Sunday, September 30, 2007
This next table shows the currency distribution of forex transactions. The dollar makes up 86.3% in 2007.
Very interesting reading...
Is Price Stability Enough?
William White , Bank for International Settlements
"One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one. "
Yes, I have provided a link to this article before, but I after looking at it again today I thought it was worth another plug on my blog. Read the entire article.
Gross: There's No Inflation (If You Ignore Facts)
By Daniel Gross
Oct. 8, 2007 issue - Imagine that a cardiologist told you that aside from the irregular heartbeat, the stratospheric cholesterol count and a little blockage in your aorta, your core heart functions are just fine. That's precisely what the government's cardiologist—Ben Bernanke, chairman of the Federal Reserve—has just done. The central bank is supposed to make sure the economy grows fast enough to create jobs and make everybody richer, but not so fast that it produces inflation, which makes everybody poorer. "Readings on core inflation have improved modestly this year," the Federal Open Market Committee said in justifying its 50-basis-point interest-rate cut last month, while conceding that "some inflation risks remain."
Catch that bit about "core inflation"? That's Fedspeak for: inflation is under control, unless you look at the costs of things that are going up. The core rate excludes the prices of food and energy, which can be volatile from month to month. Factor them in, and inflation is about as moderate as Newt Gingrich. In the first eight months of 2007, the consumer price index—the main gauge of inflation—rose at a 3.7 percent annual rate. That's more than 50 percent higher than the mild 2.3 percent core rate. The prices of energy and food are soaring, at 12.7 percent and 5.6 percent annual rates, respectively, and have been doing so for years. As a result, the CPI—including food and energy—has risen 12.6 percent since July 2003, for a compound rate of about 3 percent.
Signs of inflation are evident throughout the economy. When investors fear a rising inflationary tide, they latch onto the driftwood of gold. The day Bernanke cut rates, the price of the precious metal soared to heights not seen since 1980, when inflation ran at nearly 12 percent! I read about this in The Wall Street Journal (whose newsstand price rose 50 percent in July), which I picked up in the lobby of a New York hotel (where the average nightly rate soared 12.5 percent in the first seven months of 2007 from 2006, according to PKF Consulting) while sipping on a Starbucks Frappuccino (whose price has risen twice since last October).
There are sound macro-economic reasons to believe higher inflation may be a fact of economic life, according to former Federal Reserve chairman Alan Greenspan, who discusses the topic in his new memoir, "The Age of Turbulence." (Apparently, the editors killed the original title: "The Dotcom Bubble Wasn't My Fault. Nor Was the Housing Bubble.") Greenspan notes that vast anti-inflationary forces in the 1990s—especially China's emergence as a low-cost producer of goods—helped tamp down prices. But China's rampant growth and rising living standards could encourage inflation. "China's wage-rate growth should mount, as should its rate of inflation," he writes.
In a recent paper, Albert Keidel of the Carnegie Endowment for International Peace warns of China's "gathering inflation storm," powered in part by "explosive price increases in key consumer categories" like noodles and pork... China is bound to export its inflation—it exports everything else, after all—either in the form of higher prices for toys, or in the form of higher global prices for the commodities it consumes in increasingly huge gulps.
In the United States, companies are passing along high-er commodity and fuel costs by boosting prices, slashing portions and tacking fuel surcharges onto things ranging from deliveries to lawn service. And because food and energy prices are so visible—the prices are posted in public, and consumers buy these goods frequently—price increases have a disproportionate impact on perceptions of inflation.
China's government is trying to deal with its inflation in predictably Orwellian fashion. "Beijing has instructed local provincial and urban statistical bureaus in a subtle form of denial—they are not to use the word 'inflation' to describe what is happening," notes Keidel. It's easy to mock Beijing's clumsy bureaucrats. But by focusing on core inflation, the Federal Reserve—along with the legions of investors who reacted ecstatically to the interest-rate cut—is practicing its own subtle form of denial.
Friday, September 28, 2007
"When the Federal Reserve slashed its discount rate by a half-percentage point earlier this month, it was trying to add a little lubricant to a credit market that seemed on the verge of seizing up. But by giving weary investors a chance to catch their breath, the move also gave them an opportunity for finger pointing – at avaricious mortgage lenders, at naive borrowers, and at rating agencies.
One culprit, though, has not only avoided blame but has come across as the episode's hero. And that culprit is the Federal Reserve itself. Like some renegade fireman, though unwittingly, the Fed played a part in igniting the conflagration it's now trying to smother.
Because the disaster was kindled years ago, responsibility for it belongs not to the current Fed board but to Alan Greenspan and his team of monetary policymakers. The fundamental problem, however, transcends the actions of any Fed chairman. Indeed, the Fed as it's presently managed can hardly help causing sometimes ruinous market distortions.
Why did mortgage lenders earlier this decade start showering credit as if it were spewing from a public fountain? The answer is that credit was spewing from a public fountain – and that fountain was the Fed. In December 2000, the Fed began an unprecedented year-long series of rate cuts, reducing the federal funds rate from over 6 percent to just 1-3/4 percent – a level last seen in the 1950s. By mid-2003, two further cuts had reduced the rate to just 1 percent.
The general aim of these cuts was to keep a mild growth slowdown from getting worse. But they had the quite unintended effect of generating euphoria in the mortgage market by flooding it with funds. Lenders dramatically lowered mortgage rates and kissed old-fashioned lending standards goodbye. Buying property was never easier. As one jubilant industry insider put it, "Who could ask for anything more?"
