Monday, October 29, 2007

Regional Economic Activity in the USA

I have made several postings to this blog (here and here) about my recent move from the depressed Michigan economy to the vibrant Texas economy. This move really was an eye-opener for me on the amount of variation in regional economic activity. Below is a graph of the year-on-year growth rate of real economic activity (measured by the Philadelphia Fed's state coincident indicator series) in Michigan, Texas, and the USA. Notice how Texas over the past few years has been doing better than the USA while Michigan has been doing worse.
Gene Epstein picks up on this theme in his interesting article on regional economic differences in Barrons. I have excerpted the first part of his piece below:

Fifty States, Fifty Job Rates

"IF A RECESSION IS WHEN YOUR NEIGHBOR loses his job, and a depression is when you do, then our neighbors in Michigan have been suffering a recession for some time. But if, to put a new spin on the time-worn quip, an expansion is when your neighbor gets a better job, and a boom is when you do, then if you live in Texas, you're probably enjoying a boom.

That a boom and a bust could be happening at the same time, in the same country, only highlights an underappreciated fact: While the U.S. economy is a useful abstraction, it consists of many different economies, each with its own special story. State and regional data are not as timely as national data. But the recently issued Bureau of Labor Statistics release for September 2007 on regional, state, and certain local labor markets provides a reasonably timely update.

Nationally, the U.S. unemployment rate stood at 4.7% in September '07 (the October reading is due out this Friday), up marginally from 4.6% in September '06. While that technically qualifies as a growth recession -- economic growth accompanied by a rise in joblessness -- it's at rates of joblessness that are still historically low.

Now, unravel what that 4.7% is derived from, and we find widely different stories state by state, although not quite as widely different as in previous periods in history. Michigan, to begin with, is surely suffering a full-blown recession. The Great Lakes state's unemployment rate hit a 14-year high of 7.5% in September, up from 7.1% in September '06, giving it the dubious honor of having the highest jobless rate by far of any of the 50 states. (The runner-up: Mississippi, with a jobless rate of 6.4%.)

The unemployment rate in the Detroit area is one of the highest in Michigan, at 7.9% in September, up from 7.3% 12 months ago. And that, of course, is another way of saying that the main cause of Michigan's bust is the hemorrhaging auto industry, with woes in real estate only a supporting player. While the national economy has had substantial gains in jobs of around 6% since the last peak in the business cycle in early-2001, Michigan's employment tally is down around 6% from that peak.

Texas, by contrast, seems to be enjoying a boom. The second-most-populous state in the union has seen its unemployment rate fall from 4.8% in September '06 to 4.3% in September '07, close to a seven-year low. And at 10%-plus since early 2001, job growth has been much higher than the national rate."

Friday, October 26, 2007

Asset Bubbles... and Monetary Policy

There was an interesting article this past week from Daniel Gros who reminded us that the boom-bust cycle in the U.S. housing market is not unique. Rather, there are also "House Price Bubbles Made in Europe." Here is a figure from his paper that compares real housing prices in the Euro area and the U.S. through 2006:

It is interesting how real housing prices in the Euro area follow a similar pattern to the U.S. real housing, albeit with a lag. As JMK has noted in the comment sections of this blog, this common movement in real housing prices means my often-expressed past monetary profligacy view (here, here, here, and here) cannot be the whole story. Financial innovation, low financial literacy, predatory lending, and excess saving from other parts of the world are meaningful contributors too. Nonetheless, the macroeconomist in me has a hard time believing these factors as being completely independent of--or as consequential as--loose monetary policy in advanced economies coupled with boom psychology.

To illustrate my point here is a figure (click here for a larger file) from one of my working papers:

