Tim Duy keeps us abreast of the latest on the Federal Reserve including the possibility that Greenspan may stay on for a few more months. I hope so and I pray no one who takes seriously the musing over at the National Review is ever placed on the Federal Reserve Board. David Malpass lists a series of assertions and gives his fact-free responses. Since I predicted the NRO would quickly contradict the latest from Lawrence Kudlow, let’s start with:
Assertion: Money supply growth has slowed, pointing to a slowdown.
Response: I don’t think money growth is well correlated to GDP growth when exchange rates are unstable and money velocity is as variable as it has been since the 1971 departure from the gold standard. Growth of the M2 money supply (currency, checking accounts, and savings accounts) slowed with the pace of mortgage refinancings after the jumps in bond yields in June 2003, April 2004, and March 2005, yet GDP growth didn’t slow. Growth of M0 (basically currency outstanding, since U.S. banks now have very little in assets that are subject to reserve requirements) is slow today because interest rates are rising and the dollar weakened in recent years.
Assertion: The yield curve has flattened, pointing to a slowdown. “Shrinking disparity between long and short (Treasury) notes waves caution flag on economy,” went the Wall Street Journal headline of May 9.
Response: Longer-term bond yields have stayed low in part due to unusually accommodative and restrained monetary policy. Rather than indicating a slowdown, low long-term bond yields have, at least in 2003 and 2004, preceded a surge in economic growth. I don’t think bond yields, inflation-protected TIPS, or the shape of the yield curve are useful economic indicators when exiting a deflationary period by way of an extraordinary monetary policy. I expect bond yields to rise in 2005 in jumps, as in 2004 and 2003, in response to evidence of economic growth, inflation, and continuing Fed rate hikes.
Did Malpass check with Kudlow on the latest NRO “theory” on the role of money in the economy? While I disagree with Malpass on the need for monetary restraint, it is because I disagree with him as well as with Kudlow on their assertions that the economy is booming. If one believes as they do, then one would agree with Malpass’s policy prescription and would disagree with Kudlow. So why does Malpass believe the economy is booming? Let’s check out his responses to various assertions of others:
Assertion: First-quarter growth was weaker than the reported 3.1 percent because inventories built up, adding to GDP, but subtracting from future GDP.
Response: First-quarter GDP will likely be revised up substantially – perhaps to 3.8 percent. Demand growth remained strong in the first quarter, so even after the inventory build, inventories are at low levels relative to sales, arguing that the inventory build is necessary and helpful to future growth. Inventories built in the first and second quarter of 2004 without causing a slowdown.
So Malpass knows the revision cannot be downward? Huh?
Assertion: The labor market still has slack. Said St. Louis Fed president William Poole in a May 11 speech, “Although unit labor costs edged modestly higher over the second half of 2004, growing at a 3% rate, their rate of gain in the first quarter of 2005 slowed to about a 2.25% rate … As the modest first-quarter gains in the employment cost index showed, the threat level is not terribly high … ”
Response: The labor market is tighter than widely perceived. Unemployment is 5.2 percent. Unit labor costs rose 4 percent in the third quarter of 2004, the most recent quarter with revised data, after being originally reported up 1.6 percent. Unit labor costs rose 1.7 percent in last year’s fourth quarter and 2.2 percent in this year’s first quarter, a brisk pace that is also subject to possible upward revision when actual compensation data surfaces from state unemployment insurance taxes.
All Malpass notes here is his own spin on compensation, which we’ll address in the next A&R. He fails to note that much of the decline in the unemployment rate is due to a fall in the labor force participation rate with the employment-population ratio still at only 62.6%.
Assertion: Real wages are falling.
Response: Pre-tax nominal wages rose 2.6 percent over the last year while the overall consumer price index (including gasoline) rose 3.1 percent. Real wages fell by this measure. But real wages typically decline well into an expansion and have done at least as well in this expansion as in the strong expansions of 1994 and 1986, especially on an after-tax basis. The wage measure being used to show the worst wage performance is for non-supervisory production workers, a group that is under particular pressure in a globalized economy. A broader inflation measure (the overall PCE deflator for all personal consumption) was up 2.4 percent, so real wages were higher than inflation by this measure.
Even using the PCE deflator, real wages are near the levels observed at the end of 2001. While total compensation has risen relative to the overall consumer price index, most of the increase in fringe benefits is simply covering higher health care costs.
Assertion: Consumption has risen to over 70 percent of GDP, so people are using up their savings.
Response: The rise in consumption per GDP is a long-standing trend for the U.S. economy. There are several reasons for this. 1) Investments are increasingly in the form of education and research, which show up in consumption. 2) For tax and other reasons, people seek capital gains rather than ordinary income. The proceeds show up in savings and consumption but not in GDP, distorting the ratios.
Maybe Malpass has forgot to read our discussions of how even his favorite measure – household net wealth – shows a decline in real per capita wealth over the past 5 years.
Assertion: The deficit is going to sink us. “We are approaching a trillion-dollar trade deficit,” said Sen. Harry Reid in the May 10 New York Times. “We can’t survive as a viable, strong country doing that.”
Response: I expect the trade deficit to get bigger and the U.S. economy to remain strong and prosperous. U.S. imports grow with the U.S. economy while exports grow with foreign economies. The U.S. trade deficit is being driven by capital inflows related to the demographic gap between the U.S. and other developed countries. With a growing population, the U.S. needs more capital than other countries do and benefits more from adding it. Conversely, with an older population, foreigners want to buy bonds even at today’s low yields, allowing the U.S. to capture the spread between the cost of foreign capital and the return on investments in the U.S. The U.S. trade deficit will likely grow until Japan and Europe undertake pro-growth structural reforms, developing economies get substantially bigger, or the demographic gap narrows.
Malpass suggests we are exporting more but exports have fallen as a share of GDP. As far as needing more capital because of our allegedly rapid population growth, Malpass ignores several things. Population is growing in other nations, while there is a debate in this nation about the consequences of all alleged slowdown in population growth in the U.S. But more importantly, the U.S. savings rate is very low, which is why we are running massive current account deficits. Maybe Malpass is talking about the late 1990’s when we did save and invest a lot more than we are doing now.
Assertion: Higher interest rates will slow the economy.
Response: Real interest rates are very low and haven’t risen much. Interest rates rose in 2004 and didn’t cause a slowdown. I think the Fed’s measured rate hikes have been acting as an accelerant to the economy, maintaining low real interest rates, giving assurance against faster rate hikes, allowing longer-term yields to stay low, and encouraging a “get it while you can” reaction.
The low interest rates over the past few years are a product of a weak economy. If the economy does get back to full employment, the low savings will mean that real interest rates will have to rise. Then again, I may have not seen the NRO economics paper proving the law of scarcity was repealed. But where did Malpass get this notion that a higher cost of borrowing will induce less savings and more investment? As far as whether real interest rate rose during 2004, check out what the Federal Reserve reports.