3 Potentially Ominous ideas from Yellen’s Speech
Janet Yellen gave a speech today at the Jackson Hole conference. Here are 3 parts from her speech that are noteworthy and somewhat ominous…
1. “For example, as I discussed earlier, if downward nominal wage rigidities created a stock of pent-up wage deflation during the economic downturn, observed wage and price pressures associated with a given amount of slack or pace of reduction in slack might be unusually low for a time. If so, the first clear signs of inflation pressure could come later than usual in the progression toward maximum employment. As a result, maintaining a high degree of monetary policy accommodation until inflation pressures emerge could, in this case, unduly delay the removal of accommodation, necessitating an abrupt and potentially disruptive tightening of policy later on.”
If the Fed gets too far behind the curve (I think they are already way behind the curve), we could see a dramatic situation where the Fed must react by raising the nominal base rate abruptly. That would be dramatic.
2. “Second, wage developments reflect not only cyclical but also secular trends that have likely affected the evolution of labor’s share of income in recent years. As I noted, real wages have been rising less rapidly than productivity, implying that real unit labor costs have been declining, a pattern suggesting that there is scope for nominal wages to accelerate from their recent pace without creating meaningful inflationary pressure. However, research suggests that the decline in real unit labor costs may partly reflect secular factors that predate the recession, including changing patterns of production and international trade, as well as measurement issues. If so, productivity growth could continue to outpace real wage gains even when the economy is again operating at its potential.”
I think she is wrong here. Productivity is already constrained against the effective demand limit. So productivity will not grow as she says. If labor share was to fall further (productivity rising faster than real wages), that would further constrain productivity putting downward pressure on real wage gains.
The better scenario would be real wages rising faster than productivity, since productivity is already constrained. Then we run into the ramifications of decreased profit rates for firms and their willingness to share those profits. This scenario has led to many economic contractions in the past.
3. “Of course, if economic performance turns out to be disappointing and progress toward our goals proceeds more slowly than we expect, then the future path of interest rates likely would be more accommodative than we currently anticipate.”
This scenario would be dramatic. She is describing a situation that the economy starts to form a possible recession as is happening in Europe now. As a reaction, the Fed would loosen projected monetary policy, basically keeping the Fed rate stuck at the ZLB. The result would be going into the next recession with a zero lower bound… again. There would be a lot soul-searching at the Fed or a lot of finger-pointing.
So if the economy grows fast, the Fed will tighten and markets will react. If the economy slows down like Europe, monetary policy will loosen again and we fall back to the ZLB. How does the Fed steer the boat away from a storm? Grit your teeth and tie yourself to the mast. There are ominous hints of high-drama in the future.
I still don’t understand why there should be a business cycle caused recession. In the absence of a mechanism that causes aggregate demand to exceed effective demand, why should aggregate demand and effective demand (and GDP) not just grow with population?
Which recession in the past was caused by business cycle rather than by bursting bubbles or policy changes or oil price shocks?
Edward,
I see us plodding along about the same as we have been. So the 3rd scenario seems the most likely.
Most of us have full time jobs or are retired, and we have adjusted to our incomes. There is a much smaller group drawing unemployment which certainly does not replace their former incomes. There is also a much smaller group which has exhausted their unemployment eligibility and is working part time because they can not find full time jobs. Those last 2 groups are undoubtedly feeling the income pinch. Then we have the unemployed who are no longer eligible for unemployment checks and they must be in a much worse position. In this environment, how is it possible to believe the employers would have to raise wages or hire more full time employees? Therefore incomes should continue at about the current levels. (In the aggregate.)
Now let’s look at Total Household Debt because if that could be increased then the economy might still have legs. Total Household Debt peaked at $12.675Trillion in the 3rd quarter of 2008. It then dipped to $11.153Trillion in the 2nd quarter of 2013 before it started to rise. It rose back to $11.650Trillion in the 1st quarter of 2014 and then dipped in the 2nd quarter 2014 Total Household Debt down to $11.632Trillion. Total Household Debt appears to be stabilizing at a level about $1Trillion less than the peak which seems realistic given the prior fraudulent or poorly underwritten mortgages. And also given the poor state of the overall economy.