The sad sequel is grist for the mill of monetary economists long critical of central banks' attempts at fine-tuning. It illustrates the late Milton Friedman's claim that the full effects of monetary policy changes happen only after "long and variable lags," when conditions that motivated the changes have passed into history. The result is that fine-tuning often ends up promoting business cycles instead of dampening them.
The subprime lending crisis also shows that, while central banks certainly have the power to expand a nation's spending power, they can't guarantee that the extra power gets used as intended, namely, to give a roughly uniform boost to the overall demand for goods. On the contrary: The crisis supports the argument, first developed by Austrian-school economists Ludwig von Mises and Friedrich Hayek, that the techniques central banks employ to increase spending power are bound to distort spending patterns by driving lending rates below their sustainable, "natural" levels.
By injecting the new money they create into credit markets, central banks create an artificially high demand for long-term investments, such as real estate, in which interest costs loom large. Think back a few years. Even your auto mechanic was bragging about "flipping" condos with easy credit. That's a natural consequence of the way central banks distort spending patterns. The trouble, however, is that the new money does eventually swell overall demand, including the demand for credit. Interest rates soon rise, ending the investment boom. Regrets multiply.
That's exactly what happened last year, when the federal funds rate climbed back above 5 percent.
In hindsight, it's easy to say that the Fed blundered. But avoiding similar blunders in the future is another matter. The truth is that the Fed, as presently constituted, faces an impossible task: It can't tell whether its targeted rates are "natural" (and therefore sustainable) except in retrospect, when it's too late; and it will always be tempted to engage in fine-tuning, both because the Humphrey-Hawkins Act of 1978 calls for it to do so, and because a myopic and inadequately informed public rewards Fed bureaucrats for "doing something" even when they ought to stand pat.
Only institutional reform can get us out of this predicament. The Fed must be taken out of the fine-tuning business. Instead, it must observe a strict and unambiguous monetary rule, such as one calling for the Fed to announce and stick to an inflation-rate target. As it happens, chairman Ben Bernanke favors such a rule. If Congress gives him what he wants, the Fed may be spared some future finger pointing; and the public may be spared further crises."
• George Selgin is a professor of economics at the University of Georgia's Terry College of Business.
Wednesday, September 26, 2007
"There is no glut of global saving. Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP. In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990. At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world. This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead.
There can be no mistaking the dramatic shift in the mix of global saving in recent years. A particularly stunning change has occurred in just the past decade. According to IMF statistics, in 1996 the advanced countries of the developed world accounted for 78% of total global saving. By 2006, that share had fallen to 65%. Over the same decade, the developing world’s share of global saving has risen from 22% in 1996 to 36% in 2006. Put another way, the rich countries of the developed world – which made up 80% of world GDP in 1996 – accounted for just 43% of the cumulative increase in global saving over the past decade. By contrast, the poor countries of the developing world – which made up only 19% of world GDP in 1996 – accounted for fully 58% of the cumulative increase in global saving over the 1996 to 2006 period, or approximately three times their weight in the world economy. This wealth transfer from the poor to the rich – the exact opposite of that which occurred in the first globalization of the early 20th century – is one of the most extraordinary developments in the modern history of the global economy.
The United States, of course, stands out for extreme negligence on the saving front. By 2006, America’s gross national saving rate – the combined saving of individuals, businesses, and the government sector – stood at just 13.7%. That’s down from the 16.5% rate of a decade earlier and, by far, the lowest domestic saving rate of any major economy in the developed world. Adjusted for depreciation – a calculation which provides a proxy for the domestic saving that is left over after funding the wear and tear on aging capacity – the US net national saving rate averaged just 1% over the past three years, a record low by any standards. Over the 1996–2006 period, the US accounted for a mere 12% of the total growth in worldwide saving – less than half its 26% share in global economy as of 1996. Elsewhere in the developed world, it has been more of a mixed picture. The Japanese saving rate, while a good deal higher than that of the US, fell from 30.4% in 1996 to 28.0% in 2006. By contrast, gross saving in the Euro Area held steady at around 21.0% over the past 10 years...
The dramatic shift in the mix of global saving over the past decade is a big deal. It drives the equally unprecedented disparity between current account surpluses and deficits – the crux of the global imbalances debate. It also accounts for the gap between trade deficits and surpluses that is shaping the current protectionist debate in the US Congress. In theory, of course, this shift in the mix of saving also has the potential to shape relative asset prices between debtor and lender nations. Although those impacts have yet to take on serious proportions, I continue to suspect the risk of such a possibility is a good deal higher than that envisioned by the broad consensus of global investors.
From the start, the concept of the global saving glut was very much a US-centric vision (see the March 10, 2005, speech of then Federal Reserve Board Governor Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit”). From America’s myopic point of view, it believes it is doing the world a huge favor by consuming a slice of under-utilized saving generated largely by poor developing economies. But this is a very different phenomenon than a glut of worldwide saving that is sloshing around for the asking. The story, instead, is that of a shifting mix in the composition of global saving – and the tradeoffs associated with the alternative uses of such funds. I suspect those tradeoffs are now in the process of changing – an outcome that is likely to put downward pressure on the US dollar and upward pressure on long-term US real interest rates. If the borrower turns protectionist – one of the stranger potential twists of modern economic history – those pressures could well intensify. Don’t count on the saving glut that never was to forestall these outcomes."
