Not Hitting the Fan Yet

The dollar is now at a record low against the Euro, down more than 20 percent from its peak in 2002, down so low it’s about equal to a Canadian dollar.

So begins Robert Reich's blog post to which I referred on Friday. By my arithmetic the situation is even more extreme, with the dollar having lost about 40% of its value in Euros since the 2002 peak. But should the drop in the dollar between January 2002 and September 2007 really be a cause for concern in the US?

I don't see why. Most of the drop happened in 2002 and 2003, and the remainder has happened slowly over the subsequent four years, with a slight acceleration over the past few weeks. That's water under the bridge. If that drop in the dollar were going to cause inflation in the US, or to cause a drop in US real incomes, it would already have happened.

But incomes (on average) have continued to rise, and as for inflation, I think the figures in the August Personal Income and Outlays report (see Tables 9 and 11, along with historical data available here) should put to rest any immediate concern. Looking at my favorite inflation indicator, the market-based personal consumption deflator excluding food and energy, we have the following annualized (logarithmic) growth rates:

1 month    1.15%
2 months   1.34%
3 months   1.39%
6 months   1.18%
9 months   1.67%
12 months  1.61%
18 months  1.89%
2 years    1.87%
3 years    1.80%
4 years    1.70%
5 years    1.57%
6 years    1.56%

None of this suggests that inflation has yet become a problem at all. Given the presumed target of 1.5%, the recent data would even make a better case for worrying about deflation than about inflation. (Remember that food and energy prices can be quite volatile, so one shouldn't ignore the risk that, for example, a reversal in the oil market could send the full deflator quickly into negative territory.)

Though I have worried in some recent posts about the potential for a drop in the dollar to force the Fed into a stagflation regime, it needs to be emphasized that this worry is about the future and not about the present. If the s___ is going to hit the fan, this is actually a pretty good time for it to hit.

Conflicting Opinions

I know I should have been done with this last year, but after coming across this piece of Fedspeak reported by Mark Thoma, I couldn't resist.

You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve...

--Arthur Laffer, Founder and Chairman, Laffer Associates, Wall Street Journal, August 24, 2006

The Phillips curve is a core component of every realistic macroeconomic model.

--Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco, speech, Boston Fed Conference on Behavioral Economics, September 28, 2007


(Perhaps they keep the realists at the bottom of the duffle bag?)

For Richer or Poorer

Robert Reich (hat tip: Mark Thoma) says that the weak dollar is going to make Americans poorer (except for those who are rich enough to hedge against the dollar’s fall) and that “the real worry isn’t inflation” but “our pocketbooks.” Reich’s scenario is indeed what you get from a comparative static exercise in a simple full-employment model: when the terms of trade shift against you, you end up worse off, and (provided nobody expands the money supply) inflation isn’t an issue because falling prices outside the tradable sector (like, let’s say, in housing) offset rising prices for tradables.

But real life is not a comparative static exercise, and everything else doesn’t get put on hold when we go from an old equilibrium to a new one. In the past, the overwhelming tendency has been for the US (as a whole, anyhow) to get richer over time, and I doubt that the terms-of-trade shock, by itself, will be enough to reverse that tendency over the next few years. The US may get a recession, and that may make the US temporarily poorer, but if we are heading for a recession right now, it is in spite of, not because of, the falling dollar. Aside from the possibility of a recession, the US capital stock will continue to grow as usual, technology will continue to improve as usual, and, provided that the terms-of-trade shock is not too precipitous, improving domestic productivity will offset the deteriorating terms of trade.

What if the terms-of-trade shock is too precipitous? Then the US will get poorer, temporarily, but the long-run improvement in productivity will continue, and after a few years, we should catch up again. But a precipitous shock would lead me to question Professor Reich’s assertion that “the real worry isn’t inflation.” A sudden deterioration in the terms of trade would (as I argued in my earlier posts about labor cost targeting) put the Fed in a difficult position. Given the stickiness of many domestic wages and prices, the diminution of living standards that Reich foresees would not happen without a fight, and the result of the fight would be either inflation or recession. I would be more worried about either of those possibilities than I would about the fact that some people will have to make modest reductions in their standards of living.

It’s also not unthinkable that the falling dollar could end up improving US living standards, paradoxical though that may seem. The overvalued dollar has pushed a disproportionate fraction of US resources into the nontradable sector. One has to wonder whether this imbalance has damaged productivity growth. It’s a lot easier to imagine productivity growth happening in tradable industries like manufacturing and Internet-based services than in, say, construction and mortgage finance. Surely real investment will make a much greater contribution to productivity if it goes into plant and equipment for export industries rather than into residential housing. And as one who believes that there is more slack in the US labor market than is generally recognized, I hold out the hope that the stimulus from a weak dollar will help us discover that slack and give the US a Keynesian free lunch to offset the rising cost of the French wine we’ll be drinking with that lunch.

Professor Reich also suggests that the weak dollar will have a regressive effect on distribution, but again I’m skeptical. The tradable sector is where most of the good working class jobs are (or were, and presumably could be again). Reduced foreign competition will also put workers in a better position to negotiate a bigger slice of the pie in industries where there’s room for negotiation. If it becomes relatively more economical to produce in America, that’s no net advantage for the world’s capitalists (who will lose, for example, on European production what they gain on American production), but it will be a big advantage for the American workers who are available to do the producing.

Having said all this, I want to point out that, while the prognosis for the dollar is certainly not good, reports that the dollar is already dead have been greatly exaggerated. Yes, the dollar is at a record low against the Euro, but this doesn’t mean that the dollar has crashed. It just means that the dollar’s general downtrend, which has been in place for five years, is continuing, and that we happen to have been in a declining phase of the variation around the trend. There is a good chance that the dollar will keep going down from here and that the general trend will accelerate. But that’s hardly a foregone conclusion. Anyone who remembers the fall of 2004 should know to be cautious in extrapolating the weak dollar into the immediate future.

No Help

Today the Conference Board announced that in August, its Help Wanted Advertising Index fell for the eighth straight month, by a larger-than-expected 8% (using the integer numbers that the Board reports), to its first new all-time low since 1958. ("All-time" in this case means since 1951, when the series began.) This means that major newspapers in the US carried fewer help wanted ads than they did at the depth of the 1958 recession. This is despite the fact that the scale of the US economy, by any measure, has more than doubled since 1958. (In particular, there were about 51 million employees on nonagricultural payrolls in mid-1958, compared to 138 million today.) It's also despite the fact that many of the smaller local newspapers, which used to compete with the surveyed major newspapers for advertising, have gone out of business or been absorbed by the major newspapers during that time.

Part of the explanation is the emergence, over the past decade, of online recruiting as an alternative to newspaper-based recruiting. This is only a partial explanation, though, and it only helps explain the general downward trend in newspaper help wanted advertising over the past decade, not the specific decline this year. Online help wanted advertising, according to the Monster Employment Index, has been (uncharacteristically) roughly flat since March (over which time the Conference Board index* has fallen by 23%), though the Monster index has doubled between October 2003 and today. But in 2003, online help wanted advertising had only 19% of the market share vs. newspapers, so even the doubling doesn't begin to make up for the 36% drop in newspaper help wanted advertising over the same period.

Also this morning, ironically perhaps, we got the news that new unemployment claims fell below 300,000 in the week ended September 22, for the first time since May. There has been no pattern of rising unemployment claims this year while help wanted advertising has been steadily falling. Apparently, the US is experiencing a new kind of economic weakness -- one where the trailing edge of the labor market keeps steady but the leading edge stops advancing.


*UPDATE: Just to clarify, I'm referring to the index of newspaper help wanted advertising discussed in the previous paragraph. The Conference Board also has an index of online help wanted advertising, but I haven't started to follow it yet.