So incomes are not likely to improve significantly and consumer debt is about as high as it can get.
I do not foresee exports bailing us out of this. Japan has been in the doldrums for decades, Europe is looking worse by the month, and China seems to be degrading too.
So we are stuck. Stuck because we refuse to do the one thing that we control which would create more domestic jobs. That is force the return of domestic production by using tariffs.
There will be a recession, that is our post war history. If for no other reason, it will happen because companies misjudge the consumer market,and overproduce thus creating excess inventories. That would require a correction which usually involves layoffs.
There are already some news reports saying that automobile companies are resorting to increased leasing to move inventory. Leasing is less profitable over the long run, so the automobile companies try to avoid it.
Edward:
“where the Fed must react by raising the nominal base rate abruptly. That would be dramatic.”
Are you suggesting raising Fed Rates to slow down the economy?
Run,
The time to raise the Fed rate was a couple years ago, and then raise it slowly. Firms get used to it. But now firms are used to the zlb. Any rise in the Fed rate would be considered drastic. The economy is like students who have gotten used to grade inflation. The moment you tell the students that grades will be harsher, they get all stressed out. But really you are just trying to put the gradind system back where it should be.
Basically I am saying that the Fed is way behind the curve, so get ready for some drama.
Edward:
And what in 99 leading up to 2000? Did Fed Rates provoke an un-needed recession?
Arne,
The business cycle will top out at the effective demand limit in terms of the utilization rates of labor and capital… not total utilization , but % utilization. That is the key.
Once the economy hits the ED limit.it can stay there for a while. Eventually marginal firms begin decaying and losing funding, or they have overextended their plans. Then those marginal firms make other firms more marginal. The process takes time. How much time? That depends on many factors. I see the process being shorter this time. Less innovation. Less tolerance for fraud. Also the Fed will have to react faster than people expect.
Run,
In 2000 the Fed may have thought the natural real rate had risen above 5% due to GDP reaching 7%. If so, they raised the Fed rate properly. But looking back, that growth was over-estimated. It was not real. So from where we sit now, we cannot blame them.
Ultimately firms had overextended their growth plans. The economy tended toward reality, and marginal firms began to appear. The recession then formed. It seems Greenspan could not deny the inflated expectations of the internet revolution. He like others overestimated the growth. The high Fed rate back then reflects that. That is what I get from my analysis.
Edward:
Does raising the Fed Rate have an impact on the economy or not? Did raising the FED rate give way to a recession or not? It appears to me the economy would have corrected itself over time and Greenspan raising the Fed Rate only made it worst. From that point, PR started a much severe decline in the amount of Non-Institutional Civilian Population in the Civilian Labor Force from which we never really corrected. Compliment it with the growth of service as compared to manufacturing Labor.
Greenspan’s meddling in the economy with Glass-Steagall from 1983 onward and in 1999-2000 coupled with a failure to apply fiscal stimulus by the radical side of Congress who wish to apply austerity measures has brought us to where we are today. Why all of this effort to whitewash Greenspan?
Run,
From my perspective, raising the Fed rate when there is spare capacity (UT index above 4% let’s say) helps balance the expansionary phase of the business cycle. Raising the rate when the UT index is below 2% has an impact to control overheating the economy beyond its natural limit.
We should not see firms push too much beyond the effective demand limit because firms have sophisticated monitoring of costs and revenues with computers. However, the Fed’s forward guidance may have encouraged firms to overshoot the natural limit. So we would see more firms turn marginal if the Fed starts to raise the Fed rate.
At the natural limit, the Fed rate should hit a point equal to the natural real rate plus the inflation target. If firms have planned appropriately for the natural limit without overextending their growth plans, the Fed rate should be stabilizing at the natural limit. However, firms tend to overextend their plans. So firms begin to become marginal (vulnerable to decaying profits) at the natural limit. Then the Fed rate at that point does affect them. Also, if some firms try to push beyond the natural limit in order to avoid becoming marginal, the economy will show signs of overheating in the aggregate. Then the Fed will respond with a higher rate, and more firms will instantly become marginal.