Monday, September 24, 2007
So the yield curve's predictive power is contingent on the uncertainty of the underlying monetary regime. This finding is consistent with what Michael Bordo and Joseph Haubrich found in their paper, The Yield Curve, Recessions and the Credibility of the Monetary Regime: Long Run Evidence 1875-1997 (with Joseph G Haubrich) NBER Working Paper No10431, 2004. Here is the abstract:
"This paper brings historical evidence to bear on the stylized fact that the yield curve predicts future growth. The spread between corporate bonds and commercial paper reliably predicts future growth over the period 1875-1997. This predictability varies over time, however, particularly across different monetary regimes. In accord with our proposed theory, regimes with low credibility (high persistence of inflation) tend to have better predictability."
Sunday, September 23, 2007
What I have not done is spell out how one could systematically allow for benign deflationary pressures in monetary policy while correcting for malign deflationary pressures. That is why knzn's proposal is so interesting to me. His ideas line up nicely with George Selgin's work, which shows how to implement a monetary policy rule that allows for benign deflation. Selgin proposes a "Productivity Norm" rule that in one form would effectively stabilize the nominal wage but allow the price level to reflect changes in productivity.
There are actually two forms of his rule. Under the first one--the "Total Factor Productivity Norm" rule--Selgin would have monetary authorities target a nominal income growth rate equal to the expected growth rate of real factor inputs. Such a nominal income target would monetarily accommodate the real output effect of factor input growth, but not productivity growth and therefore allow the price level to inversely reflect both shocks to and anticipated changes in productivity. Under the second version--the "Labor Productivity Norm" rule-- Selgin would have nominal income growing at the expected growth rate of labor inputs. This monetary policy rule would still stabilize the nominal wage but lead to a slightly higher rate of deflation than the total factor productivity norm rule. These productivity norm rules, like other nominal income stabilizing rules, would also provide a natural offset against aggregate demand shocks, thus correcting for malign deflationary pressures.
The productivity norm rules are intended to improve macroeconomic stability by allowing for benign deflation. Why benign deflation is important to macroeconomic stability has been outlined in this blog (see above links), but to see Selgin's reasons look at his book "Less than Zero: the Case for a Falling Price Level in a Growing Economy" or this paper.
Below I have copied (with some slight adjustments) from Selgin's above book the appendix that outlines in a more formal way how the two productivity norm rules would appear in nominal income targeting rules.
(1) Py = wL+rK
represent an economy's nominal income, where P is the general price level, y is real output, w is the price of a unit of average-quality labor, r is the rental price of average-quality capital, L is labor input and K is capital input. Also, let
(3) y = A + bK +(1-b)L,
where italics represent growth rates. A, then, is the growth rate of total factor productivity. Rearranging (3) gives
(4) y - L = A + b(K-L)
where y-L is the growth rate of labor productivity and (K-L) is the growth rate of the capital-labor ratio. A labor productivity norm requires that
(5) P = L - y
whereas a total factor productivity norm requires that P = -A or equivalently, (from equation 4) that
(6) P = -y + bK + (1-b)L
Equations (5) and (6) can be rearranged to give corresponding rules for nominal income growth. A labor productivity norm requires that
(7) P + y = L,
that is, that nominal income grow at the same rate as labor input; while a total factor productivity norm requires that
(8) P + y = bK + (1-b)L,
that is, that nominal income grow at a rate equal to a weighted average of the growth rates of labor and capital input.
Lastly, we can compare the behaviour of (constant-quality) money wages under the two regimes by taking the logarithmic differential of (1) and recalling that b=rK/Py = a constant:
(9) P + y = w + L.
By substituting (7) and (8), respectively into (9), and solving in each case for w, we find that, under a labor productivity norm,
w = 0
meaning that money wages are kept stable; whereas, under a total factor productivity norm,
w = b(K-L),
meaning that money wages rise as production becomes more capital intense."
Friday, September 21, 2007
So there is some debate on what these monetary aggregates mean for the future. What do they tell us about the past? In particular, what do they say about how we got here? Below is a figure that plots the ratio of MZM to industrial production, a monthly proxy for real economic activity. The series is normalized to 100 in 1959.
The figure shows above-trend levels in the series over 2001-2005. This is what I have called in past blogs the past monetary profligacy of the Fed. To be fair, though, this spurt could have been endogenously generated from strong money demand growth that in turn drove central bank actions. The question then is whether any of this growth was the result of exogenous central bank decision making.
In the comments section, JMK makes an interesting observation on the above graph: there is no trend up through the late 1970s, the very period that inflationary pressures were building. I am not sure I have a satisfactory answer to this puzzle, but I did go ahead and graph the MZM velocity for the above time period. The graph was created using the MV=PY identity along with MZM money supply, industrial production, and the CPI (i.e. V=[PY]/M). This figure is below and shows an upward trend in velocity during the period in question. It is also interesting to see velocity relativey stable thereafter until about the 2000s.
Above I plotted the ratio of MZM, a nominal variable, to the industrial production index, a real variable. Below I plot the ratio of MZM to the industrial production times the CPI. This ratio, therefore, is a nominal variable to a nominal variable. The Results are interesting.