Fiscal Policy and Changing Times

To anyone who is familiar with opinions I expressed (in real life) about fiscal policy during the 1980s and 1990s, it may appear that my opinions have changed dramatically, or indeed, that I have completely reversed myself. In particular, anyone who knows what I thought of the Reagan tax cuts (and how harshly a coauthor and I expressed it even 15 years later) will probably be surprised to hear me defending the Bush tax cuts even as Alan Greenspan tries to disown them (not to mention that I spent six posts last year on why I'm not convinced by various arguments for cutting the deficit and one on why the one convincing argument doesn't apply for the immediate future). But I don’t believe my opinions have changed much; what have changed are the economic conditions.

In particular, nominal interest rates have generally been much lower during the new millennium than they were during either of last two decades of the old millennium. (I have a vivid memory of walking through Kenmore Square in Boston in 1992 reading in the Wall Street Journal that traders weren’t willing to buy 10-year treasury notes at a yield below 7%. Today the notes yield 4.6%, and people are surprised how the yield has risen since the Fed meeting.) As I argued in two posts in July, nominal interest rates determine both the harm and the good that can potentially be done by budget deficits. When nominal interest rates are high, deficits are unambiguously harmful. When nominal interest rates are low, deficits may still be mildly harmful, but they can also be helpful and can even become critically necessary when rates fall to near zero.

This all seems to me a fairly straightforward application of textbook macroeconomics: when interest rates are high, budget deficits push them higher and crowd out private investment; when interest rates are low, budget deficits can provide a useful stimulus to keep employment high and avoid deflationary conditions, since monetary policy may not be able to provide a sufficient stimulus. Of course it’s more complicated for an open economy, but the same argument applies to the world as a whole, and the US is a big part of the world economy.

It Depends Why You're Using the Word "Why"

Gabriel M. makes a good point about John Stewart's and Greg Mankiw's question, "Why do we have a Fed?" The answer not only depends (as I argued) on what alternative you have in mind; it also depends on what you mean by "why." The question can mean, "Why is it a good idea to have a Fed?" (Gabriel's answer: it's not. Obviously I disagree.) Or it can mean, "How did it come about that we have a Fed?" Only under a very optimistic view of history are the two questions equivalent. I would personally argue that the reasons given at the time for establishing the Fed were (approximately) valid and remain (approximately) valid today. But even with my relatively sanguine view of quasigovernmental institutions, I have to acknowledge both that the Fed's founders may have had ulterior motives and that the rationale they gave proved quite imperfect in many respects.


UPDATE: In a comment, Gabriel indicates that his answer to "Why is it a good idea to have a Fed?" is not as extreme as I stated above.

How to Solve the National Debt

Holy S___, Batman, Look at the Foreign Exchange Market!

In reaction to my last post about the s___ that may soon hit the fan and why labor cost targeting would help, Gabriel M. suggests that I discuss the nature of the s___ in question and how it came about. In a nutshell, the issue is that most economists (not all, but I would say the vast majority) think the dollar is significantly overvalued. For the moment, the market seems to disagree, inasmuch as interest rates on dollar-denominated bonds are not much higher than those on bonds denominated in, for example, euros. In theory, if people believed the consensus of economists, it would be a no-brainer for anyone with an international bond portfolio to dump their dollar assets and replace them with other assets such as euro bonds. (It’s implausible to me that the slight difference in nominal creditworthiness between the US treasury and, say, the German treasury, is enough to make this less of a no-brainer.) If everyone were doing that, dollar interest rates would already be significantly higher than non-dollar interest rates.

I don’t think I’m going too far out on a limb to say that, historically, when economists and the market disagree, the economists usually eventually turn out to be right (though the economists are usually wrong about how long it takes to get to “eventually”). A case in point is the last time the dollar was regarded as severely overvalued, in 1984. It may have taken an international agreement (the 1985 Plaza Accord) to get the dollar on a downward path, but once the decline started, it was beyond what international policymakers seemed able to control. Anyone who listened to economists in 1984 about the dollar, and then changed his mind when they turned out at first to be wrong, would have been extremely unhappy by late 1987.

I should note in passing that there were factors present in the mid-1980s that mitigated, and even reversed, the supply shock from the falling dollar. In 1985, when the dollar began to decline, the US was still recovering from worst recession since the 1930s, so there was considerable slack in the economy. (There may be considerable slack today, too, but that’s not the consensus.) Also, as a consequence of having shown itself willing to induce and prolong the worst recession since the 1930s, the Fed had a surplus of inflation-fighting credibility. And since the dollar had been continuing to rise until early 1985, there was something of a favorable import price shock already in the pipeline to offset the subsequent unfavorable one. Then in 1986, OPEC members were unable to reach agreement on new quotas, and the price of oil dropped dramatically, providing a favorable supply shock to (probably more than) offset the unfavorable shock from the falling dollar. Another factor was that many goods sold to Americans were (either explicitly or implicitly) priced in dollars, so the import price shock from the weak dollar was not as strong as it otherwise would have been. The same is true today, but less so.

Part of the reason that the dollar remains overvalued is that much of the investment in fixed income dollar assets comes from sovereign entities, such as the People’s Bank of China (PBoC) or the Saudi Arabian Monetary Authority (SAMA), that are less concerned about profit and loss than private investors. But even such entities are not entirely oblivious to profit and loss, and lately there are increasing signs of their desire to diversify away from the dollar. In doing so, they would also probably have to give up the currency pegs that have kept the dollar overvalued relative to their own currencies. SAMA gave the world a bit of a shock recently, when it uncharacteristically failed to echo the Fed’s interest rate cut. From China there are vague noises about the “nuclear option” of divesting of US bonds, which would entail dropping the dollar peg entirely. And China’s rising inflation rate is, one may presume, making it clearer to the Chinese authorities that continuing the peg in its current form is not in their national interest. So there are obvious cracks developing in the structure that has supported the overvalued dollar.

Another factor is the low national savings rate in the US, evident in both the negative personal savings rate and the federal fiscal deficit. With Americans not saving, the nation as a whole needs to attract capital from abroad, and that demand tends to keep interest rates high enough (relative to foreign rates) to keep the dollar from weakening too much. (My Keynesian self is telling me that is a big oversimplification, but I don’t want this post to get too long.) The risks here are (1) that (because of liquidity constraints due to falling home prices, or because of demographics, or just because of an attack of prudence) the savings rate could rise, taking away this support for the dollar, and (2) that, if the savings rate does not rise, foreign investors will lose confidence in the creditworthiness of the US and dump dollar assets until the dollar weakens or US interest rates rise.

The low savings rate in the US is necessarily offset by an excess of savings over investment abroad – the so-called “savings glut.” There’s a bit of a chicken-egg debate about which of these is the first cause, but from the point of view of the exchange rate, it doesn’t much matter. If the savings glut is the primary cause (a view to which I’m sympathetic), then the glut itself is arguably what has supported the dollar. However, the scenarios described in the previous paragraph still apply: (1) if Americans become no longer willing to absorb the excess savings, then the dollar will drop; (2) if international savers begin to think that the US is not a good place for their savings, then the dollar will drop. (The first of these scenarios – which I will call the “ice” scenario – is particularly troubling because, while it could be an inflationary shock for the US, it could at the same time be a particularly strong deflationary/recessionary shock for the rest of the world.)

So, whether or not it happens immediately, chances are there will be downward pressure on the dollar in near future, and we cannot assume that the market’s response will be orderly. If the dollar drops quickly, the price of imports would likely rise much faster than the US economy can adjust by shifting demand and production to domestic producers. That’s a classic example of an import price shock, and it would likely cause a rise in aggregate US consumer prices out of proportion with its relatively mild stimulative initial effect on US output (though the latter should increase over time). The shock will likely be exacerbated by rising commodity prices (including oil), as demand by stronger-currency countries pushes up the dollar price of commodities. (It’s debatable whether the last point has any real substance: most commodities are priced in dollars by convention, and their price in terms of some hypothetical “average” currency should not be affected by exchange rates. In theory, rising dollar commodity prices are just part of the original exchange rate shock, but when oil goes to $100, it will certainly get separate coverage in the media.)


