125 Basis Points

Is it time for another Fed meeting already? How time flies when you’re watching CDO tranches get downgraded from top quality to junk!

I just want to point out that the Taylor rule is still calling for a federal funds rate of 3.5%, and there are 125 basis points left to get there, so by this measure, the FOMC’s job has barely begun. Since the last meeting, the (12-month market-based core PCE) inflation rate has fallen (from 1.7% to 1.6%, rounded) and the unemployment rate has risen (from 4.6% to 4.7%, rounded, but mostly due to rounding), so if anything, the target would be even lower. But with quarter-point rounding in the funds rate target, the combined effect of these changes is not enough to change the result.

As to what the FOMC will actually do this week, I’ll go with the consensus of 25 basis points. As Mark Shivers suggests, there are persuasive arguments to be made for either 0 or 50, and the arguments are sufficiently persuasive that neither of these options can be chosen, because either one would imply a strong rejection of the other. Although the financial crisis has clearly diminished, it may not have diminished as much or as quickly as the Fed had hoped, and part of the reason for its diminishing is the expectation of another rate cut. Depending on how you read the beige book, there either are or aren’t indications that the crisis is affecting the real economy, so the appropriate rate cut is either 50 basis points (to nip this trend in the bud) or 0. An individual might make the choice by flipping a coin, but a committee makes it by splitting the difference.

As for my serious opinion of what the FOMC should do, I think I would go with 50. A 75 basis point cut would risk too much financial market (and foreign exchange market) instability, but even a more conservative Taylor rule would call for at least 50. (Say, for example, we reduced the target inflation rate from 2% to 1.5% and increased the natural real federal funds rate from 2% to 2.5%. That would increase the target funds rate by 75 basis points, leaving 50 still to go. Personally, I’d rather stick with the original rule if we’re going to use Taylor rules at all, but I’m open to choosing a higher inflation reading than my 1.6%.) Some of the arguments I made in September no longer apply (e.g. the temporarily robust dollar, falling employment), but most of them still do, and the bottom line is that even 4.5% qualifies as a slightly restrictive policy, not appropriate when the core inflation rate is still low and 65% of Americans expect a recession (hat tip: Barry Ritholtz).

I could also point out that, while the financial crisis has diminished, the underlying housing problem has gotten worse (and by worse I mean worse relative to expectations). Here in eastern Massachusetts (home of the world champion Boston Red Sox!), where a year ago it was difficult to find anecdotal evidence to support the statistical finding that house prices were declining, it is now difficult to avoid the anecdotal evidence. At dinner Saturday evening, for example, the waitress told my wife about how she and her husband were planning to move but underwater on their mortgage and hoping the bank would accept a short sale. With the personal savings rate still near zero, declining house prices are likely to be a drag on consumer spending for quite a while, and the risk that the we could discover a nonlinearity in the response sometime soon – particularly with oil prices making new record highs and credit conditions fairly tight – is palpable. When and if we hit that nonlinearity, it will be too late to prevent a recession.

Democratic and Republican Approaches to Social Security

Democrats want to raise the income ceiling to pay in, while Republicans want to means test payments. In other words, Democrats want to tax labor (since social security contributions are determined by labor income), while Republicans want to tax capital (since most of the recipients’ additional income, which would be subject to means testing, is income from capital, either directly or indirectly). So, remind me again: which party is the workers’ party, and which is the capitalists’ party?

Backward Oil

Interesting article in the Wall Street Journal Weekend Edition (starting on the front page of the print edition). Over the past 12 months the price of oil has risen by about $21/barrel. But that’s just if you want the oil right now. The futures price of oil for delivery 2 years hence has only risen by about $8/barrel.

A year ago, the oil futures markets were in contango, meaning that distant futures were more expensive than spot oil. There is a theory that contango is normal for most commodities, since by buying distant futures, you can avoid storage costs (including the cost of financing inventories) and therefore should be willing to pay more than if you had to store the commodity yourself. Apparently, a year ago, the contango was too severe to be explained by storage costs. The usual explanation is that traders were worried about demand oustripping supply in the future – so much so that they were willing to give anyone with storage capacity a strong incentive to use that capacity. That has to be only part of the explanation, though. The other part is that oil producers were not so worried about demand outstripping supply in the future; otherwise they would have put off production into the future (expecting prices to rise) and driven up the spot prices. So presumably the contango happened because speculators were more bullish on oil than producers were. (I guess the speculators got it right this time – so far anyhow.)