(Blogger won't let me load up pictures tonight so click here to see the graph)
Thursday, September 20, 2007
Wednesday, September 19, 2007
Tuesday, September 18, 2007
This is apparent in the figure below from the Cleveland Fed. Using options on fed fund rate futures, this figure shows the estimated probability of different outcomes in the October FOMC meeting. This new belief in a rate-cutting cycle is evident in the changed probability for for the FOMC moving the fed fund rate to 4.50% in October. Today the probability hit 60.2%, yesterday it was only 30.4%. That is a dramatic change in market expectations. Apparently, the markets believe they have seen a new side to the Bernanke Fed.
Monday, September 17, 2007
Next look at the intrade contract for the ffr being equal to or greater than 5.00% by year end. The latest probability for this contract is at 15%. While this figure does not say at which FOMC meeting the ffr target will be lowered, it does say that there is a 85% probability the ffr target will be less than 5.00% by year end. Interesting times...
Now had monetary authorities allowed the benign deflation to emerge, the policy rate and the neural rate would be better aligned and there would be no credit boom. Asset prices, in turn, would better track fundamentals.
This story I just told implies that there is a trade off between stabilizing output prices and asset prices when AS is growing. Is there any evidence for this claim? Below are several scatterplots that plot real S&P stock price growth rate against the CPI growth rate for the period 1871 to the present. The data are in monthly frequency and come from Robert Shiller's database. There are several graphs based on different growth rate measures for each variable: a 2-year growth rate, a 3-year growth rate, and a 5-year growth rate. Here is the scatterplot using 2-year growth rates:
Not much going on here, so now take a look at the scatterplot using 3-year growth rates:
The results are getting more interesting as there is almost a Phillips curve-like form emerging amidst the noise. To make better sense of this graph, recall that the output price-asset price trade off is conditional on there being positive economic growth. The above graph, however, includes all data points, including those that occurred during during economic downturns. To clean up this potential noise, I created another graph where I excluded all points where output prices and stock prices are both negative (i.e. eliminate points from quadrant 3). The assumption here is that if both variables are negative there must be economic weakness. After this adjustment, the trade off curve is even more apparent.
Now, take a look at the scatterplot using 5-year growth rates (without any adjustments):
Again, an output price-asset price trade off is suggested by the figure. To whiten some of the noise in the scatterplot, I once again remove points from quadrant 3. Now the scatterplot looks as follows:
These figures all indicate there is a potential trade off between stabilizing output prices and asset prices. While further refinements are needed in these figures, they add perspective to what I have been arguing in my blog: the Fed in its attempt to prevent benign deflationary pressures from materializing over the past few years has been fueling financial imbalances, particularly asset prices. In short, the Fed has been exploiting the trade offs implicit in the figures above. Now, I need to coin a clever name for the trade off curves above. Any suggestions?
Saturday, September 15, 2007
Both Menzie Chinn and Michael "Mish" Shedlock touch on what I think is an important point: loose monetary policy in the United States has been an independent (i.e. exogenous) contributor to global economic imbalances. Specifically, they claim that monetary policy-generated low real interest rates are a good explanation for the low U.S. saving rate and hence the large U.S. current account deficits. Note, they are not arguing it is the only cause of the global economic imbalances. Like I have argued before (here, here, here), this (exogenous) liquidity glut perspective is complementary to the saving glut story--there is no reason why they cannot both be at work. (Why the Fed would push rates so low is something I have discussed here and here.) Here is some of what what Menzie and Mish have to say
"While I'm not going to assert that monetary policy was the cause of unnaturally low real interest rates (that in turn might have contributed to the housing boom and the associated mortgage equity withdrawal...), I will claim there is a plausible argument that the extended period of monetary ease was a contributing factor. It's even more plausible, when one considers the rise in real (risk free) real interest rates even as China and oil exporting countries continue to run large surpluses after the increase in the target Fed Funds rate. This latter observation is documented in this post from January. (I'll also observe the notion of real interest rates being equalized across borders with free capital mobility is not necessarily validated by the data -- so low US real interest rates might or might not be indicative of anything, .) It all sort of depends whether you think relative PPP holds instantaneously; if you don't think so, then monetary policy can cause divergences in real interest rates."
"In a long winded article Bernanke is yapping once again about Global Imbalances and the Global Savings Glut. The article is complete with charts and 11 footnotes but mostly twisted logic as well as stunning statements like "There is no obvious reason why the desired saving rate in the United States should have fallen precipitously over the 1996-2004 period."
Actually, there is every reason for the U.S. savings rate to have fallen: The Fed continuously held interest rates too low thereby creating a negative incentive for anyone to save. Eventually a near unanimous belief set in that asset prices were a one way street headed North and the purchasing power of the dollar a one way street headed South. So why save?And after the Greenspan Fed foolishly cut rates to 1% in the wake of the dotcom bust, there was a mad dash out of cash, culminating with panic buying of houses. That panic in turn was followed by cash out refis to support consumption as people bit off more house than they could really afford. This is the origin of the much talked about negative savings rate. It is also one of the moral hazards of Bernanke's proposed inflation targeting scheme...
Yes, it really is as simple as that.
Nowhere does Bernanke address those simple constructs. Instead his mind sits in long winded academic theory and models that do not even take into account real world constructs like global wage arbitrage, asset bubbles, overcapacity, U.S. deficit spending, the War in Iraq (that has to be funded somehow, and if not by domestic taxes then by foreigners) or disincentives to save caused by interest rates held too low too long.But there is now no way to pay back what has been borrowed as there are no real savings.