Unfortunately, the prospects for anything even vaguely resembling explicit labor cost targeting are dismal at best. So I have left two great hopes for avoiding an unpleasant outcome for the US. First, that the rise in import prices will continue to be slow enough to avoid having much inflationary impact. Second, that there is more slack in the US labor market than the consensus recognizes, and this slack will absorb much of the price shock. Even if my hopes are realized, the outcome will be less than optimal, but then, when do we ever get an optimal outcome?

Shorter Case for Labor Cost Targeting

Look, there’s a good chance the s___ is going to hit the fan in the next few years, if not in the next few weeks**, with a crash in the dollar and a takeoff by commodity prices, especially oil. The Fed has 3 choices:

1. It can wait for the s___ to hit the fan and then do nothing.* Bond markets, product markets, and labor markets will lose confidence in the Fed’s resolve for price stability, and the result will be stagflation (a concept with which readers my age and older will be familiar from experience, but younger readers may have to use their imaginations).
   
   
2. It can wait for the s___ to hit the fan and then tighten aggressively. The result will be a major recession.
   
   
3. It can “announce” as soon as possible that it intends to target labor costs, and when the s___ hits the fan, do nothing.* The result, with any luck, will be a couple of years of high inflation rates, with normal economic growth, followed by more normal economic growth along with low inflation rates.
   

I’m just saying, choose what’s behind door number 3. It doesn't really matter if you're a capitalist or a worker or a rentier or a financial technocrat or what. It's just the best choice.


*That is, nothing except for a mild tightening to offset the economic stimulus from the weaker dollar.

**UPDATE: Let's say quite possibly in the next few weeks, if not in the next few days. The following item appears in my email this morning:

Venezuela’s state-run oil company has demanded payment for all future sales of crude and products to be in euros rather than US dollars, according to a letter to customers on September 21.

More about Labor Cost Targeting

Several issues arise in the light of Mark Thoma’s post about my last post. First, there is the distinction between labor cost targeting and wage targeting. Mark brings up the general argument for targeting sticky prices and/or wages (in particular as presented by Michael Woodford). To the extent that wages are stickier than prices, the theoretical argument would call for targeting wages, if one wants a simple policy (although more generally it should be an index of most wages and some prices). The problem with targeting wages is that it makes the inflation rate less predictable by taking away its long-term anchor. If productivity grows quickly, a wage targeting policy would imply a very low rate of price inflation (possibly even deflation); whereas if productivity grows slowly, a wage targeting policy would imply a higher rate of inflation. Productivity growth is notoriously difficult to forecast over long horizons, so the details of the long-term inflation rate become a wild card. I’m not sure I have a theoretically sound argument, but something about having an indeterminate long run inflation rate makes me uncomfortable. Certainly it has the disadvantage of making it harder to price long-term bonds.

In contrast, targeting labor costs would only permit temporary variations in the inflation rate in response to external supply shocks or distribution shocks. For example, a large increase in import prices would cause the inflation rate to rise in the short run, but eventually the domestic price level will adjust, and the inflation rate will go back to its long-run path. It’s true that the relevant long run could be very long: for example, the inflation rate has been higher than the labor cost growth rate for most of the last 16 years, as the chart in my last post shows, because the distribution of income has been shifting gradually toward capital. We don’t know if that shift will continue or reverse or how much longer it might continue, but we can be sure it will end eventually, because income shares can only vary between 0% and 100%. (Historically, income shares have in fact been mean-reverting. Possibly we are in a new regime now in which there has been a permanent increase in capital’s share, but for practical purposes, even if we can’t be sure it will mean-revert, I think we can rule out a large permanent increase in capital’s share beyond its current near-record.)

Which brings me to another point I wanted to make. Several people have objected that targeting labor costs would mean putting a limit on wage growth, potentially further shifting income toward capital. I would call this a “glass half empty” view of labor cost targeting. The “glass half full” view is that labor cost targeting would insist on wage growth (up to a point). Since we’re talking about nominal wages, it’s not clear to me that either of these two views really has much substance to it: no matter what happens to nominal wages, prices can still change in such a way as to render real wages either higher or lower.

It has been suggested that, if the Fed were programmed to react to large wage gains by tightening, that would give workers less bargaining power. But if you look at the past 15-20 years, it looks like the Fed might have been targeting inflation at around 2%; if instead the Fed had targeted labor cost growth at 2%, that means the Fed would have tolerated even larger wage gains than it actually did, so presumably workers would have had more bargaining power than they actually did.

I’m not inclined to give much credence to these kind of arguments about bargaining power anyhow, because the Fed would be targeting aggregate labor costs, whereas wage bargains are made in individual industries (or at individual firms, or, these days, more likely by individual firms dealing with individual workers). If, for example, auto workers are somehow magically able to bargain for a 20% wage increase, the Fed need not necessarily react, unless it expects workers in other industries to get the same wage increase. I don’t see how there is much loss of bargaining power.

It’s also important to realize that labor cost targeting does not necessarily mean reacting directly to labor cost growth in the short run. As I pointed out in my last post, the data in the short run are unreliable, and it wouldn’t be appropriate to put too much weight on recent data that could be revised or could be just a temporary blip. So even if everyone gets a huge wage increase, the Fed’s reaction might be delayed. In general, workers could probably expect enough delay in the Fed’s reaction to make them comfortable driving as hard a bargain as their particular circumstances seem to warrant, since the tightening might well come later on when employers are trying to raise prices instead of when the actual wage increases happen.

Furthermore, to some extent labor costs have a predictable business cycle pattern, and big increases in labor costs are more likely to precede a recession. Since the Fed would want to dampen rather than amplify the business cycle, it would not be well advised to tighten in direct response to a cyclical increase in labor costs. Rather, it should have a forecast of the cyclical behavior of labor costs, and it should tighten or loosen depending on what labor costs do relative to that expected cyclical behavior. Realistically, though, the forecast should also include a lot of other indicators, and the Fed would be concerned with the ultimate level of labor costs at some point in the future. Though unexpected cyclical behavior would be a reason to revise that longer-term forecast of labor costs, it might well be offset by other reasons relating to the other indicators involved.


UPDATE: Another point occurs to me, which sort of ties together some of the points above. With wage targeting, the "damaged bargaining power" school might have a stronger case, because wage targeting would attempt (though with only limited likely success over any short time horizon) to put a constraint -- one that could be anticipated in advance -- on the aggregate behavior of wages at any particular time. With unit labor cost targeting, there is no absolute intended constraint on wage growth, because the intended wage growth would depend on productivity growth, which (a) could not be known in advance, (b) would not be known with any reliable precision until quite a bit later, and (c) might well depend on other aspects of labor negotiations, or for that matter, on wages themselves.

Target Unit Labor Costs

Last year (here and here, with related posts here, here, here, here, here, here, and here – or just read the August 2006 archives and my post from yesterday) I suggested that the Fed should target unit labor costs. Upon additional thought, I still think so. I won’t go through the whole argument again, but I want to note a few important points:

1. I’m referring to targeting a forecast of labor costs (using a “price rule” that would correct for the failures of earlier forecasts), not trying to react to every wiggle in the reported series, which is reported with a lag, quite volatile and subject sometimes to fairly dramatic revisions. The idea is for the Fed to have a long-run stable growth rate of unit labor costs as its ultimate objective, upon which it could be judged after several years of hindsight, when the final revisions come in and the trends become clear.
   
   
2. The main purpose of this approach is to have a simple and easily understood (by the market) answer to the question of how to react to supply shocks. The appropriate response to supply shocks is a matter of great controversy in macroeconomics: should a central bank accommodate supply shocks and let the inflation rate rise temporarily in order to avoid a recession or a slowing of growth (or a boom, in the case of a favorable supply shock), or should it lean heavily against the inflationary impact (or the deflationary impact) of supply shocks in order to pursue an unchanged target inflation rate? The labor cost target settles the question: if the shock is to domestic productivity or to the labor market, then lean against the inflationary impact; if the shock is entirely outside the domestic labor market and production process, then accommodate (except to the extent that you expect the shock to have indirect effects on productivity and the labor market, such as might arise, for example, from sticky real wages).
   