So looking back at the years before the 2001 recession, Greenspan was doing pretty well according to the data available to him… for example, the CBO number of the output gap showed that a highly inflationary gap. Real GDP was much above real potential. My numbers from the way I determine potential GDP show that real GDP was sitting between the recessionary gap and inflationary gaps. So from my stand point, he should have moderated the Fed rate some. But he did not have my numbers. He had numbers from the CBO showing that he was pushing the limits of the inflationary gap. There was not much inflation, but there were concerns because the CBO was showing such a high inflationary gap.
So Greenspan did the best he could with the data that he had. He just had bad models and bad data. My model of the ED monetary rule would have corrected the bad data because it does not use the CBO potential number. It incorporates potential by relating labor share to the utilization rates of labor and capital. But not even I had my model back then… so there were mistakes made in retrospect…
I am not whitewashing Greenspan, as much as I am understanding what he did and the weaknesses of model and data available at the time.
Edward Lambert wrote “So Greenspan did the best he could with the data that he had. He just had bad models and bad data.”
I would be more willing to accept this logic, if he had not fallen for the Ayn Rand agenda decades before. I doubt that Ayn Rand’s philosophy was ever an excepted part of college taught economic theory.
See the transcript here:
http://www.pbs.org/newshour/bb/business-july-dec08-crisishearing_10-23/
—————————- Start of Extract ——————————–
REP. HENRY WAXMAN: The question I have for you is, you had an ideology, you had a belief that free, competitive — and this is your statement — “I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We’ve tried regulation. None meaningfully worked.” That was your quote.
You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. And now our whole economy is paying its price.
Do you feel that your ideology pushed you to make decisions that you wish you had not made?
ALAN GREENSPAN: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to — to exist, you need an ideology. The question is whether it is accurate or not.
And what I’m saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I’ve been very distressed by that fact.
REP. HENRY WAXMAN: You found a flaw in the reality…
ALAN GREENSPAN: Flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.
REP. HENRY WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?
ALAN GREENSPAN: That is — precisely. No, that’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”
—————————- End of Extract ——————————–
Paraphrasing Waxman repeating Greenspan’s statement. He had an ideology, his judgement was that free competitive markets are by far the unrivaled way to organize economies. And we had TRIED regulations and none of them worked in a meaningful way.
Read further. He is still hedging, he is not sure how SIGNIFICANT or PERMANENT the ‘flaw’ would turn out to be???
I conclude that he had a agenda and the rest of us paid for it. He shouldn’t get a passing grade. He flunked modern economic practicum.
It is important that those in power take their share of the blame for the Great Recession. He was the intimidating EXPERT. He earned plenty of blame.
JimH,
I do not for a second agree with Ayn Rand.I do not like Greenspan’s affinity with Ayn Rand.
However, setting the proper Fed funds rate is a separate question. You can do your best to set a proper Fed funds rate while you promote the ideology of Rand. I think that Greenspan tried his best to set a proper Fed rate with the models and data available to him.
It wasn’t the Fed rate that caused the severity of the crisis, but the deregulation and shenanigans related to Greenspan giving the green light to all kinds of free market “innovations” (cynical quotes).
Edward Lambert wrote: “It wasn’t the Fed rate that caused the severity of the crisis, but the deregulation and shenanigans related to Greenspan giving the green light to all kinds of free market “innovations” (cynical quotes). ”
I believe that the severity of the Great Recession was due to ignoring consumers growing problems with stagnate wages, for at least a decade. Stagnate wages caused consumers to withdraw equity out of their homes which masked the income problems in the GDP stats.
Getting back to the year 2000, I would have expected the Fed to monitor lending more closely. If they had done that then they would have noticed that homeowners were removing very large amounts of equity from their homes.