In Austrian Economist terms, the pool of real funding is simply tapped out. And once psychology changed, there was a mad scramble for cash with no bids for commercial paper as all the savings (and then some) had already been lent out. The result is a credit crunch and a new dance craze called The Bernanke Shuffle."
Friday, September 14, 2007
Again, a rough and dirty cut in need of further refinement, but I got a pseudo R-squared of 74.5%! That is a huge improvement over what I had before and a better fit than probit models that use the yield curve spread alone. Obviously, my interest was peaked so I went ahead and plugged the numbers into a cumulative standard normal distribution and came up with the following graph:
Wow! This graph shows a 100% probability for every NBER recession that happened and does a much better job with the two periods that plagued the policy rate gap results, 1984 and 1994. The only miss is 1966-1967 which is a common miss for yield curve spread models. Edward Leamer, in his KC Fed symposium paper, notes that the year 1967 should have seen a recession--like today, there was a major housing bust dragging down the economy at the time--had it not been for the increased government spending on the Vietnam War. Of interest to us now, though, the model shows there to be an almost 50% chance of a recession.
Look forward to a paper from me that further develops this approach. These results are too promising not to do a paper.
Thursday, September 13, 2007
Here again Mr. Wolf's 'saving glut' blinders do not allow him to consider the possibility that just maybe loose monetary policy in the United States was contributing to rise of excess saving in the first place. Moreover, he closes the paragraph by making the bizarre claim that the Fed was essentially hostage to the world economy and had to push easy money. In other words, the Fed was doing the world a favor in 2002-2005 when it held the federal funds rate at a historically low level. If true, then the related housing boom and the increased indebtedness of U.S. households were a good--dare I say an optimal--outcome. Applying this logic to its end, the Fed should continue pushing easy money no matter the consequences because it is good for a world economy out of balance. These absurd implications are why Mr. Wolf should take more seriously a 'liquidity glut' view to complement his 'saving glut' understanding of the world--the world is too complex to believe otherwise.
Wednesday, September 12, 2007
The European Central Bank pumped an extra €75bn ($103bn) into the financial system for a fixed period of three months in a bid to cut the interest rate gap between overnight funding and lending over longer maturities.
In contrast, the governors of the Bank of England and the Bank of Canada publicly doubted whether such action would work. Mervyn King, the Bank of England governor, also warned in a written submission to the UK parliament that this approach risked encouraging “excessive risk-taking and sows the seeds of a future financial crisis."
The ECB said last Thursday that it would pump three-month money into the system to “support a normalisation of the functioning of the euro money market”. Both Mr King and David Dodge, the Canadian central bank governor, said commercial banks were well capitalised and strong enough to absorb the assets of troubled off-balance sheet investment vehicles that need to be brought on to their books.
Speaking in London, Mr Dodge said he thought investors would be more careful to understand what is contained in complex products in future. “The responsibility does rest on the investor to make sure he or she understands the risk in the product they are buying,” he insisted.
The Federal Reserve, meanwhile, appears to occupy the middle ground. It has not extended the duration of its money market operations, but it has made 30-day money, renewable at the borrower’s request, available through its discount window.
Policymakers are expected to step up calls for more transparency in structured finance when European finance ministers meet in Portugal on Friday. Discussions also continue over possible responses, such as a review of bank capital standards or efforts to pool distressed assets.
A Simple Metric for the Stance of Monetary Policy: Nominal GDP Growth Rate minus the Federal Funds Rate
Using this metric, a neutral monetary policy would be one where the federal funds rate never wondered too far from the nominal GDP growth rate. Here, I calculate this metric as the year-on-year growth rate each quarter of nominal GDP less the nominal federal funds rate for the quarter. Since the early 1980s the average difference between these two series, called the policy rate gap, was about 0.50%. From the 1960s to the early 1980s the policy rate gap average almost 2.00%. If, in fact ,this is a reasonable measure of the stance of monetary policy, these two averages shed some light into the 'Great Moderation' debate in macroeconomics.
I used this metric in an earlier post where I looked at the role the Federal Reserve may have played in the housing sector. Now, I want to see how well it predicts the NBER recessions. To begin, take a look at the figure below which plots the policy gap rate for 1956:Q1 through 2007:Q2 and shades in those quarters that fall under the NBER Recession.
This figure shows that every NBER recession was preceded by a negative value for the policy gap rate, but not every negative policy gap rate was followed by a NBER recession. This problem also arises when using the yield curve spread to predict recessions, but my impression is that it is not as pronounced. This information can be used in a probit model to estimate the probability of a recession. Specifically, the policy rate gap is regressed upon a NBER recession dummy variable that is 1 if a recession is present and 0 otherwise. Below are the results from two forms of this probit regression. The first recession simply regresses the contemporaneous value of the policy gap rate on the recession dummy. The second recession regresses the 4 lags of the policy gap rate on the recession dummy.
These results look promising, but still need refining (e.g. need to account for serial correlation). Nonetheless, I took a first stab at the data by taking these estimates, the actual policy gap measure, and then plugging it into and standard normal cumulative distribution to get the following figures. These figures show the probability of a recession given the policy rate gap:
While these initial results look promising there are again some notable misses such as 1994. Of the two models, the non-lagged probit model appears to do better with the misses (compare 1984 in both models). Overall, the policy rate gap appears to be a promising way--in need of further refinement--to measure the stance of monetary policy.
