reports should focus on what are their comparative advantages. For example, the ADP payroll figures likely have information on wages that cannot be ascertained from the BLS’ survey approach. Or WANTED uses online job applications – perhaps it can provide an earlier indication of labor prospects than can the survey as a whole.

We will see what happens tomorrow.

Rebecca Wilder

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