The first graph in the figure plots the year-on-year growth rate of quarterly world real GDP against a weighted average G-5 short-term real interest rate. The quarterly world real GDP series is constructed by taking the quarterly real GDP series for the OECD area and using it with the Denton method to interpolate the IMF’s annual real world GDP series. This figure reveals that just as the global economy began to experience the rapid growth in the early 2000s, the G-5 short-term real interest rate turned negative as monetary authorities in these countries eased monetary policy. This positive G-5 interest rate gap—the difference between the world real GDP growth rate and the G-5 short term real interest—narrowed as the short-term real interest picked up in 2005, but it still fell notably short of the world real GDP growth rate by the end of 2006. Two measures of global liquidity corroborate the easing seen by the positive G-5 interest rate gap. The first measure is a ratio comprised of the widely used ‘total global liquidity’ metric, which is the sum of the U.S. monetary base and total international foreign reserves, to world real GDP. The second measure is a ratio comprised of a G-5 narrow money measure, which is the sum of the G-5’s M1 money supply measures, to world real GDP. Both measures show above trend growth beginning in the early 2000s. The bottom panel of Figure 5 shows some of the consequences of this global liquidity glut: real housing prices soar in the United States and United Kingdom and are systematically related to the positive G-5 interest gap. (I would love to get Daniel Gros' real housing price index for the Euro area and run a scatterplot of it too)

So in the end I am stuck on the view that loose monetary policy (in conjunction with boom psychology) was very important to the housing boom-bust cycle of the past few years.

Monday, October 22, 2007

Not a Pretty Sight

Menzie Chinn over at Econbrowser is feeling distressed today. He came across the below graph in the IMF's Global Financial Stability Report that shows the dollar amount of mortgage resets coming due in the future, as well as those in 2007. Take a look at the resets coming due in 2008--they are mostly subprime mortgages. Menzie looks at this sobering graph and concludes the "subprime resets in 2008 should put to rest the notion that the housing market's troubles are soon to be put behind."

C. Fred Bergsten on the Euro

Here is C. Fred Bergsten of the Peterson Institute on the fate of the Euro. His punchline is very similar to Thomas Palley (Triangular Trouble: the Euro, the Dollar and the Renminbi),
C. Fred Bergstein
Op-ed in the Financial TimesOctober 11, 2007

The euro has recently hit a succession of record highs against the dollar. A number of European leaders, including Nicolas Sarkozy, the French president, and Jean-Claude Juncker, chairman of the group of 13 eurozone ministers, have called on the United States to take action to halt the trend. The issue will be high on the agenda of the forthcoming Group of Seven leading industrialized nations and International Monetary Fund meetings in Washington. The eurozone should look to Beijing rather than Washington, however, if it wants to avoid the costs to its economies of a much stronger currency.

The bad news for Europe is that the dollar is likely to decline by at least another 15–20 percent on average. Growth differentials have now moved against the United States, which may experience the slowest expansion of any G-7 country in 2007. Differentials in short-term interest rates have correspondingly moved against the dollar. The US current account deficit is still running close to 6 percent of gross domestic product and, along with America’s own capital outflow, requires financing through an unsustainable $7 billion of foreign capital inflow every working day. The sharp pickup in US productivity growth that underpinned the strong dollar for a decade has been fading. The euro creates a meaningful international competitor for the dollar for the first time in a century and will attract continuing portfolio diversification from around the globe, including the super-rich sovereign wealth funds.

The good news for Europe is that most of the remaining decline of the dollar should take place against the currencies of the East Asians and the oil exporters. They are running the counterpart surpluses to the US deficits. They have piled up massive foreign exchange holdings that already far exceed any plausible needs. They are enjoying rapid economic growth that could most easily accommodate the reductions in external surpluses.Many of them need to shift their growth patterns to domestic expansion for internal reasons. A few of the surplus countries have moved in this direction. The currencies of South Korea, Indonesia, and Thailand have risen more against the dollar than has the euro. Kuwait has abandoned its dollar peg and let its rate float upward.

But the exchange rates of the largest surplus countries of Asia have barely budged. China is, of course, the most blatant case. Its global current account surplus is likely to exceed $400 billion in 2007, more than half of America’s global deficit. This will represent more than 12 percent of its GDP and provide one-third of its total economic growth. The renminbi needs to rise over the next several years by a trade-weighted average of more than 30 percent, and much more than that against the dollar, as part of a broader rebalancing of China’s growth strategy towards relying more on domestic consumption than on investment in heavy industry and climbing trade surpluses.