In response to a commentator's suggestion, I have enlarged the probit results and the last two graphs to make them more readable. I also went ahead and redid the analysis using a longer time series.
Now take a look at the 2008 contract in the figure below. According to this contract there is as of today (September 12) a 55% chance of a recession in 2008. The entire month of September has seen an steady climb in the contract price or probability of recession. Historically, when odds have reached this high using the yield curve spread as a predictor of recessions there almost always has been a recession. To the extent these results carry over to prediction markets it seems safe to conclude that a recession is inevitable. Given this future, let's hope the Economist's provocative claim that a recession is good for the economy is on the money.
For a different take on the matter, I point you now to an article in Barron's titled "Recession May Begin Within 12 Months":
Then there is our good friend Nouriel Roubini who chimes in with these words:
... the forthcoming easing of monetary policy by the Fed will not rescue the economy and financial markets from a hard landing as it will be too little too late... Fed easing will not work for several reasons: the Fed will cut rate too slowly as it is still worried about inflation and about the moral hazard of perceptions of rescuing reckless investors and lenders; we have a glut of housing, autos and consumer durables and the demand for these goods becomes relatively interest rate insensitive once you have a glut that requires years to work out; serious credit problems and insolvencies cannot be resolved by monetary policy alone; and the liquidity injections by the Fed are being stashed in excess reserves by the banks, not relent to the parts of the financial markets where the liquidity crunch is most severe and worsening.
Hang in there America as we weather this economic storm.
Monday, September 10, 2007
I know his family is well-versed in the Middle East construction business and that he is once thought to have written a rather audacious call option on US airline stocks in the days before 9/11. But he has been rather more into demolition than construction of late and if he ever did make that infamous airline trade, you’d have to acknowledge he had the benefit of some unusually good inside information. In any case, being forced to live in a cave for the past six years somewhere on the Pakistan-Afghanistan border must have rather limited his effectiveness as an investment guru.
Yet there he was on our TV screens again last week, sporting a new look and dilating happily on the state of the US economy.
He took the opportunity of the anniversary of the 9/11 attacks to branch out from his usual theological strictures and offer a rolling lecture to Americans on, among other things, global warming (bad), the writings of Noam Chomsky (good) and a priceless little observation about “the reeling of many of you under the burden of interest-related debts, insane taxes and real estate mortgages”. So there you have it. If the US sub-prime mortgage crisis has reached into the inner sanctums of the al-Qaeda leadership bunker, you know it must be pretty serious.
The man’s timing, as it happened, was impeccable. On the very day he released his video, the US Government released another unpleasant surprise. The employment data for August were a bigger horror show than Osama’s ridiculous ramblings. The decline in non-farm payrolls of 4,000 was the first monthly fall in four years... These figures are certainly consistent with a sharp slowdown in the US economy. They were bad enough to warrant serious consideration now of the question: is the US headed for its first recession in six years? Or put it this way: are bin Laden and his friends finally going to get their hearts’ desire and see the US tip into its first slump since their efforts six years ago to the day actually helped it to emerge from its last one?
On the other hand, the big uncertainty is that we don’t have a real clue yet about the economic impact of the credit crunch. The August employment report will have largely reflected conditions when the squeeze was just beginning to bite over the summer. The housing market seems certain to weaken further and many employers may now be struggling to raise funds from nervous banks and frosty credit markets.
It’s still possible that August was just a bad month – we have had them before in periods of sustained expansion. But – and I want this to be understood in only the very narrowest of terms – Osama was right. The US economy is in perilous waters right now. While recession is not inevitable, perhaps not even probable, it just got significantly more possible.
Sunday, September 9, 2007
Most importantly, so much debt has been created that it may lead to debt deflation. Globalization would have caused benign deflation that benefits consumers and causes some industries to relocate to lower-cost locations. But fighting against this sort of deflation with bubbles and debts must lead to deflation. In my view, this is what happened in the 1920s after World War I.
When the global property bubble bursts, debt deflation could ensue. It is always possible that the Fed could create another bubble to postpone the inevitable. For example, direct purchase of US Treasuries to push the 10-year yield down to 2% could create another property bubble. However, the Fed may repent and Mr. Greenspan could retire. It may not be profitable to bet on the next bubble."
Looking back from 2007, Andy Xie seems to have been a economic prophet. Particularly fascinating was his call that by avoiding benign deflationary pressures monetary authorities were setting themselves up for malign deflationary pressures in the future. Too bad his views did not get more of hearing back in 2003-2005. Sadly, the Morgan Stanley Global Economic Forum no longer has its archives open to his article. So this is my attempt to preserve his words for posterity's sake.
I found another Andy Xie gem at the Morgan Stanley Global Economic Forum titled "Three Horsemen and the Ghostbusters" dated January 26, 2006. In this piece Andy notes the following:
The asset inflation party is not costless, I believe, and will be followed by a burst or an extended period of slow growth. Inflation due to commodity inflation, deflation due to overcapacity, or a shock should mark the turning point. I see the cycle turning down in 2006"
Right message once again, just off on his timing by a year or so. Hey, even great ones miss a few calls (e.g. Nouriel Roubini).
