Are You Smarter Than A Professional Forecaster?

I have been making a lot of noise here about the Fed's passive tightening of monetary policy.  In particular, I have been pointing to declines in both inflation expectations and forecasts of nominal GDP (NGDP) to show that the Fed is allowing expectations of future aggregate demand (AD)  to fall.  Since future spending affects current spending, current Fed policy is also effectively slowing down current AD.  Given this running discussion of mine, I thought it would be interesting to see what my undergraduate students think about it.  Specifically, what is their outlook for AD?  On the first day of class I assign a personal profile sheet they have to fill out--helps me get to know them better--and this semester I added a question that asks them to forecast of the annualized NGDP growth for 2010:Q3 and 2010:Q4. I gave them a chart of the annualized NGDP figures of the previous 6 quarters and and told them to use it and their knowledge of what is happening to make their forecasts.

Since these are undergrad students mostly from Texas, a state that hasn't been hit as hard by the recession, and since many undergrads are not as engaged with the current events as they should be I expected rather optimistic forecasts.  Here is what I got from my three classes (click on figure to enlarge):

Much to my surprise my students overall see an ongoing downward trend in the growth rate of nominal spending.  All of their 2010:Q4 forecasts are lower than that coming from the Survey of Professional Forecasters.  I really expected more optimistic numbers.  Maybe they simply followed the trend from the previous quarters in making their forecasts or maybe they truly are worried about the future.  I look forward to class today to hear their justification for their forecasts.  I also look forward to seeing how their forecasts pan out compared to the professionals during the semester.  

Bernanke's Speech: A Big Tease

Ben Bernanke delivered a much anticipated speech today at the Jackson Hole Economic Symposium.  Many observers, myself included, were wondering if he would advocate a more aggressive role for monetary policy given the signs of weakening in the U.S. economy.  Instead, what he delivered was a big tease: he acknowledges three points made by advocates of more monetary easing, but then either ignores the implications of these points or argues against them.

Let's look at the three points he acknowledges in turn.  First, he concedes that the low interest rates can reflect a weak economy rather than being a sign of loose monetary policy.  Second, he grants that the Fed can be effectively tightening monetary policy simply by being passive.  He makes these two big concessions in his discussion of why the FOMC decided to stabilize the Fed's balance sheet (my bold):

[A]llowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.

Consider the implications of these points.  First, if lower interest rates reflect economic weakness--though he mentions long-term interest rates recall they are the expectation of a bunch of short-term interest rates plus some term premium--then one implication is that the low federal funds rate may not be so accommodative after all. Given the state of the economy, maybe the 0%-0.25% range for the federal funds rate is not low enough.  Now the federal funds rate cannot go negative (and this is one of the problems with using an interest rate target), but if it could the implication here is that it may need to go deep into negative territory in order to be at the appropriate level.  Folks like Andy Harless and Glenn Rudebusch have made this very point. So what does Bernanke think? Does he run with his own argument to its logical conclusion?   The answer is no. Elsewhere in the speech he claims that "monetary policy remains very accommodative" and that the "Fed has also taken extraordinary measures to ease monetary and financial conditions. Notably,... the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points..." In short, Bernanke thinks the low federal funds rate is sufficiently accommodative, even after acknowledging that low interest rates can reflect weak economic conditions rather than loose monetary policy.

Now consider his second concession: the Fed can effectively be tightening monetary policy just by being passive.  He acknowledges this point in the context of stabilizing the Fed's balance sheet.  This is an important insight, but what about the other ways the Fed can passively tighten monetary policy? Currently, the Fed is failing to stabilize the NGDP or aggregate demand forecast. By allowing this to happen the Fed is effectively tightening monetary policy.  Why is he not concerned here too about such passive tightening of monetary policy?

Bernanke's third concession is an important one too. In his discussion of what the Fed can do if more action is required, he alludes to the idea of price level targeting. Now this option is not as good as NGDP level targeting, but it would be vast improvement over what is going on. Here is what he said:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability... in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

He is absolutely right that a price level target would mean higher than normal inflation currently to get the economy back to its previous price level path.  If such a price level target were formally announced, it would go a long ways in (1) creating more economic certainty  and (2) helping household balance sheets repair themselves. So is Bernanke on board? Unfortunately, for two reasons the answer is no. First, he sees no support for such a policy in the FOMC .  And, apparently, this is one battle he does not want to fight at the Fed.  Second, and more troubling, he does not think it is needed and believes it could even be problematic:

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy

 This is perplexing on so many levels. First, an explicit price level target would not destroy long-run inflation expectations.  Yes, there may be an inflation catch up period, but over the long-run the inflation rate would be governed by the inflation rate implied by the price level target.  (Of course, an even better solution would be targeting a NGDP level, but I digress.) Second, for the 100¹⁰⁰ time, inflation expectations are not stable or well anchored.  The have been falling all year across all horizons as can be seen with the Clevend Fed data .  This sustained decline can also be seen below on a daily basis for the five-year horizon:

How can there be any question about falling inflation expectations?  (For those concerned that the liquidity premium is distorting the implied expected inflation rate from the Treasury market note the following.  First, the Cleveland Fed data corrects for this potential distortion.  Second, even in the case of the chart above a heightened liquidity premium only reinforces the likelihood of growing deflationary pressures. This is because a heightened liquidity premium implies a heightened demand for highly liquid assets like treasuries and money. In turn, this implies less spending and greater deflationary pressures.) Third, if there is anything driving increased uncertainty it is a weakening economy. And by failing to stabilize  inflation expectations, the Fed is allowing economic uncertainty to grow.  Bernanke seems hung up on a potential source of economic uncertainty instead of looking to an actual source of economic uncertainty. 