China claims to have adopted a market-oriented currency policy in July 2005. At that time, it was buying $20 billion to $25 billion monthly in the foreign exchange markets to block appreciation of the renminbi. It is now intervening at $40 billion to $50 billion per month. On that metric, its exchange rate is about half as market-oriented as two years ago. It is thus no surprise that the renminbi’s rise of about 10 percent against the dollar over this period was more than offset by the dollar’s fall against other currencies, so that China’s average exchange rate is weaker today than it was then, or in the early part of this decade when China’s current account was near balance and the dollar was at its record peak. Nor is it a surprise that China’s external surplus continues to soar.

Many other Asian countries hold their currencies down, through sizeable intervention of their own, to avoid losing competitive position to China. This is especially true of Hong Kong, Malaysia, Singapore, and Taiwan. Most of the large oil exporters intervene heavily to maintain undervalued pegs to the dollar as well. Japan’s currency is also substantially undervalued, though due to its appropriately easy monetary policy rather than any official manipulation. A substantial rise of the renminbi would almost certainly pull at least the other Asian currencies, including the yen, up with it.

The problem for Europe is that the inevitable further decline of the dollar will continue to occur mainly against the euro unless the large Asian countries and oil exporters permit substantial increases in the value of their currencies. Hence eurozone leaders should be addressing their concerns to Beijing, and to some extent Tokyo and Riyadh, rather than Washington, especially with the US current account deficit now falling and the budget deficit for fiscal 2007 at a mere 1.2 percent of GDP. Even if the euro were to rise a bit more against the dollar, large appreciations from the Asian countries and oil exporters would limit or even negate any further increase in its trade-weighted average and thus in the eurozone’s global competitiveness.

Rather mysteriously, Europe has been largely absent from efforts to address global imbalances over the past three years, in spite of warnings that it had the biggest stake in a geographically diversified outcome. The obvious places to start are effective implementation of IMF rules against competitive currency undervaluation and “prolonged, large-scale one-way intervention,” and the World Trade Organization rules against “frustrating the intent (of the Articles) by exchange action” and export subsidies, as Ben Bernanke, Federal Reserve chairman, has labeled China’s currency practices. Perhaps a euro at $1.50 or $1.60 will focus European minds on these imperatives.

Friday, October 19, 2007

House prices and the stance of monetary policy

A new paper provides further evidence on a view (see here, here, and here) promoted by this blog: past monetary profligacy contributed to the U.S. housing boom-bust cycle. Marek JarociƄski and Frank Smets of the European Central Bank in a conference paper titled House Prices and the Stance of Monetary Policy find the following:

In this paper, we have examined the role of housing investment and house prices in US business cycles since the second half of the 1980s using an identified Bayesian VAR... There is also evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

I wrote a similar note on U.S. monetary policy and the U.S. housing boom. In my note, though, I use a different measure of monetary policy than the paper above and discuss the issue from a more Wicksellian perspective. Nonetheless, the conclusions are essentially the same: the Fed was too accommodative during the "deflation scare" 2002-2003 and was slow to return to normalcy thereafter.

The Business Cycle and Religiosity

Does economic distress increase religiosity and vice versa? This is a question that first intrigued me back in 2001, during the last U.S. recession. I was visiting my sister in Atlanta, Georgia and attended her church. During a part of the church service a microphone was passed around to individuals who then shared with the rest of the congregation what was going on in their life. Almost everyone who participated during this open mike time had just lost their job and were asking God to find a new one for them. As the right side of my brain sympathized with these suffering individuals, the left side of the brain got excited and started thinking about the econometric possibilities. I wondered, might this experience be reflecting a much broader, systematic relationship between church attendance and the business cycle? If so, were would I get data to test for such a relationship? And would this relationship be different for different denominations? I was curious and wanted to find out more.

I was a graduate student back in 2001 and had other pressings issues that put this interesting question on hold. I recently started looking at this issue again and now have a working paper titled "Praying for a Recession: The Business Cycle and Church Growth." I will be presenting this paper at the annual meetings for the Association for the Study of Religions, Economics, and Culture (ASREC) in November. My abstract reads as follows:

Some observers believe the business cycle influences religiosity. This possibility is empirically explored in this paper by examining the relationship between macroeconomic conditions and Protestant religiosity in the United States. The findings of this paper suggest there is a strong countercyclical component to religiosity for evangelical Protestants while for mainline Protestants there is both a weak countercyclical component and a strong procyclical component.