Friday, September 7, 2007
John Taylor: "Using an econometric model, Mr. Taylor says the Taylor rule would have told the Fed to raise the federal funds rate from 1.75 % in 2001 to 5.25% by mid-2005. Housing starts, around 1.6 million in 2001, would have peaked at 1.8 million (annual rate) in early 2004 then begun a gentle decline. In reality, the Fed cut the rate to 1% in 2003, then began raising it in 2004, only reaching 5.25% in mid-2006. Housing starts soared to 2.1 million by early last year and have since plummeted, to around 1.5 million. A higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp..."
The Economist: "Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates... the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending... The Fed's massive easing after the dotcom bubble burst... simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place.
Tito Boeri & Luigi Guiso: "The first two factors [ of the current crisis, financial illiteracy and financial innovation,] aren't new. Without the third factor – the legacy of the 'central banker of the century' – the crisis probably would have never occurred. The monetary policy of low interest rates – introduced by Alan Greenspan in response to the post-9/11 recession and the collapse of the new economy “bubble” – injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1% – their lowest level in 50 years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium. Interest rates were kept at low levels for a long time, and were often negative in inflation-adjusted terms. The result was no surprise. Low returns on traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search of profits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise duly reallocated their portfolios towards more lucrative but riskier assets in an attempt to increase their wealth and preserve its purchasing power. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers – families above all who were seduced by the possibility of acquiring assets that for had always been beyond their means. At the same time, house prices soared, ultimately encouraging the additional extension of credit; the value of real estate seemed almost guaranteed. . .Thanks Alan! Today we’re paying the cost of your overreaction to the 2001 recession."
I am also working on a short note to be submitted shortly to a journal on this issue. I will keep you posted on its developments.
Wednesday, September 5, 2007
Dude, Where's My Bailout?
An open letter to Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Senate Banking Committee Chairman Chris Dodd Honorable
Public Servants: As you know, the conflagration in the subprime mortgage market is beginning to singe the very fabric of the American dream, by which I mean life, liberty, and the pursuit of home equity. I was elated to hear everyone from bond guru Bill Gross to Democratic Presidential hopefuls endorsing the idea of a government bailout of homeowners facing foreclosure as the payments on their zero-money-down mortgages soar.Bad credit? No credit? No problem! Uncle Sam has your back.I don't have a mortgage, much less one that's about to blow up. But I have no shortage of other losses, some of them quite painful, from the many well-considered investments I've made over the years. Therefore, under the equal protection clause of the U.S. Constitution, I'm entitled to a bailout as well. At least that's what my law school buddies tell me.Here's an annotated invoice:
STOCKS. In the dot-com heyday, I had the misfortune of buying shares of two companies that went poof within 12 months: Excite@Home, the residential high-speed Internet provider, and Allied Riser, a commercial broadband startup. (I was diversified—homes and offices.) Subtotal: Seven long years of regret and pitiful looks from my CPA have encouraged me to repress the exact sum of my capital losses, but for expediency's sake let's put it at $60,000.
MUTUAL FUNDS. I also invested in a tragicomic Putnam fund that somehow managed to lose an average of 44% a year between 2000 and 2002. It turns out that Putnam Investments was also at the heart of the market-timing scandal. Yet I never got any checks in the mail from Eliot Spitzer or from the investment pros who all but forced me to buy the shares. Subtotal, including compounded pain and suffering: $10,000.
PERSONAL RELATIONSHIPS. At about the same time, I was getting irrationally exuberant about a beautiful brunette, spending my paper stock gains on a series of expensive dates in Manhattan. There were mezzanine seats at Broadway plays, candlelit dinners in Greenwich Village, and enough orders to 1-800-Flowers to line the streets of Pyongyang on Kim Jung Il's birthday. Oh, and cab fares. Lots of those. Then, sometime between NASDAQ 5000 and the end of the Elián Gonzáles saga, said brunette dumped me. She broke my heart, but only after she broke my bank account. Subtotal: About $3,000, including $1,000 in self-prescribed Johnnie Walker Blue.
COLLECTIBLES. Twenty years ago, I was the last kid on my block to score a coveted "first series" Garbage Pail Kids trading card, for a total consideration of $25 in cash, three bags of Doritos, and the guitar Dad bought me in the second grade. Then the Garbage Pail market crashed. But the Los Angeles Dodgers dramatically won the '88 World Series, and my enthusiasm shifted to baseball. By 1990, with bar mitzvah winnings in hand, I shelled out for a José Offerman rookie card. Fifty bucks bought me the Lucite-encased visage of this dynamic Dodgers infielder, who knocked a home run in his first major league at bat. I figured it would double in price during every season of Offerman's promising career. Instead, his résumé came to entail mediocre stints with seven teams, culminating with the August clubbing of a pitcher in an independent-league game that invited two counts of second-degree assault. Subtotal: How can I attach a cold sum to the shattered dreams of a middle schooler? Sigh. $1,400.Please remit my $74,400 by check, money order, or PayPal. Rest assured that I will cycle the dollars back into economically vital investments. I hear some hedge funds are slashing their minimum buy-ins to $10,000, and that half-finished condos in Miami can be gotten for pennies on the original dollar. In any case, my efforts to bolster the U.S. gross domestic product could surely be strengthened by a series of interest rate cuts, so please see to those, too. After all, gentlemen, while intrepid investors like me crank the engine of American capitalism, times like these call for all of us to pitch in.