See page 16 Table 2 line 1 “Free cash resulting from equity extraction [(2)+(3)+(4)]”:
http://www.federalreserve.gov/pubs/feds/2007/200720/200720pap.pdf
Year——Free Cash——Disposable Income—-Percent Increase
1997———$276.0————-$6148.9———————4.48%
1998———$346.9————-$6561.3———————5.29%
1999———$467.2————-$6876.3———————6.79%
2000———$553.4————-$7400.5———————7.48%
2001———$626.9————-$7752.3———————8.08%
Note: Dollars are in billions. Free Cash is from Table 2 line 1 of the study. Disposable Income is from BEA Table 2.1 “Personal Income and Its Dispositions” line 33. Percent Increase is my calculation for the increase in disposable income caused by Free Cash extracted.
I would expect those additional consumer funds to raise consumption and GDP. In my opinion if they wanted to reduce that borrowing out of equity then the Fed Funds Rate was the wrong tool.
Inflation looks reasonably good. GDP does not seem to be increasing rapidly.
The only statistic that I can see that they might have been looking at was Unemployment which was 4.3% when they started raising the target rate in June 1999 and it was down to about 3.8% in April 2000 before they raised the target rate to 6.5% in May 2000. Unemployment was 4.2% in January 2001 and it went up to 5.7% by the end of 2001.
From: http://data.bls.gov/timeseries/LNS14000000
Note: Then set range of years from 1996 to 2003 and click blue GO button.
See Fed Funds Target Rate here:
http://research.stlouisfed.org/fred2/series/DFEDTAR
They began to raise the target in June 1999 taking it from from 4.8% to 5.0%. They raised it up to 6.5% by May 2000. They took it back down to 6.0% in January 2001. The recession began February 2001.
I believe that the Fed brought on that recession with their increases in the target rate. When they were done unemployment was on its way up. Maybe that was the intent.
Fed Beige Book – 16 June 1999
From: http://www.federalreserve.gov/fomc/beigebook/1999/19990616/default.htm
“Persistently tight labor markets have resulted in many reports of increased wage pressures, especially for some specific industries and skilled occupations. Chicago, St. Louis, and Richmond report upward wage pressures in almost all sectors, while other districts report more scattered wage increases. For example, retailers in the Boston district report a recent increase in the use of higher wages as a recruiting tool, while a large retail chain in New York notes increased wage pressures primarily for entry-level positions. In Dallas, wages have risen for truckers, secretaries, legal assistants, and workers with technical skills. Similarly, wage changes in San Francisco have been generally limited, but increases were noted for some types of workers. Cleveland and Philadelphia report that wage pressures have generally been held in check, but rising benefits costs have become more common. The Kansas City district is an exception, as wage pressures there appear to have eased somewhat from previous surveys.”
What specific statistic do you believe caused the Fed to change the Fed Funds Target Rate?
Jim:
Greenspan did not like Labor either.
Run has a good point… Greenspan did not like labor. Labor power meant inflation tendencies could get out of control. He thought it better for firms to set wages according to market conditions, instead of labor asking for more than they should.
Yet, JimH, what statistic caused the Fed to start raising the Fed rate in 1999 and 2000?
For one, I look at the output gap. The CBO was reporting that real GDP was way over potential. That was a sign of impending inflation tendencies. Yet, core inflation only started to rise in mid 2000. But not much.
Look at this graph…
http://research.stlouisfed.org/fred2/graph/?g=Iwo
The CBO output gap (green line) was positive and very high hitting $400 billion. It had never gone much over $250 in real terms before that. In the moment that the output gap started to surpass $250, the Fed rate started to rise. Such a high positive output gap was a signal for potential inflation, and the stock market was rising too. The high positive output gap supported the idea that the economy had changed to one of higher productivity through the internet revolution.
However, look at the purple line, that is how I measure the output gap. My measure was going down, which would have been a signal that there were little inflationary pressures and that it was definitely not the time to raise the Fed rate. Slack was building. But the CBO was showing a story of high inflationary gap, while I see a falling inflationary gap.