This paper is preliminary and I would appreciate any comments on it.

Tuesday, October 16, 2007

The Bubble Man Song

Via the Big Picture ,we have a great song from Scott Pettersen about the bubble man. Sit back, relax, and enjoy some great music.

The Fall of the Dollar

Above is the trade weighted value of the dollar against major currencies (major currency index includes the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden). Although the figure shows the dollar to have fallen significantly against the major currencies since 2002, many observers believe it has not hit bottom yet given the large U.S. current account deficits. Take a look at this graph to get a better sense of why a further fall in the dollar may be needed. The ongoing fall of the dollar is attracting much attention. Below are some interesting articles on this development.

A more competitive dollar is good for America, by Martin Feldstein, Commentary, Financial Times: The dollar has finally begun its long overdue correction. The dollar’s decline in recent weeks is just a prelude to the much more substantial fall needed to shrink the US current account deficit, running at a nearly $800bn annual rate, about 6 per cent of gross domestic product. If the dollar remained at its current level, the US trade deficit would continue to expand because Americans respond to rising incomes by increasing imports more rapidly than foreign buyers raise their imports from the US. Although a faster growth rate in the rest of the world would raise US exports and reduce the US trade deficit, experience shows that even substantially faster foreign growth would have only a very small impact. A lower dollar has to do most of the work of reducing the global trade imbalance. (Read the rest)

Triangular Trouble: the Euro, the Dollar and the Renminbi , by Thomas I. Palley: For the last several years the euro has been appreciating steadily against the U.S. dollar. Given the Chinese renminbi and other East Asian currencies are pegged to the dollar that means the euro has been appreciating steadily against all. This spells trouble for Euroland, and it suggests European policymakers should join with the U.S. to address the global problem of under-valued currencies. (Read the rest and see related article at the Economist: A Worker's Manifesto for China)

Is the United States headed for double bubble trouble?, by Richard Baldwin, Vox EU: In the minds of most mainstream international economists, there is never much doubt that the dollar must eventually decline significantly.[1] A trade deficit this big cannot persist indefinitely. Many analysts hope that the necessary real depreciation of the dollar might be gradual. After all, isn't the avoidance of such jumps one of the reasons we abandoned the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar?

Here is the basic idea underlying dollar 'plunge scenarios.' Foreign investors have long demonstrated an increased appetite for US assets, moving a greater share of their portfolios into dollars and thus generating large capital flow into the US. But the capital flows needed to maintain an increased dollar share are much smaller than those needed to achieve it. Thus, when investors reach their desired holdings, there will be a drop off in capital flows into the United States, leading to an abrupt decline in both the current account deficit and the value of the dollar. (Read the Rest)

Why These Historical Patterns?

A number of blogs have pointed to some interesting patterns in the history of financial markets: the month of October (1929, 1987, 1997) and years ending in 7 (1837, 1847, 1907,1987,1997, 2007) seem prone to financial crises. These patterns may be purely coincidental or they may reflect some real economic phenomenon yet to be discovered. In any event, below are two blogs commenting on these patterns.
As experts look back at 20th anniversary of the stock market’s Black Monday crash, some questions remain about why October has been a common month for major declines. The reasons aren’t clear, but Federal Reserve Chairman Ben Bernanke has offered one possible explanation.

In today’s
retrospective of the 1987 crash, the Journal’s E.S. Browning notes, “For reasons analysts don’t fully understand, October has been the month for market crashes and other sudden drops. It was in October that stocks crashed in 1929, falling 23% over two days. On Oct. 27, 1997, within a day of the anniversary of the 1929 crash, the Dow Jones Industrial Average fell 7.2%, for a drop of 13% in two months.”

Mr. Bernanke commented on the phenomenon in a 2005 interview with Randall Parker, an economics professor at East Carolina University, about the Great Depression. “Classically, October has always been the month for financial problems,” Mr. Bernanke said. “If you look at the reasons for the Federal Reserve Act in the beginning, one reason was to provide an elastic currency. The main purpose of an elastic currency was to provide extra money as needed during periods of harvest or planting which in turn was intended to keep short-term interest rates more stable,” Mr. Bernanke said. “The high short-term interest rates during the fall and the spring created a shortage of liquidity and often provided the backdrop in which banking panics would take place.”