But as I understand it (from casual reading: I’m no oil expert), contango is not normal in the oil market. The situation today – known as backwardation – where spot prices exceed distant futures prices – is apparently much more typical. The standard “theory of normal backwardation” (due to John Maynard Keynes) is that producers, being risk-averse, are willing to accept lower prices on distant contracts in order to lock in a price rather than being subject to unpredictable price changes. That theory works even for competitive markets, but I’ve heard that there is something else going on in the partially monopolized oil market – namely that OPEC (and perhaps Saudi Arabia in particular) deliberately tries to keep spot supplies tight in order to maximize its control over spot prices. In other words, it’s not because producers sell the futures; it’s because they refuse to sell enough of the spot.

I wonder if what’s going on is an interaction between producer expectations and producer capacity constraints. If producers a year ago (and in recent years in general) expected prices to fall (as some of their public statements suggested, though such statements are often seen as untrustworthy), they would have an incentive to produce at full capacity. And if, for example, Saudi Arabia was producing at full capacity, it might also have had an incentive to increase capacity so as to have more control over prices in the future. If capacity has subsequently increased relative to demand, and if the Saudis have begun to doubt their forecasts for falling prices (which one could imagine they might have, since the forecasts keep being wrong), then we’re back to the old situation where they hold back on production to keep control over spot prices.

I’m not sure if this makes sense. I’m not sure what it means. I’m not sure if it’s bullish or bearish for oil. But it seems really interesting.

Core Inflation and Price Stability

I’ll begin with a hypothetical question: If half the prices went down by 10%, and the other half went up by 10%, would that be price stability? If you have faith in the General Price Level, you may answer yes, but since the General Price Level has never revealed itself to me, nor did my parents teach me to believe in it, I must ask, “How can it be price stability if none of the prices are stable?” As a price level agnostic, I have to think that “reasonable price stability” (a phrase from the Fed’s mandate in the 1978 Humphrey-Hawkins Act) requires that at least some prices (perhaps as many prices as possible) be stable.

Now, food and energy prices are nearly impossible to stabilize, because they are so volatile, and because it’s extremely difficult, except over very long time horizons, to distinguish temporary fluctuations from longer-term trends. (One could, I suppose, choose a particular food or energy price and stabilize it by intervening directly in the market, but I think most people can agree that would not be a reasonable policy.) Given that food and energy prices cannot reasonably be stabilized, does it make sense to make a half-hearted attempt to stabilize them at the expense of destabilizing most other prices?

Many prices, on the other hand, can be reasonably stabilized, primarily because the people who actually set those prices prefer them to be stable and will be willing partners (up to a point) in any attempt to stabilize them. I would argue that pursuing “reasonable price stability” does not mean sacrificing Isaac or Iphigenia on the altar of the General Price Level. Rather, it means using monetary policy to discourage the aforementioned naturally stable prices from exiting the realm of stability.

You can see (I hope) why I think that the core inflation rate is more relevant to the Fed’s mandate than the overall inflation rate. You may say that I am just playing semantic games here, but I believe the semantics have substantive importance. For one thing, my reference to human sacrifice is not entirely metaphorical: the human cost of attempts to stabilize the general price level can be quite high when volatile commodities face upward price pressures.

More to the point, perhaps, the semantic problems with attempting to stabilize the general price level are indicative of the danger that such attempts will backfire even with respect to their semantically questionable objective. Food and energy commodities are typically traded in speculative markets, and speculative markets have been known to exhibit both excessively persistent trends and very dramatic reversals. I don’t think I need to remind anyone of what NASDAQ stocks did between 1995 and 2003. Suppose the same thing were to happen to oil. (It very well may be happening, though I don’t mean to suggest that I expect a reversal.) Suppose oil prices were to rise persistently for 5 years and then reverse dramatically. A central bank bent on achieving “general price level stability” would be forced to keep the economy weak for those first 5 years so as to drive down other prices and compensate for the rising price of oil. When oil prices began to fall rapidly, the economy would be weak, and the non-energy part of the economy would already be experiencing falling prices. Before the central bank’s reaction to the reversal had a chance to affect most prices, the “general price level” would be dropping dramatically. (The same logic also applies in reverse, if you imagine oil prices falling for 5 years and then suddenly jackknifing upward and consider what the general inflation rate would look like.)