It is similar to the problem now, where the CBO is showing a massive negative output gap, while I see a positive output gap. I would recommend the higher Fed rate now instead of the zlb. Whereas in 2000, I would have seen the opposite and recommended a lower Fed rate. The CBO gets slack wrong a lot from what I see.
But realize, if you blame Greenspan for the mistake of mis-reading slack back in 2000, they you would also have to blame Yellen and company now for mis-reading slack. That is how I see it.
So the problem is not Greenspan or even Yellen, it is a problem of calculating slack.
The key to seeing slack is to understand effective demand.
Look at the situation now, Does the Fed really believe the stock markets can keep setting records for 3 more years? After all, it is the firms that have to hire the slack.
But in retrospect, Greenspan set a Fed rate that was too high for the true underlying conditions.
I thought that the Fed’s goal was to control inflation while at least considering unemployment. Fearing that inflation might develop does not seem enough reason to adjust the Fed Funds Target rate.
Adjusting the Fed Funds Rate now is a little different. It is effectively set at its lower limit. Reducing it to that limit was reasonable but it should have been seen as temporary and after 2 or 3 years it should have slowly been increased. We needed to see the real economy, so that corrections could be forced into place. Now they no longer have that control mechanism.
Frankly I don’t consider the stock market any kind of indication of the health of the economy. It is one part confidence poll, and one part gambling hall where the gamblers are trying guess what other gamblers will do next.
Your discussion of slack leaves me wondering if it should be used prospectively. Probably better to wait until inflation actually raises its head. The problem for me is that while consumers are accumulating new debt, they are masking problems. I don’t believe that you can put that into an equation. And perhaps there are also other factors which could mask problems.
The truth is that economics is at a very primitive stage. Those who seek to understand or control the economy need to have a little humility. And allowing a personal bias to creep into decisions is dangerous.
JimH,
I read an article justnow that helps to understand how the output gap played a role in setting the Fed rate in 1999. There were debates on what the real output gap was. Greenspan I think, as well as Yellen, must follow the CBO projection of potential.
But here is the link to the article written in 2001…
http://www.frbsf.org/economic-research/publications/economic-letter/2001/may/the-science-and-art-of-monetary-policy/
From what I see in my effective demand equations, they got the output gap wrong in 1999, and they are getting it wrong again now…
Edward,
Thanks for the link. That economic letter does help me understand their public explanation of their methods.
Unfortunately principle 1 and 3 leave enough room for bias to creep in.
“The output gap is the difference between something we can measure (real GDP) and something we can’t (the economy’s potential output level).”
(Skipped text)
“A similar problem had beset the Fed during the 1970s. Then, the problem was the productivity slowdown.”
I believe that it is just about impossible to use the economic policy in the 1970s and up to 1986 as an example, since the dramatic oil price increases were severely distorting the economy. Outside forces were arbitrarily and dramatically raising prices and employees still had the power to get raises or quit and find another job paying more money. That dynamic obviously causes inflationary cycles because the outside forces will raise prices again to protect their prices.
See my 2 part response to another post here for statistics:
http://angrybearblog.strategydemo.com/2014/08/understanding-piketty-part-2.html#comment-1252500
And in the principle 3 discussion.
“If the forecast says inflation will rise, the central bank should act to slow the economy down—it doesn’t wait until inflation actually has increased.”
You believe that they misjudged the economy’s potential output and you may be correct. But we should all reserve the right to judge the Fed based on results.
The public should be very skeptical if the overall effect of Fed polices tends to act in favor of business, to the detriment of the working class! In 2000 they stomped on employment and thus wage increases!
I believe that Fed policy has at times been helpful to the overall economy, especially for the garden variety recessions. So I am not in favor of getting rid of it. They may at times get it wrong and when they do then they will have to take their lumps just like everyone else. More transparency would be helpful. I believe that five years is too long for the release of meeting minutes.
JimH,
There is iron in your words…