Although, it’s hard to understand why this should still be the case when agriculture has become such a smaller part of our economy. Perhaps, people just can’t let go of harvest traditions, whether they be jack-o-lanterns or banking panics.
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

Thursday, October 11, 2007

How Bad Will It Get in the Housing Market?

Nouriel Roubini had a recent posting on his blog where he concluded he had been "Way Too Optimistic on the Housing Recession", this coming from someone known as one of the biggest bears on the housing market. He notes that his assessment of the housing market a few months, which many observers considered to be extreme, is now sounding very similar to the forecasts for the housing market coming from major investment banks on Wall Street. For example, Morgan Stanley is now calling for a cumulative decline in the number of housing starts to reach 56% while Goldman Sachs is saying housing prices will fall a further 15% on average before the dust settles sometime in 2008-2009. Robert Shiller is saying home prices will need to fall as much as 50% in some areas. So Nouriel was not too far off calling this the worst housing recession since the Great Depression.

The chief economist at Standard & Poors is now seconding this bleak outlook, as reported in the New York Post. (hat tip: NYC Housing Bubble). Some excerpts:

October 10,2007--A top economist predicted an even bleaker housing recession, saying it will last at least another two years, dragging down the American economy to trail the rest of the world. "Housing prices won't hit bottom until next summer and the losses won't peak for another two years, until 2009," said David Wyss, chief economist of Standard & Poor's. "We are not halfway through this crisis yet."

Although there has been an improved outlook for the economy overall, this housing sector analysis suggests we can look forward to deteriorating conditions in the housing market though 2009. Hang in there America.

Sudeep Reddy at the WSJ Real Time Economics blog reports on a AEI panel discussion today on the outlook for the housing market and its influence upon the broader economy. Here is some of what Sudeep reports:

But the recent interest-rate cut by the Federal Reserve, and a rallying stock market, aren’t swaying some economists from their expectation of a housing-induced recession. It was more a question of when, not if, during
a discussion today at the American Enterprise Institute about risks from the deflating mortgage and housing bubble.

"AEI visiting scholar John Makin said the recent performance of stocks suggests “financial markets are in a period of denial.” Housing downturns of today’s magnitude have always been followed by a recession, Mr. Makin says, calling the current environment a “textbook recession lead-up.”

“When you have a recession and the market doesn’t believe a recession [is coming], you get very radical changes in the financial markets,” he said. Credit instruments today “that are sort of hanging on by their fingernails…are not priced for a recession. I’m very concerned that we have a bit of a false dawn here, because that only delays the adjustment process.”

Desmond Lachman, a resident fellow at AEI, spelled out the key figures in case they’ve been forgotten: Previous housing booms featured a 20% inflation-adjusted appreciation in home prices. The current housing boom: an 80% increase in prices. House prices from 1979 to 2000 were 3.2 times people’s incomes; now they’re 4.5 times income. Mr. Lachman expects house prices to fall 15% to 30% from the peak to the ultimate trough. “This isn’t your regular kind of housing bust,” he said. “This is the worst housing bust that we’ve had in the post-war period.”

New York University economics professor Nouriel Roubini said housing starts would fall from the current annual rate of 1.3 million (a 12-year low) to 900,000 to clear the market glut, pushing down prices along the way. With a drop in business investment and consumer spending as well, that means a hard landing for the economy, he said. The stock market rallied in April and May of 2001 (just after a recession started) as the Fed eased interest rates. “The Fed cannot rescue neither the markets nor the economy,” he said."

Wednesday, October 10, 2007

Another Look at the Depressed Michigan Economy

In a previous posting I mentioned how the depressed economy in Michigan was making it difficult to sell my home. I posted a graph that showed how the Michigan housing market never benefited from the U.S. housing boom of 2003-2005, yet it is now feeling the pain of the U.S. housing bust. Poor, poor Michigan.