   
3. If the Fed is going to adopt such a policy, now is the time to announce it – or rather, to let the idea of prioritizing unit labor costs find its way into the speeches of Fed officials, since that’s the way the Fed operates. All indications today are that we are heading directly into an unfavorable import price shock. How will the Fed react? The market shouldn’t have to make random guesses. Moreover, there is great uncertainty about the intensity of the shock, and to some extent, the direction (because oil is something of a wild card and could have a big drop in price just as easily as a big increase). We want to know now what reactions to expect when these uncertainties are resolved.
   
   
4. When today’s incipient shocks are fully realized, Fed credibility is going to be a big issue, especially with a relatively short-tenured Chairman and given the market’s response to this week’s Fed action. In the case of a severe adverse shock, if the Fed hasn’t specified in advance how it intends to react, it will face a choice between recession and loss of credibility. That’s not a situation that anyone will enjoy.
   
   
5. As the following updated chart indicates, the Fed can make a pretty good case that it has already been targeting unit labor costs since the early 1990s. (The old talk about a preferred inflation rate between 1% and 2% rings a bit hollow – in addition to being, in my opinion, a less than optimal target range for inflation. But unit labor costs have stayed pretty nicely in that range – although, in my opinion, it’s a less than optimal target for unit labor costs as well, and I would hope the Fed would go maybe for something like 2%.)

From the chart, it looks like we need a slowing of unit labor costs now to continue keeping in line with the target. But given the recent weakness in the labor market and simultaneous recovery in output growth, as well as various factors suggesting a high risk of recession, I think the central tendency of the Fed’s forecasts will be for slower labor cost growth anyhow. All in all, labor costs are still very close to the presumed target, so the priority at this point should be for maintaining stable growth rather than attacking a bulge in labor costs. (And if the Fed were to do as I prefer, and raise the target to 2%, there wouldn’t be any question.)

Keynes (quoted by DeLong) on Liquidationism

Brad DeLong digs up a nice quote from Keynes, which makes a point similar to what I was trying to argue here, here, and here. I can't claim that the recent US housing boom was either quite as benign or quite as productive as the investment boom of the late 1920s, but the same general principle applies. The behavior of investors in the late 1920s appeared quite reckless in immediate retrospect, but they obviously did more good than harm (or at least, the great harm that resulted indirectly was only because of subsequent bad policies). And we do now, of course, have to be concerned about the risk of inflation, which was not (or shouldn't have been) an issue in the early 1930s. But the idea that speculators have to be severely and broadly punished by the monetary authority for taking excessive risks -- that idea, I contend along with Keynes, is foolish. It is very hard to distinguish which speculative actions were ex ante prudent and/or valuable and which were excessive. It is (as the Fed now clearly realizes) not the job of the central bank to make such judgments after the fact (or, except in its regulatory role, before the fact). The mandate is for high employment and reasonable price stability, and it is not desirable that the mandate should be broadened to include assuring the right incentives for speculators.

Revised Smoothed Unit Labor Costs

Perhaps the most striking piece of data adduced by Allan Meltzer in arguing against an easing of monetary policy was “unit labor costs rising at a 5% rate.” It appears that he is comparing second quarter 2007 unit labor costs to second quarter 2006 unit labor costs to get that 5% growth rate. As I argued last year (ironically, arguing against Marty Feldstein, who went on to become Allan Meltzer’s major adversary in the recent debate),

...the right way to analyze these data is neither by comparing years to years nor by comparing fourth quarters to fourth quarters, but by smoothing the quarterly data over time to extract an estimate of the general trend.

I have updated the chart I made last year of the smoothed rate of unit labor cost growth, and the picture has not changed dramatically, though things do look a little bit more inflationary than they did a year ago. Certainly, my smoothed series does not suggest that that the 5% growth rate cited by Allan Meltzer is a very good indication of the general trend. The most recent smoothed growth rate is 2.5%, which, while it is higher than what today’s Fed would probably consider ideal, does not suggest that we are moving into a new regime of rapid labor cost growth.



It might also be worth thinking about what we should expect unit labor costs to do in the immediate future (or in the immediate past that hasn’t yet been reported in the data). Are there reasons to expect productivity growth to accelerate or decelerate? Are there reasons to expect compensation growth to accelerate or decelerate? To the extent that there are reasons for either, they go generally in the direction of accelerating productivity growth and decelerating compensation growth, so they point to a less inflationary trend in labor costs. Simply, the labor market is weak. With employment at a near standstill for the past 3 months, employers have little reason to raise compensation, and any significant output growth will have had to come in the form of rising productivity (since there is no indication that hours worked per employee is rising). Various indicators do suggest that output is still rising at a reasonable rate. (Also, I imagine compensation may take a substantial seasonally-adjusted hit when bonus time comes around for Wall Street and the mortgage and construction industries.) All in all, I don’t see much reason to be worried about rising labor costs.

Why do we have a Fed?

John Stewart asks the question, and Greg Mankiw echoes it, elevating the question from comedy to serious economics, or at least serious economic pedagogy. The problem, as I argued in the comments section of Greg’s post, is that the question is ambiguous unless you specify what alternative you have in mind. (Part of John Stewart’s comedy technique, it seems to me, is to ask oversimplified questions.) You need to ask, “Why do we have a Fed instead of X?” where X is some specific other possibility. Otherwise (in the words of my commenting self)

you're asking a lot of different questions, and no wonder there is no simple answer: Why do we have money instead of barter? Why do we have a huge, public central bank instead of letting private banks handle the function of "bankers' banking"? Why do we have fiat money instead of a commodity standard? Why do we have a discretionary central bank instead of a merely technical money-creation facility that would follow a set of legislated rules?

And now I will answer those questions.

Why do we have money instead of barter? Because barter is ridiculously inconvenient. Do I really have to go into the economic theory here?

Why do we have a huge, public central bank instead of letting private banks handle the function of "bankers' banking"? Because of economies of scale in central banking and the fact that an efficiently sized private central bank would have too much power. Before the Fed came into existence, the “central” problems in banking were often solved by temporary cartels. The last straw in private central banking was when J.P. Morgan solved a banking panic by essentially declaring himself the leader of an impromptu central banking cartel and demanding, successfully, that the other members do his bidding.

Why do we have fiat money instead of a commodity standard? Greg should be happy with “sticky prices” but I don’t even think we need to mention such theoretically troublesome matters. How about just the risk of hyperdeflation – when the monetary commodity becomes a bubble asset. This is roughly what happened during the early 1930s, and it was solved, separately in various different countries, by abandoning the commodity standard. Granted, sticky prices and wages made the hyperdeflation a lot more painful than it otherwise might have been, but isn’t avoiding hyperdeflation a good enough reason by itself?

Why do we have a discretionary central bank instead of a merely technical money-creation facility that would follow a set of legislated rules? One way to answer this is to say that there is no good reason and to spin some theory of conspiracies or vested interests or self-important macroeconomists standing in the way of progress. But I think there is a good reason. The reason is that our objective function for central banking is so complicated that it would be impractical to put it into a fixed set of rules. The rules would constantly run into problems when we realized that they were missing some detail that circumstances suddenly rendered critical, and Congress would have to have emergency sessions and appoint temporary central bankers to deal with the problems. We want a stable financial system (even though the system is constantly evolving); we want stable prices; we want stable interest rates; we want stable employment; we want this; we want that; … The macroeconomy is like a spoiled child demanding all sorts of subtle and incompatible things. Rather than trying to make the child (who, by the way, isn’t very good at making decisions, since he has to use the democratic process to do it) specify “I’m willing to accept X amount of interest rate variance in exchange for Y amount of inflation variance” and so on, isn’t it better just to appoint a wise and respected nanny to make the necessary compromises?

XFE vs. Trimmed Mean, etc.

Karl Smith’s objection to my whimsical call for a 175 basis point cut in the federal funds rate seems to depend on what price index is used. My preference was for the most recent 12-month change in the deflator for market-based personal consumption expenditures excluding food and energy:

The best price index we have is the market-based core personal consumption deflator, which gives an inflation rate of 1.7%…over the most recent 12-month period.