It’s interesting to consider alternative core measures, such as the Cleveland Fed’s median CPI or the Dallas Fed’s trimmed mean measures, in the light of my agnostic semantics of price stability. A literal application of those semantics would suggest that means and medians are the wrong kinds of statistics to use. Rather, it is the mode of the price distribution that should be of concern if the objective is to stabilize as many prices as possible. My last example, though, suggests that the purely statistical month-by-month trimming of a price index is not an adequate approach. The prices that need to be stabilized are not the ones that have recently been most stable but the ones that are most likely to be stable in general. While there may still be a good case for ignoring outliers in the price distribution, there is an even better case for ignoring prices that are generally unreliable.

Core For: More

Barry Ritholtz replies in the comments section of my earlier post about core inflation:

By framing the issue the way you did, you get one answer.

I prefer a different set of questions. These of course generate a different set of answers.

My questions:

1) What is the actual rate of inflation?

2) Why does the BLS model (the official inflation rate) vary so greatly from the real world experience?

3) What are the Fed policy repercussions of the spread between the two?

4) What does this mean to consumers? Investors? Savers?

I am not surprised that traditional economists have circled the wagons around my attack on the credibility of BLS and the Fed. Thats what all Guilds do when they sense a challenge to their authority . . .

He has more on his own blog, but let me try my answers. I first note that these questions, as he stated them originally, mostly relate to the full CPI, not particularly to the core CPI. The core is not “the official inflation rate,” nor should it be. At least in my view, the “official inflation rate” should measure what prices in general have done retrospectively; it gives us information about the past, and the core would be the wrong information. To the questions,

1. What is the actual rate of inflation?
   
   It depends on what you mean, specifically, precisely, operationally, by inflation. It is a mistake to think there is one “true” inflation rate, because different prices are changing by different amounts and in different directions, and because quality is changing in ways that affect different people and different businesses differently, and because the effects of these changes – even on an individual – are often impossible to measure. How can we know, for example, how much it is worth to have a more powerful computer for the same price? In most cases, all we can do is make an educated guess, and depending on how one chooses to educate the guess, many different reasonable answers are possible.
   
   It is also a mistake to go (as Barry Ritholtz seems to do in the post cited) directly from the premise that “inflation is primarily a monetary phenomenon” to the conclusion that inflation should show a consistent quantitative link with a particular measure of the money stock. The relation between inflation and (any particular definition of) money depends on the evolution of payments technology and potential output. In particular the finding that the CPI diverged from M2 and M3 starting in the mid-90s tells us very little: either productivity really did start growing more quickly (in which case we should expect such a divergence) or else it didn’t.
   
   
2. Why does the BLS model (the official inflation rate) vary so greatly from the real world experience?
   
   The question is not very meaningful unless you can specify what you mean by “real world experience” and demonstrate that it differs from the BLS model. If you mean subjective “real world experience,” then I’m inclined to blame psychology rather than measurement for the difference.
   
   
3. What are the Fed policy repercussions of the spread between the two?
   
   OK, never mind. On his own blog, Barry changes the question:

   Why does the Fed Focus on the Core rate, and not the actual rate? What are the Fed policy repercussions of this?

   To the extent that the Fed does focus on the core rate, it does so primarily for two reasons (and more which I may discuss in a later post):
   
   
   • Using short-run (e.g, 1 year or less) measurements, the core rate has generally proven to be a better predictor of future inflation than the full rate.
     
     
   • The core represents items with relatively sticky prices, so price pressures on the core do more damage than price pressures on noncore items. In particular, downward price pressure on the core causes recessions. Because noncore prices are more flexible, the damage is absorbed by prices before it can cause distortions in quantities.
   
   The repercussion, over the past 5 years of rising energy prices, is that we have had 5 years of economic growth when we could have had an ongoing recession.
   