Over the past few days there has been added attention given to the depressed Michigan economy because of the Republican debate that was held there last night. For example, the New York Times reports on "Michigan's economic Woes" and the Arizona Republic reports "Michigan's plight backdrop of GOP debate on economy." Here is an excerpt from the latter article:

"We're an economic basket case, and it's dominating everything here," said Bill Ballenger, editor and publisher of the influential nonpartisan newsletter Inside Michigan Politics. "Our unemployment rate is 7.4 percent, the highest in the country. We've lost 400,000 manufacturing jobs, which is the heart of our economy here in Michigan. We've just never really recovered from the 2001 recession, and that has affected state revenues and has led to a budget crisis here that has been largely averted now, but there are still a lot of problems. Michigan is the worst, probably, in the entire country."

I find it interesting that Bill Ballenger says the Michigan economy never really recovered from the 2001 recession. This lack of recovery is evident in the my housing graph from this previous posting. Following its report on the debate last night, NPR also chimed in on the depressed Michigan economy with this discussion. By far, however, the most interesting piece I saw on the Michigan economy is the video clip below from CNBC. Among other things, it discusses how the foreclosure rate in Michigan is one of the highest in the nation and how home prices in Detroit have fallen 32% over the past year. (Thanks to Brian Arner for helping me make the video clip work.)

CNBC's Diana Olick reports on the Michigan housing market.


Paul asks about the housing market in Ann Arbor in the comments sections. I turned to the OFHEO housing price index for insight. Here is a figure constructed from the OFHEO index that shows the year-on-year housing price growth rate in current dollar terms.

Sunday, October 7, 2007

The Probability of a Recessin for 2008 Falls Below 50%

Friday we learned that nonfarm payrolls showed 110,000 jobs were created in the month of September. This report does not sound like a recession to me. However, the best news from Friday was that the supposed 4000 lost jobs in August were actually 89,000 new jobs. These job numbers led to headlines such as : '"Nevermind--US job growth firm after revisions", "Job Growth Looks Rosier, Easing Recession Fears", or "Jobs: A September Shocker." These numbers certainly are encouraging and, as noted in the above stories, have some observers reevaluating their economic forecasts. I went to intrade and looked at the contract for there being a recession next year. Here is the graph:

The wisdom of the markets now say there is now less than a 50 probability of a recession next year. I really hope these jobs numbers are a turning point for the US economy, but for reasons discussed in this blog before I will not surprised if this good news is fleeting.

And from the Big Picture, Barry Ritholtz keeps us sober by reminding that "[a]ny report under approximately ~150k month (subject to revisions) is weak. It means that job creation is failing to keep up with population growth."

Below is a graph from the Cleveland Fed showing the market's expectation for the outcome of the October FOMC meeting. This graph is based on options on federal fund futures. Note that as of Friday it shows a greater than 50% of the federal funds rate staying at 4.75%.

Wednesday, October 3, 2007

Lawrence White on the Right Type of Inflation Target

Lawrence White has a interesting article in the most recent CATO journal titled "What Type of Inflation Target?" One point from his article is that an inflation targeting rule that only targets output prices is not sufficient to prevent the boom-bust cycles in asset prices we have seen over the past few decades. An excerpt:

"The remedy for central-bank-generated-asset-bubble problems isn’t continued discretion, but rather a better “price rule”... In other words: the problem isn’t in having a target, it’s in having a target limited to the CPI. A better target would incorporate asset prices, directly or indirectly, rather than only consumer prices. Examples of direct incorporation include a gold standard, a rule targeting an Alchian-Klein-type index that incorporates asset prices, or a rule targeting an index of input prices (wages and/or raw material prices). An example of indirect incorporation would be a rule targeting a broad measure of per capita nominal expenditure (Py), as proposed by George Selgin (1990), rather than only the CPI price index (P)."

Similar arguments have been made by others observers. Here is the Economist magazine in a 2005 article titled "Steering by a Faulty Compass." Some excerpts:

"When inflation targets were first introduced (in New Zealand in 1989), the exact measure of inflation did not matter much. The main objective then was to reduce high rates of inflation by anchoring expectations. Today, however, consumer-price indices are arguably too narrow. Charles Goodhart, a former member of the Bank of England's Monetary Policy Committee, has long argued that central banks should instead track a broader price index which includes the prices of assets, such as houses and equities...

The idea that central banks should track asset prices is hardly new. In 1911 Irving Fisher, an American economist, argued in a book, “The Purchasing Power of Money”, that policymakers should stabilise a broad price index which included shares, bonds and property as well as goods and services. Central banks already take account of asset prices by estimating their effect on wealth and hence on demand and future inflation, but the idea behind a broad price index goes much further, acknowledging that asset-price inflation can be harmful in its own right.