I really do think that’s probably the best simple indicator of the inflation rate (though without the constraint of simplicity I would make a lot of changes, such as using a weighted average rather than a 12-month figure, putting some nonzero weight on food and energy, taking other kinds of price indices into account, and so on). Rumor had it a few years ago that Alan Greenspan liked it too. Anyhow, Karl uses a slightly different PCE-based deflator:

Using the 12 month trimmed mean PCE deflator of 2.2, we get 4.3 rounded down to 4.25 for a 100 bps cut.

The difference in those inflation figures accounts for the difference in the interest rates prescribed by our respective Taylor rules. There are a couple of differences in the indices we use: mine excludes non-market based prices and all food and energy, whereas his excludes only the most extreme price changes, wherever those should happen to occur.

Though in real life I think Karl’s 100 basis point cut would have been a better idea than my 175 basis point cut (for reasons of interest rate smoothing and risks of market instability rather than basic Taylor rule considerations) and indeed, I think the Fed’s 50 basis point cut was probably just the right thing to do under the circumstances (given that there will be another chance at the end of October), I stand behind my preference of price index. Regarding the market-based feature, I’ve always preferred accuracy to comprehensiveness when it comes to price indexes, and I really don’t trust prices that have to be computed by statisticians rather than observed in a market context. And I have a couple of reasons for preferring the “ex food and energy” core to the “trimmed mean” core.

First, I see a core index not so much as a way of filtering out volatility (which, if you’re going to do it, shouldn’t you apply a time series filter as well as a cross-sectional one?) but as a way of filtering out price changes that specifically aren’t likely to be repeated. One thing much of the food and energy component has in common is that the prices are determined in speculative markets for storable commodities. Oil is the most obvious example: any change in the observed price of oil roughly represents a revision of the market’s best guess as to what the price of oil will be in the future, less storage and financing costs. If there’s a jump in the price of oil, and we want to know whether that jump will be repeated, we can infer that the people who know the most about it, on average, don’t think so. If they expected the jump to be repeated, futures traders would have bid up the prices of distant contracts, and spread traders would have bid up the spot price further in anticipation of purchases by arbitrageurs with storage capacity (who could sell the distant futures, buy the physical commodity at a lower price, and lock in a profit), and the original jump would already have been large enough to eat up most of the hypothetical repeat jump.

Granted “food and energy” is not the ideal proxy for “storable commodities with speculative markets plus goods and services whose prices depend primarily on such commodities,” but it’s a pretty good first stab. Excluding such items amounts to outsourcing part of the task of forecasting inflation to the private sector. When it comes to general macroeconomic conditions, the Fed may have better information than the market, but when it comes to pricing of specific commodities, it’s not really plausible that the Fed’s information is even as good as that of the market, where people with specialized knowledge (and often private information) stand to make and lose large amounts of money daily on price changes.

By contrast, if there’s a jump in the price of some non-speculative item – say, for example, hairstyling services – there is no a priori reason to think that the jump won’t be repeated. There are empirical reasons – price jumps tend not to be repeated – but without knowing something about the fundamentals of the hairstyling market, it’s hard to know whether a given experience is expected to represent the rule or the exception. So, at least as compared to oil prices, I would not be greatly inclined to exclude hairstyling services temporarily from my price index just because it had a big jump in one month or one year. To do so amounts to making a naïve inflation forecast, and if we’re going to make inflation forecasts, why not go to someone who knows how to do a better job of it, rather than just using naïve rules of thumb?

The other reason I like excluding food and energy is that I don’t think it’s optimal for the Fed to try controlling such prices. The point of controlling prices overall (the point, for example, of having an inflation target), as I see it, is to provide a nominal anchor for monetary policy, so as to avoid a situation where nearly all prices start rising at a faster and faster rate (roughly as they did in the 1965-1980 period). As I argued last year, the choice of nominal anchor is a matter of convenience. You could choose gold, but that turns out (as we learned in the early 1930s) to be a very inconvenient choice. You could also choose a comprehensive basket of goods and services, but that’s probably not the most convenient choice either.

If the price of important commodities such as oil were to continue rising rapidly year after year, it might necessitate a downward path for real wages. Given that nominal wages can be sticky downward, rather than forcing a difficult decline in nominal wages (and most likely one or several recessions) by trying to keep the overall price level stable, it would make more sense to let the energy component of prices rise while letting nominal wages remain stable. Taken to its logical conclusion, my argument might imply that the Fed should target wages, or some combination of wages and stickier prices. The details have yet to be sorted out, but it is clear that typically non-sticky prices, such as those that largely determine the cost of the food and energy component of personal consumption, are not a convenient part of the nominal anchor.

Unanimous

The Fed didn't quite give me the 175 basis point cut that I was calling for, but depending on how you look at things, it kind of almost did. You can divide the conceivable Fed actions into those that I thought might actually happen and those that were merely my fantasies. If you had asked me before the meeting about the possibility of a unanimous vote for a 50 basis points cut, I would have assigned it to the latter category. So at least things came out on the right side of the reality/fantasy divide.

The disappointing part, though, is that, now that the meeting is over, I won't get a chance to do a post on why the cut should be 200 basis points.

175 Basis Points

At the Open Market Committee meeting tomorrow (today if not yesterday or a month ago, by the time anyone is likely to read this), I recommend that the Fed cut its federal funds rate target to 3.5%. This recommendation is based on a direct application of the rule presented in John Taylor’s 1993 paper:

   r = p + .5y + .5(p – 2) + 2

where p is the inflation rate
and y is the deviation of output from potential

Today, the unemployment rate (if you divide the number of unemployed by the number in the labor force instead of using the one-decimal-place figure reported by the BLS) is within 0.01% of the Phili Fed SPF median NAIRU estimate of 4.65%, so y is zero.

The best price index we have is the market-based core personal consumption deflator, which gives an inflation rate of 1.7% (the very last number in this report) over the most recent 12-month period.

Plug in 1.7 for p and zero for y.

   r  =  1.7 + .5(0) + .5(1.7-2) + 2  =  3.55

which rounds down to 3.5



How on earth is Allan Meltzer (hat tip: Greg Mankiw) able to reach the conclusion that the target should remain at 5.25%?

Fire and Ice*

Marc Shivers of The Talking Fed notes the following new material from Ben Bernanke’s speech on Tuesday (referring to the way that current global imbalances might end, given Bernanke’s argument that they are caused by a global savings glut):

What implications would a gradual rebalancing have for long-term real interest rates? The logic of the global saving glut suggests that, as the glut dissipates over the next few decades and thereby reduces the net supply of financial capital from emerging-market countries, real interest rates should rise

Upon which the blogger comments:

He presumably leaves it as an exercise for the reader to figure out what implications a sudden rebalancing would have on long-term interest rates, like might happen, for example, if U.S. consumers collectively decided tomorrow that they no longer wanted to be the consumers of last resort for the rest of the world. I'm guessing this is what the FOMC was referring to on Aug 17 when they said "the FOMC judges that the downside risks to growth have increased appreciably."

Despite Bernanke’s research linking the two, though, I think we should be careful to separate conceptually the issue of the savings glut from that of the international imbalance. In principle it is possible to have either one without the other. One might ask separately the questions, “How (and when) will the savings glut end (and will it ever end)?” and, “How (and when) will the international imbalance end (and will it ever end)?”

In my own mind, I have an easier time imagining a more-or-less “permanent” savings glut than I do imagining a “permanent” international imbalance. The case that comes to my mind is the 1930s, when the world had a prolonged savings glut. Indeed the glut might have gone on indefinitely if the brilliant economists in Nazi Germany and Imperial Japan had not hit on an ingenious method for coordinating international policies.** During the course of the savings glut in the 1930s, however, there were some successful attempts to alter the international balance.