   
4. What does this mean to consumers? Investors? Savers?
   
   To consumers, it means more of them have jobs than otherwise would. It also means that the decline in their real incomes has come in the form of price increases rather than wage cuts, so they can (wrongly) blame it on the Fed rather than the scarcity of oil. (It is always nice to have an institution to blame instead of an abstract concept.)
   
   To investors, it means that, in retrospect, they should have owned TIPS instead of nominal bonds. By the way, the Treasury is still selling TIPS, if you want ’em. Unfortunately, just as in 2002, we lack perfect foresight as to what the noncore component of inflation will do. It may go down, and you may get screwed owning TIPS. But if you want a secure real return, it’s available.
   
   To savers, I’m not sure what it means. Barry has a wee bit of a point that, by focusing on the core without making sufficient qualifications, the Fed may be misleading people into thinking that the core is the actual inflation rate, and savers will be disappointed when it comes time to spend their savings. I don’t see this as a reason to de-emphasize the core for policy purposes but as a reason to be more careful when speaking about it.

If traditional economists are circling the wagons around the core, that’s because it really is a better policy target. (As to BLS methods, that’s another question entirely, about which Barry and I might be able to find some common ground...but this post is already too long.)

The Seven Effect

A lot of people have compared the recent financial crisis to the crisis of 1907. It’s interesting that the time difference is exactly 100 years, but it’s easy to call that a coincidence. The modern economy hasn’t been around long enough, hasn’t provided enough data to say whether the 7th year of a century has been a more likely occasion for a financial crisis, and there’s no particular reason (that I know of) to think that it would be. But it’s vaguely interesting that both years end in 7: there are enough years ending in 7 that one could look for a correlation in the actual data if one thought there were any point in doing so.

The story gets more interesting in the light of a piece by financial historian Harold James (hat tip: Greg Mankiw). Without any apparent inclination to look specifically for sevens, he comes up with three years that he thinks are better parallels for 2007: they are 1837, 1847, and 1857. Since only 1 in 10 years end in 7, the chance of pulling 3 such years by random chance is 1 in 1000. That’s looking like statistical significance, considering that we already had an empirical basis for the hypothesis that there is something special about 7. Thinking back over the last two decades, I also recall that that the great Asian financial crisis began in 1997, and the US stock market crash happened in 1987.

Perhaps this is still all coincidence, but it seems that, if someone could think of a reason why financial crises are more likely in years ending with 7, it would make sense to listen to that reason. (Maybe the “lucky number” 7 makes people more inclined to take imprudent risks? Maybe there is a pattern of confidence-building during each decade, and it reaches an unstable point after 7 years?) Anyhow, this “seven effect” should fit nicely into my delusional system, along with the nine-zero effect wherein decades boom at the end and crash at the beginning.

What is the core for?

Suddenly I have so much to say about the core CPI, in response to the latest attacks by Barry Ritholtz and Daniel Gross. I've already said most of it in comments to a post by Brad DeLong (also note kharris' insightful comments) and one to the original Barry Ritholtz post. I may reproduce some of them in future posts here, but my last (thus far) comment (from the DeLong post) is probably what needs to be said first:

There are really 3 separate questions here:

(1) What is the best measure of retrospective changes in purchasing power?

(2) What is the best indicator of the general trend in prices (with respect to what can expected in the immediate future)?

(3) What is the best target for monetary policy?

For the first question, obviously the full index is better than the core, and nobody denies that.

For the second question, there is room for debate, but if the only choices are the core and the full index (to measure inflation for a specific period of a year or less), I would still choose the core. (If you let me smooth the inflation rate with, say, an exponential smoother, I might prefer the full index.)

For the third question, I think there is little room for reasonable debate: the core is better. When food and energy prices go up relative to other prices, the optimal policy rule would accommodate those increases so as to allow other prices to remain stable. The increase in the general inflation rate does little harm; the alternative of deflation in the non-core component would do considerable harm.

Messrs. Ritholtz and Gross, and their supporters in this commentary, are finessing the issue by not distinguishing among these three purposes.

The answer to the third question only works if people know roughly what to expect in advance. If people expect the Fed to control the overall inflation rate but the Fed only attempts to control the core, the outcome will not be good when the two start to diverge. People who attack the core index are contributing to the likelihood of such a bad outcome, as well as to the likelihood of the other bad outcome in which the Fed actually does control the full inflation rate even in situations where it shouldn't.