Tuesday, September 4, 2007
First, why did this crisis start in the US? The answer is: “The borrowing, stupid”. Default on debt – actual and feared – always drives big financial crises because creditors think that they ought to be repaid. US households were the world economy’s most important net borrowers in the mid-2000s, replacing the emerging markets of the 1990s.
[Blogger: Yes, the United States is increasingly being defined by its debtor status... just look at the ongoing U.S. current account deficits]
Second, what created the conditions for the crisis? It took foolish borrowers, foolish investors and clever intermediaries, who persuaded the former to borrow what they could not afford and the latter to invest in what they did not understand. In fact, even the borrowers might not have been foolish: if one owns nothing, it may be quite sensible to speculate on ever-rising house prices in the knowledge that personal bankruptcy is always a way out.
[Blogger: Hey, what about the Fed's role in all of this? Yes, financial innovation and low financial literacy played their part, but both of these developments were made consequential by the Fed's past monetary profligacy as noted by Tito Boeri and Luigi Guiso]
Third, why did this crisis escalate? “Contagion” is, as always, the answer. Ben Bernanke, chairman of the Federal Reserve, described the process in his speech at the Jackson Hole conference last weekend.“Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in US housing will restrain overall economic growth. But other factors are also at work. “Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex pay-offs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities.”*
[Blogger: Is the word "contagion" a creation of economists and the markets or does someone else get the credit for creating this nifty word?]
Fourth, how bad might the impact become? Since Americans borrow in their own currency, the US authorities can, it seems, loosen monetary and fiscal policy at will. Nevertheless, a significant global slowdown is not impossible. One reason is that even the US cannot risk losing the confidence of its creditors. Another is that risk premiums are likely to rise across the board, with adverse consequences for economic activity in many countries. Yet another is that banks may lack the capital to replace a temporary shrinkage in non-bank credit. It is not obvious, in addition, who would act as the world’s “borrower of last resort”, should US households retrench. Finally, big losses may yet emerge elsewhere, not least in other countries’ overvalued housing markets.
[Blogger: Not what I want to hear... I am still trying to sell my home in Michigan)
Fifth, how should central banks respond? They have two classic functions: to ensure stability in the economy, by avoiding both inflation and deflation; and to provide liquidity to an illiquid financial system. The challenge on the first mandate is not to overreact in anticipation of what may be only a modest blip to the economy. The federal funds rate will almost certainly be cut this month. It is not obvious that it should be slashed, however. Inflation remains a risk, after all. The challenge on the second mandate is to define what keeping the financial system “liquid” means. The classic definition is to provide money – the ultimate store of value and means of payment – to sound banks threatened by a run. A possible definition in securitised markets, however, is to act as buyer of last resort, thereby guaranteeing liquidity in markets at all times. For the reasons I explored last week (this page, August 28 2007), the latter would be a dangerous departure.
[Blogger: See Ben Bernanke's take on this matter]
Sixth, what is the future of securitised lending? Good reasons can still be advanced for shifting exposure from the balance sheets of thinly capitalised banks to those of better capitalised outside investors. The theory was that risk would thus be shifted on to those best able to bear it. The practice seems to have been that it was shifted on to those least able to understand it.
The supply of such fools has, if only temporarily, dried up. In the short run, securitised debt is likely to contract, as existing debt is paid down or written off. In the longer term, intermediaries will have to find a way to make their products more transparent to the buyers. Unfortunately, the ratings agencies, which once served this purpose, have lost their credibility.
Seventh, what does this event imply for the future of regulation? It is important to distinguish two objectives. One is to protect innocents. The investors who bought the products do not fall in this category. They were, if not fools, willing speculators. It is not at all obvious why the state should try to protect such institutions from their own folly. Those who borrowed the money to buy houses may, however, be deemed innocents. Whether this applies to people who exaggerated their earnings in applying for loans is an open question. But paternalists may require minimum down payments or the abolition of “teaser” interest rates and other devices that encouraged ordinary people to borrow more than they could afford.
The second objective of regulation is to insulate financial markets against the sort of panic seen in recent weeks. The only way to do that may be to re-regulate them comprehensively. Restrictions would have to be imposed on products sold or on the ability of guaranteed financial institutions to engage in off-balance-sheet transactions. I cannot see how either would now be made to work. Regulation of the detail of the financial system may fall somewhere between hard and impossible. It is why financial institutions must never be too big to fail.
Financial crises are always different in detail and the same in their essence. This one is no exception. It showed the normal pattern of rising prices of assets, expanding credit, speculation, excess, then falling prices, default and finally panic. The new securitised financial markets are meeting a test. We will soon know how far they manage to pass it.
"It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions."
Ouch...is that a bruised ego I see there Mr. Cramer? Ben Bernanke, however, did recognize the danger of contagion by noting,
"... developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."
These words received the most attention in the media. A less noticed but nonetheless fascinating part of his speech looked at the history of housing. He specifically looked at five periods in housing finance history and its relation to macroecomic activity:
(1) Beginnings: Mortgage Markets in the Early Twentieth
(2) The New Deal and the Housing Market
(3) The Transmission Mechanism and the New Deal Reforms
(4) The Emergence of Capital Markets as a Source of Housing Finance
(5) The Monetary Transmission Mechanism Since the Mid-1980s
These five mini-chapters on the history of housing sector and its relation to the macroeconomy is the rest of the speech worth reading. Take a look for yourself at the speech.