Ben Bernanke imagines that the global rebalancing will be the result of the elimination of the savings glut (just as – in his view, anyhow – the original imbalance was itself the result of the savings glut). Marc Shivers, on the other hand, imagines what might happen if the global rebalancing resulted from an intensification of the savings glut – that is, if the US joined the glut instead of the rest of the world ending the glut. He imagines that scenario as a sudden change, but it could also happen gradually.

In the sudden scenario, I think long-term interest rates would go down, but there is some ambiguity, because the inflationary impact of sudden weakness in the dollar might lead the bond market to anticipate tight money. In the gradual scenario, there isn’t much ambiguity: a gradually weakening dollar would not have a dramatic inflationary impact, so the bond market should anticipate easy money to stimulate an economy weakened by slowing consumer spending.

I see at least one reason to expect that “gradual widening of the savings glut” scenario: demographics. The children of the baby-boomers are now at the point of graduating from college or otherwise experiencing full emancipation. Without the expenses of caring for their children, baby-boomers – that bulge in the US age distribution – will have surplus income at a time when it is becoming increasingly difficult to ignore the specter of retirement. That realization isn’t something that happens overnight to everyone at once, but I imagine it will happen faster than the matter of decades over which Ben Bernanke sees the rest of the world regaining its appetite for real investment.


*The title is an allusion to Robert Frost, but frankly, I like Pat Benatar’s version better

**UPDATE: I guess the US has tried something similar recently, but the international coordination doesn't work unless you attack a country that has allies. Just like George W to screw things up ;)

Top 25 Economics Blogs on Del.icio.us

			number
rank			of saves
1		Freakonomics	3152
2		Marginal Revloution	1132
3		The Big Picture	890
4		The Becker-Posner Blog	707
5		Brad DeLong's Semi-Daily Journal	644
6		Greg Mankiw's Blog	570
7		Calculated Risk	296
8		Economist's View	292
9		EconLog	273
10		Mish's Global Economic Trend Analysis	259
11		Econbrowser	249
12		Cafe Hayek	228
13		Daniel Drezner	226
14		Asymmetrical Information	205
15		New Economist	189
16		Nouriel Roubini's Blog	189
17		Environmental Economics	156
18		Tim Harford	136
19		Free Exchange at Economist.com	132
20		Angry Bear	129
21		Knowledge Problem	120
22		The Sports Economist	111
23		Oligopoly Watch	110
24		macroblog	107
25		Dani Rodrik's weblog	106

This information is provided with no warranty. The original list from which I worked was created by searching on "tag:economics tag:blog" in del.icio.us. For me to consider a site an economics blog, it generally had to have at least one URL bookmarked with "economics" as one of the top two tags and "blog" as one of the top four, and I eliminated some sites just because they didn't look like blogs to me. I tried to combine the number of saves for multiple URLs pointing to the same site, but there were undoubtedly some that I missed, and the decision as to what constitutes "pointing to the same site" was a subjective one. (I also ignored bookmarks pointing to particular posts within a blog.)

I'm working on a more comprehensive list (maybe the top 150, or something like that), but I may just give up, because this is turning out to be a lot harder than I expected. Maybe it will get easier if del.icio.us develops better search tools.


UPDATE: Corrected spelling of "Posner" and "Harford".

100 Basis Points

Even I won't call for a 100 basis point cut in the federal funds rate target this month. But Greg Mankiw has unwittingly made me realize that a quick adjustment to his rule-of-thumb Taylor equation would argue for just so large a cut.

To start with, Eddy Elfenbein of Crossing Wall Street does the calculation (hat tip: Greg Mankiw) using Greg's original rule of thumb

    Federal funds rate = 8.5 + 1.4(Core inflation-Unemployment)

and gets 5.088. Rounded to the nearest 25 basis points, that's 5.00, exactly what the current consensus expects from the Fed this month.

But in the original Taylor rule, it's not the unemployment rate, but the difference between actual and potential output, that shows up in the equation. Okun's law would justify using the unemployment rate instead of output, but the implicit assumption of Greg's equation is that "potential unemployment" -- which is to say, the NAIRU -- is constant over time.

In practice, the consensus estimate for the NAIRU has fallen dramatically over the past 15 years. In the early 1990s, 6% was a sort of canonical magic number (and, as I recall, Greg himself argued in December 1994 that the NAIRU was significantly higher than that). According to the Philadelphia Fed's latest Survey of Professional Forecasters, the median estimate today is 4.7% -- a difference of 1.3 percentage points from the early 90s. (Note on the chart on Crossing Wall Street that the Greg's rule tends to come out below the actual funds rate in the early years and above in the later years -- which suggests that the Fed was in fact doing something similar but with changing NAIRU estimates.)

So let's make the assumption that Greg's rule applies in the very middle of that transition -- when the consensus NAIRU estimate was half way between 6.0% and 4.7%, or 5.35%. Now write the more general rule:

    FFR = C + 1.4(Core inflation-(Unemployment-NAIRU))

plug in 5.35 for the NAIRU, and solve for the constant C:

    8.5 + 1.4*(I-U) = C + 1.4*(I-(U-5.35))

Rounding to the nearest tenth, we get

     C=1.0

(That value sounds divinely ordained; doesn't it?) Plug in today's 4.7% consensus NAIRU estimate, and you get

     FFR=1.0+1.4*(I-(U-4.7))

or

    Federal funds rate = 7.6 + 1.4(Core inflation-Unemployment)

Plugging in 4.647 for unemployment and 2.210 for core inflation, as per Crossing Wall Street, gives

     Federal funds rate = 4.188

which I'm happy to round up to 4.25


UPDATE: I just checked the Survey of Professional Forecasters, and I now realize my mind was rounding up the median NAIRU estimate from 4.65 to 4.7. Using the accurate median of 4.65, and making the same "middle of the transition" assumption about Greg's rule, would reduce the calculated target federal funds rate by 3.5 bps, to 4.15, so it still rounds to 4.25.

All for the Want of a Nail

I’m going to pick on Jeff Miron again, and in this case my only source is a couple of paragraphs in Monday’s Harvard Crimson (hat tip: Mark Thoma), so I won’t pretend that I’m really being fair to him, but I think these paragraphs are representative of a point of view that is in need of attack:

Miron...expressed less sympathy than others for the subprime lenders and borrowers, who he suggested are playing the roles of both perpetrator and victim in the current crisis.

"The subprime event is not that big a deal. It’s a small part of the economy. There will be some foreclosures, banks will lose money. That’s life. That’s capitalism. They took risks, and they lost. Policy should not bail out people for greed and stupidity, or their risk taking."

As it happens, I do think that we should have some compassion for subprime borrowers and lenders, not necessarily out of general compassion but for the reasons I discussed here. But I see that compassion as a minor issue. The fact that interest rate cuts (for example) would help these people, is one additional pebble in the balance that weighs toward my advocacy of interest rate cuts, but by itself this factor is not enough to make 25 basis points worth of difference in my opinion on the federal funds rate target. Is it possible that this factor – and the associated “moral hazard” issue – weighs 25 basis points worth (or more) against interest rate cuts for some people? It seems like it does, and that seems foolish to me, but let’s get to the main issue:

The subprime event is not that big a deal. It’s a small part of the economy.

Quantitatively speaking, it’s certainly true that the volume of subprime loans is small compared to the size of the economy. But does that observation justify the conclusion that “the subprime event is not that big a deal”? To me, it seems that the question should be rhetorical, because the obvious answer is “no,” but apparently others don’t find that answer to be obvious. And (assuming that the Crimson quoted him correctly and that he intended those two propositions to be logically connected) I’d have to say that, from my point of view, Jeff Miron doesn’t seem to understand what’s going on.

I’ll allow that Mr. Miron was quoted out of context (by both the Crimson and me); that the reporter probably surprised him when he was thinking about something else, and he didn’t get a chance to think through his answer; that he probably didn’t feel he needed to be too careful about his words when he was talking to the college paper. But when we take into account indirect effects, the subprime event is a very big deal. Subprime may be “a small part of the economy,” but LIBOR – which rose about 35 basis points because of the subprime fallout (in spite of a large drop in T-bill yields at similar maturities) – is not small: as far as short-term lending is concerned, LIBOR is most of the economy.