The most obvious way is through a giddying rise and subsequent crash of markets for shares or property. Big swings in asset prices can also lead to a misallocation of resources and so slower economic growth, just as high rates of general price inflation distort economies by blurring relative price signals. For instance, soaring property prices can encourage households to borrow too much and save too little, and can pull excessive resources into property at the expense of other forms of investment.

More fundamentally, if inflation is defined as “changes in the value of money”, then the consumer-price index is flawed because it only measures the prices of current consumption of goods and services. A classic paper written in 1973 by two American economists, Armen Alchian and Benjamin Klein, argued that people care about changes in the prices not only of the goods and services they consume today, but also of what they use tomorrow. Because assets are claims on future goods and services, their prices are proxies for the prices of future consumption. If I buy a house—i.e., a claim on future housing services—and its price is higher than a year ago, then surely that should be included in inflation since it reduces the purchasing power of my money. Many consumer durables, such as cars, which also provide services over several years, are already included in the CPI.

If the prices of goods and services and those of assets move in step, then excluding the latter does not matter. But if the two types of inflation diverge, as now, a narrow price index could send central bankers astray. Granted, asset prices are hard to measure: a rise in house prices may partly reflect an increase in the average quality of homes; and economists disagree over what weight house prices should have in a broad index. Yet buying a home is an enormous expense, so it is absurd to use such a rough approximation as rent, as does America's CPI, or to exclude the costs of owner-occupier housing altogether, as does the European Union's harmonised index of consumer prices."
Too bad the Fed did not incorporate these ideas into policy making over the past decade.

The Housing Recession Hits Home

Readers of my blog know I have taken a hard line against Fed interventions during the past few months. For example, in "Sound Policy or Liquidity Addicts" I took the Jim Cramer's of the world to task for their calls for a Fed bailout of financial markets. Some readers may read postings like that and conclude that I am just another out-of-touch academic spouting painful policy prescriptions from the comfort and safety of my ivory tower. If this thought has crossed your mind then this posting is especially for you.

Yes, I have been prescribing painful economic medicine, but this advice has not been in my own self-interest. This past summer I moved from Southwestern Michigan to Central Texas. As part of this move, I put my home on the worst national housing market in the past 40 years. What made my life even more interesting is that my house was placed on one of the worst state housing markets as well. Consequently, my home has been getting few bites and I have been making two home payments. Two home payments for our one-income family have been painful. Questions about this arrangement persisting for some time--some observers are predicting the housing recession will continue through 2009--has also been troubling. To add some perspective to this discussion consider the two figures below. These figures show the growth rates of the OFHEO housing price index for the nation, the state of Michigan, and South Bend, Indiana. The latter one is included because my home was not too far from South Bend, Indiana. The first figure shows the growth rates of housing prices unadjusted for inflation:

This figure shows the Michigan housing has had some big swings in the past and currently is declining in current dollar terms. Moreover, the figure indicates that Michigan and South Bend housing markets never really were part of the housing boom during the 2003-2005 period. The bottom line from this figure is that I bought a home in a particularly weak housing market... not very promising. But wait, there is more to this story. The above figure does not adjust for inflation. What has been the real return for houses in Michigan over this time? The next figure, which takes the OFHEO index and deflates it with the PCE deflator, answers this question:

This figure is striking: the growth rate of real home prices in Michigan has been declining since 2001 and turned negative in 2005. The South Bend, Indiana housing market is slightly better than the Michigan housing market, but still is relatively flat compared to the national average. Some caution should be taken in evaluating this figure: the regional housing price indices were deflated with a national price index. I am not sure, though, that the outcome would be much different if a regional price index were used.

Now back to my world. This week my wife and I finally received an offer on our home. We gave a counter offer and the prospective buyers accepted. Our counter offer requires us to bring money to table. We are glad to be paying this amount just to unload our home. So, we too have been hit by this housing recession. I would like to think that makes me an academic who has not lost touch with the real world

I redid the second figure with the PCE deflator. The results seem more reasonable than what they were using the CPI as the deflator.