What a big tease.

Time's A Ticking

The always colorful Ambrose Evans-Pritchard:

Fiscal and interest rate ammo has been exhausted, though not QE. I have little doubt that central banks can lift the West out of debt-deflation if needed with genuine QE – not Ben Bernanke's Black Box "creditism", or Japan's fringe dabbling. Whether they have the nerve or the ideological willingness to do so is another matter.

Also see his earlier comments on Bernanke's "creditism" here.

The Needs of Pakistan

The tragedy unfolding in Pakistan is mind boggling.   Robert Reich discusses why you should be concerned about it:

Flooding there has already stranded 20 million people, more than 10 percent of the population. A fifth of the nation is underwater. More than 3.5 million children are in imminent danger of contracting cholera and acute diarrhea; millions more are in danger of starving if they don’t get help soon. More than 1,500 have already been killed by the floods.

This is a human disaster. It’s also a frightening opening for the Taliban.

 Laura Freschi suggests ways one can help.

How Low Must It Go?

Recently I noted that aggregate demand forecasts are falling.  Well today I learned that it gets worse: aggregate demand is already falling!  Macroeconomic Advisers just updated its monthly nominal GDP series, a measure of aggregate demand,  and it shows a decline for May and June as seen below (click on figure to enlarge):

I shouldn't be surprised with these numbers since expectations of future economic activity affect current spending decisions and for some time expectations have been deteriorating. Still, I was shocked to see the outright decline in May and June. Let's be clear what this development means: total current dollar spending declined during May and June in the U.S. economy.  And most likely it continued to fall in July and August given the weak economic outlook.  This makes me wonder how low the dollar size of the U.S. economy must go before the Fed gets serious and pulls out its big guns?

Farmer Bernanke and His New Farm Tools

Building upon Christopher Hayes' metaphor of central banking as farming, Neil Irwin shows that some of the issues in implementing unconventional monetary policy can be tricky since no one at the Fed has ever tried them before.  Fed officials are reluctant to act because they are uncertain of the outcome.  Here is Irwin:

If the nation were a farm, Hayes argued, the Fed would be the agency in charge of water and irrigation. Its job is to keep water (money) flowing enough to maximize crops (strong job creation), but not pump in so much water as to cause flooding (inflation). We're currently in an extreme drought (a deep recession), but the Fed is refusing to pump in more water because it's afraid that doing so will cause flooding down the road.

This drought is so bad that the Fed has already drained its main reservoir completely (cut the federal funds rate to zero). So if it's going to take new efforts to water the fields, it has to find more water through some unconventional means, such as by airlifting water in by helicopter, or piping it in from a nearby lake. (These are the equivalents of quantitative easing, or buying Treasury bonds and other securities to increase the money supply and drive down long-term interest rates).

The problem is, while the Fed has lots of experience and knowledge about how the controls on its normal reservoir work, and how much to open the valves to get the right amount of water onto the fields, these other tools are untested. If they pipe water in, they're not sure how much will get to the fields--it might be too little to do much good, and it might be so much as to cause flooding.

That is a good point, but it certainly did not stop farmer Bernanke and all his farm hands from flooding the financial fields with large scale "credit easing" in 2008-2009.  I am sure there was plenty of uncertainty back then about conducting "credit easing", but the sense of urgency overrode this concern.  Likewise, if there were enough urgency today the Fed probably would not hesitate to do more unconventional monetary policy.  The real question, then, is why the lack of urgency?

Hat tip: Ezra Klein

A Bubble in the Bond Market?

Jeremy Siegel and Jeremy Schwartz claim there is a U.S. bond bubble:

Ten years ago we experienced the biggest bubble in U.S. stock market history.... A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.... We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.... 

While they may be right that bond prices have gone up because of economic pessimism and the associated low interest rates, there is good reason for the pessimism.  It's called a recession, not just any recession but a balance sheet recession. The balance sheets of households in particular have deteriorated so much they are back to where they were about 20 years ago.  It will probably take years to heal household balance sheets.  If so, there is little reason  to believe there is going to be a robust economic recovery anytime soon that will push up interest rates and cause bond prices to crash.  The importance of weak household balance sheets cannot be overstated.  It is the main reason why the federal government balance sheet is currently growing (i.e. the contraction of household balance sheets is being offset by the expansion of the government balance sheet) and therefore is, in part, indirectly responsible for all the concerns about exploding fiscal deficits.  Siegel and Schwartz try to dismiss this concern by saying the problem is overstated but I don't buy it.  Neither do  the economists in the Survey of Professional Forecasters. They see a weak recovery at best at least through 2011.  Even if one accepts Siegel and Schwartz's view that there is excessive pessimism in the market it is still hard to talk about bubbles in the bond market like on does with the stock market as noted by Brad DeLong.   

In short, there is economic weakness a far as the eye can see and this suggests interest rates will probably be low for an extended period of time.  Therefore, even if we do have a bond bubble it is not going away anytime soon.  As Colin Barr says, for now we may be stuck with an unpoppable bond bubble.

Update: Felix Salmon and Karl Smith make similar points.
Update II: Barry Ritholtz doesn't quite call it a bubble, but says it has the markings of something close to a bubble.