If it were just a matter of a few institutions that made subprime loans and had to recognize some losses because defaults were higher than they had planned, that would have been a virtual non-event in the grand scheme of things. But the subprime risk is not concentrated in a few institutions – or, to be more precise, maybe it is; we just don’t know where the hell it is, and that’s the problem. Can one say that walking across a minefield is “not that big a deal” because the actual mines underlie only a small fraction of the total area? When you suddenly find that institutions in France and Germany are close to toppling because of a small problem in the US, you’ve got a big problem, because people start to lose confidence in the whole global financial system.

And that’s just the beginning. Another effect of the subprime crisis has been diminished confidence in the bond rating agencies. When investors don’t know which bonds are safe and which aren’t, it becomes hard to borrow money by selling bonds. This has not been a big problem for traditional investment-grade corporate bonds outside the financial sector, but it has been a big problem for lower-rated bonds, and it has been a huge problem for just about any kind of asset-backed security that doesn’t seem to have a government guarantee. One of the results is that it has now become difficult and expensive – even for prime borrowers – to get a mortgage for any property that doesn’t conform to the requirements of government agencies or government-sponsored enterprises. (A particular case in point is the oversized “jumbo” loans that are now required to purchase even many mid-level houses in the post-boom coastal areas.)

And then there is the liquidity crisis. With all the uncertainty about the quality of loans and institutions, the institutions themselves face increased withdrawals of capital and increased uncertainty about withdrawals. At the same time, with all the uncertainty about the quality of bonds and other assets, these assets become more difficult to sell. Leverage is forcibly unwound. Failures cascade. Many of the failures occur outside the banking system and therefore outside the direct influence of central banks. Assets deflate. Otherwise solvent institutions become insolvent. Disintermediation further weakens the financial system.

Job losses in construction, finance, and home furnishings also have multiplier effects. In the financial chaos, with even prime borrowers facing difficulties in purchasing new houses, house prices could fall below fundamental value, and households will be bound by more stringent liquidity constraints and forced to curtail consumption. Financial problems abroad can be expected to dampen improvements in the US trade balance. Damn, I’m really talking myself into forecasting a recession now. Anyhow, to reiterate my original point, even though the subprime problem is a small part of the economy, it is a big deal.

Inflation Worries?

Tim Duy is worried about inflation:

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop. Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar.

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

Considering Professor Duy’s apparently high inflation expectations and my low expectations (see point 3 from yesterday), this might be a good occasion for a wager. Unfortunately, pseudonymous persona that I am, I don’t think I’m permitted to make wagers. But if Professor Duy is a betting man, he can get plenty of action from my friend Mr. Market. I see the 10-year T-note quoted at a yield of 4.31%, while the 10-year TIPS is quoted at 2.12% -- a spread of 2.19%, even slightly narrower than the 2.20% where it closed at the end of August. I’ve been keeping track of the month-end closes of this spread, and August 2007 was the narrowest close since October 2003. So if anyone wants to bet on higher inflation, Mr. Market is offering rather attractive terms.

Realistically, one has to recognize that the TIPS-to-nominals spread is narrow in part because of a liquidity premium in the TIPS yield, given today’s thirsty market conditions. So I’m not entitled to say with confidence that the bond market anticipates a CPI inflation rate of 2.19% over the next 10 years or that its anticipated inflation rate is lower than it has been since 2003. Nonetheless, since the yield on nominal T-notes should include a premium for purchasing power risk, and since, by now, TIPS are not all that much less liquid than nominal T-notes, I think it’s fair to say that the bond market doesn’t share Professor Duy’s sick feeling.

75 Basis Points

As long as we’re talking about what I think the Fed should do rather than what I think it will do, why stop at 50 basis points? What I think the Fed should do is move – in one dramatic step – from an officially “restrictive” interest rate policy to an officially “neutral” one. As I argued in the last post, 4.75% is not yet neutral. 4.50% is still not my idea of neutral, but many people will accept it as neutral, and if the Fed describes it as “neutral”, the market will accept that description. With a financial crisis and declining employment, it makes no sense to continue with a “restrictive” policy.

I realize there is a theoretical advantage to small steps in monetary policy, but this past cycle has made me question whether that advantage exists in reality. The idea is to take a small step, observe the results, and then decide whether to take another small step. The problem, though, is that you don’t really get to observe many results until it’s too late. After the Fed started its “measured pace” tightening phase in 2004, there were almost no macroeconomic results to observe until 2006. The big result, ultimately, was that houses (at any given price) became harder to buy – and harder to hold on to if you had an ARM. That result is fairly obvious today – more than 3 years after the tightening phase began – but it was almost imperceptible as recently as the winter of 2006. Moreover it wasn’t until late summer of 2006 that we saw any indication of the effect that result is now clearly having on economic growth. So the idea of doing something and observing the results appears not to be very useful when it comes to the relevant time frames for monetary policy.

When it comes to financial results, as opposed to macroeconomic results, it’s not clear that gradualism even has a theoretical advantage, at least in an environment like today’s. To stop panicking, a market needs to see dramatic action. The Fed has made valiant attempts to undertake dramatic actions that don’t involve its interest rate target, but so far those actions apparently have not been dramatic enough. Apparently, you just can’t have a tight money policy and an easy money policy at the same time.

I think there is a more general theoretical case to be made against gradualism, at least when it comes to “first moves,” in which the direction of movement in the policy variable changes. It’s kind of like menu costs and Ss pricing. After the central bank has maintained a certain policy for a significant period of time, there is a cost to changing it. Indications that might, under other circumstances, argue for a small change in policy, are outweighed by the disruption that a “first move” in policy would cause, and by whatever other “menu costs” are associated with monetary policy. But at some point, the argument for change becomes so strong that it clearly outweighs these “menu costs”. At that point, the optimal policy change is necessarily a large one – because, if the optimal policy change were a small one, then the optimal policy (given the menu costs) would be no change at all.

To put it another way, under normal circumstances, the choice is either do something, do nothing, or sort of do something. Under those circumstances, sort of doing something (e.g., changing the funds rate target by such a small amount that the change can’t be expected to have much real impact) is often the best choice. But when the action being contemplated is a reversal in the direction of policy change, the option of sort of doing something doesn’t exist, because anything you do will be noteworthy. So if nothing is clearly the wrong thing to do – and that is surely the case for the US today – then for Heaven’s sake do something!

50 Basis Points

I don’t expect that the Fed will cut the federal funds rate target by 50 basis points at its next meeting, but I do think that would be a good idea. (This conversation started on William Polley’s blog, but it’s going to get too long for a comment.) I see every reason to prefer erring on the side of too much stimulus rather than too little:

1. With the release of the payroll employment figures for August, as well as the revisions for June and July, not to mention the widely expected prospect of additional downward revisions when the real data on births and deaths come in, we face the serious possibility that the US was already in a recession when August’s financial crisis hit. (That’s in addition to the possibility that we went into a recession in August, and the possibility that the effects of the financial crisis will tip us into recession over the coming months.) If it turns out that the recession began before the financial crisis, we will be experiencing a deepening recession over the coming months, and
   
   
2. that recession could get really ugly. Although I made optimistic noises last year about the tractability of any possible recession, I am becoming increasingly worried about the possibility of a policy-resistant recession. Consider that
   
   
   • the international savings glut is still with us, and, if anything, it’s about time for the US to join the glut rather than playing the hero, as
     
     
     • American households have had a negative personal savings rate for two years, and this is unlikely to continue given the now more limited prospects for capital gains on assets and more restricted access to low-priced credit.
       
       
     • America’s children are about to graduate from college, which puts Mr. and Mrs. America at the point where it’s time to stop worrying about the kids and start panicking about inadequate retirement savings.
       
       
     • tax cuts are going to expire soon, and the Democratic congress is unlikely to extend them.
     
     
   • If the international savings glut should disappear, then we face the prospect of a potentially stagflationary fall in the dollar, which would inhibit the use of policy to end the recession.
     
     
   • A conventional monetary stimulus may in any case prove ineffective, given the “once bitten” status of the housing market and the unresponsiveness of capital spending. I don’t think Ben Bernanke wants to be in the position of having to use his helicopter.
   
   
3. By the standards of the last 50 years, the inflation rate is damn low. The 12-month growth rate of the core consumption deflator is within the target range. Inflation expectations are well-contained by almost any reasonable measure – with median expected 10-year CPI inflation (according to the Philadelphia Fed’s Survey of Professional Forecasters) recently falling below the 2.5 percent level where it has spent almost all of the past 10 years. The weight of risks is overwhelmingly on the side of too little growth rather than too much inflation.
   
   
4. From an economic point of view, monetary policy will still be tight, even after a 50 basis point cut. If you take the rule of thumb that the neutral real overnight interest rate is 2%, and add that 2% to the core PCE inflation rate, you get 3.9%. OK, maybe you don’t buy that – so make it 4.2%, or even 4.5%. But 4.75%? No way is that a stimulus policy.
   
   
5. The longer-term prospects for the dollar are dismal, but at this moment, everyone wants dollars – probably because so many foreigners are trying (or being forced) to unwind levered positions in dollar-denominated assets. Instead of saying, “Let them eat euros!” why not give them the dollars now, and you can take them away later if necessary. If the stimulus turns out to be ”too much” from a business cycle point of view, so much the better from an “orderly foreign exchange markets” point of view. When the world has had its fill of dollars and the thought of the dismal US international investment position starts to cause indigestion, it will be just in time for the Fed to prevent a free fall by raising interest rates in the face of an overheating economy. I’m not advocating exchange-rate targeting, and under normal circumstances, I would say that the Fed should ignore the value of the dollar (except to the extent that it alters the picture for expected employment and inflation). But after so many years of huge and growing current account deficits, these are not normal circumstances; the Fed needs to worry about how potential exchange market instability might constrain its future actions.
   
   
6. History will forgive a recently appointed central banker for overreacting to a financial crisis. (It surely forgave the former Chairman when he overreacted to the stock market crash.) History will not deal so kindly with a central banker who allows the economy to fall into an intractable recession. When the Emperor smells smoke, even if the odor is rather faint at first, he had best put down his fiddle.
   
   
7. One of the mistakes of the last easing cycle was not to cut aggressively enough in the beginning. Ultimately (we can say with hindsight) the easing cycle went too far, but it definitely started too slowly. The Fed was also too slow to ease in 1990-91. The Fed has a lot of inflation-fighting credibility today, and should the economy seem to move in the direction of overheating, the Fed can take back any easing moves without having lost much ground. But you don’t get a second chance to prevent a recession.
   
   
8. All the reasons that I have given already are things the financial markets can figure out for themselves. If the Fed only cuts by 25 basis points this month, markets will have good reason to expect another cut in October. If the Fed cuts by 50 basis points, it can credibly avow a reasonable hope that no further cuts will be necessary.

Monetary Policy Targets

Pondering my last post, I got to thinking: Why stop with LIBOR? Why not target commercial paper yields? Or even maturing junk bond yields? In practice, there are a couple of reasons I wouldn’t suggest such things. First, I don’t trust the rating agencies enough to make them partners in monetary policy. (The definition of what is being targeted would have to be standardized on the basis of ratings, which means that any upgrade or downgrade would change the de facto target.) Second, market-specific problems could distort the economic meaning of the policy. (The latter is already an issue, though, because problems specific to the banking system can distort the economic impact of a federal funds rate target.) But I still think that, in theory, targeting risky interest rates is a good idea.

Here’s my argument: The Fed sets its policy based on an economic forecast, which contains some implicit or explicit assumption about the price of risk. If the price of risk changes, there ought to be some automatic mechanism for altering policy so as to offset the change in the forecast. Targeting risky interest rates would be such a mechanism. (This is essentially the argument I made last month about why a cut in September would make sense.) In fact, the Fed already does this to some extent by targeting the federal funds rate: if the price of risk rises, so does the spread of the funds rate over the risk-free T-bill rate, and the Fed acts to push down the risk-free rate so as to keep the funds rate constant.

But if automatic policy adjustment is a good idea, why stop with risky interest rates? Why not, instead of targeting a single interest rate or reserve aggregate, target some linear (or nonlinear) combination of economic and financial data. (I’ve always thought, for example, that while targeting a single monetary aggregate makes little sense, the aggregates do contain information about how Fed policy is affecting the economy. I’d like to see them be part of such a composite target.) Seems to me that, with today’s technology, it is quite feasible to put monetary policy on autopilot between meetings instead of fixing some particular interest rate (which is kind of like just a primitive version of autopilot). And the formula could be announced and followed by the markets, as any competent quant could program her spreadsheet to mimic the Fed’s spreadsheet. And the decision at a meeting would be, not whether to change an interest rate target, but whether to adjust the autopilot parameters. OK, I’m dreaming, but…

The Fed Funds Puzzle

Greg Mankiw has a post today about “the LIBOR puzzle” – the observation that LIBOR has recently moved up even while other interest rates (such as the 3-month T-bill rate and the expected federal funds rate) have moved down. (In fact, a lot of interest rates that businesses and consumers actually pay have moved up, but these typically are too idiosyncratic to produce the nice statistical series that economists like.)

As I said in Greg’s comments section, I don’t find this to be much of a puzzle: there is the T-bill rate, which is risk-free, and then there is the LIBOR spread – the price of LIBOR counterparty risk – which typically moves in the opposite direction except in response to unexpected news about inflation or Fed policy. The spread (typically <1%, though it is higher at the moment) is normally smaller than the T-bill rate (typically >3%), so the movements in the T-bill rate are usually larger in absolute terms; thus the sum of the two – namely LIBOR – usually moves in the same direction as the T-bill rate. The only difference now is that the spread has moved more than the T-bill rate in absolute terms; thus the sum – LIBOR – has moved contrary to the T-bill rate. It just happens that we’ve experienced a shock which has had more effect on credit spreads than on the level of risk-free interest rates. That’s actually what you might expect from a large shock to the financial sector: since it has only a small expected effect the real economy, it produces a relatively small change in the risk-free interest rate; since it has a large effect on financial conditions, it produces a large change in the risk spread.

You can read more of my ideas about this in the comments section of Greg’s post, but I want to bring up something that has puzzled me for a while. It’s an institutional puzzle. Since the Humphrey-Hawkins Act, the Fed’s primary responsibility has been the management of the US macroeconomy. That being the case, why does the Fed choose to target an interest rate which

1. has little direct relevance to the US macroeconomy and
2. is not under the Fed’s direct control?

Wouldn’t it make more sense to target, say, LIBOR, off of which many interest rates in the US are priced, and which in any case reflects the general cost of the type of risky credit available to private sector agents in the US? Or, alternatively, wouldn’t it make more sense to target, say, the 3-month Treasury bill rate, which the Fed could (if it chose to do so) control with great precision by making a market in T-bills at a temporarily fixed bid and offer.

I presume the Fed has its reasons for targeting the federal funds rate, but if I, in my ignorance, were asked (and I’m just as glad I won’t be) to design a monetary policy, I think I would start by coming up with a LIBOR target and then estimating the expected spread between LIBOR and T-bills, and then I would fix the T-bill rate such that the expected LIBOR would equal the target. Then I would monitor the spread and adjust the T-bill target as the spread changed over time.

In extreme circumstances (like right now, perhaps), it might be necessary to free up the T-bill rate to deal with issues in the banking system. Perhaps under today’s circumstances I would maintain the bid for T-bills but temporarily stop offering them, thus placing a ceiling on the T-bill rate. That’s actually roughly what the Fed has done with the federal funds rate, except that it can’t enforce the ceiling precisely, and it is making a vague pretense to putting a floor on the funds rate, even though the data seem to show zero as the only floor.