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July 30, 2009

Can the Taylor rule describe the current stance of monetary policy?

One of the constants of monetary policymaking is the never-ending quest to characterize the stance of monetary policy in real time. Is Fed policy too easy? Too tight? Just right? It's not an easy task, but over time academics and practitioners alike have found comfort in the rule-of-thumb characterization commonly known as the Taylor rule. Glenn Rudebusch, writing in the San Francisco Fed's Economic Letters a few months back, described the Taylor rule thus:

"The resulting empirical policy rule of thumb—a so-called Taylor rule—recommends lowering the funds rate by 1.3 percentage points if core inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point. As shown in Figure 2, this simple rule of thumb captures the broad contours of policy over the past two decades."

Here, for your convenience, is the aforementioned Figure 2:

072909
Source: Federal Reserve Bank of San Francisco

The really interesting part of that picture, as noted by Brad DeLong, is the "shortfall" bit. Explains Rudebusch:

"The shaded area in Figure 2 is the difference between the current zero-constrained level of the funds rate and the level recommended by the policy rule. It represents a monetary policy funds rate shortfall, that is, the desired amount of monetary policy stimulus from a lower funds rate that is unavailable because nominal interest rates can't go below zero. This policy shortfall is sizable. Indeed, the Fed has been able to ease the funds rate only about half as much as the policy rule recommends."

Cue John Taylor, via Bloomberg:

"John Taylor has a message for economists who say Ben S. Bernanke is ignoring a benchmark guide for interest rates: They're wrong. Taylor should know: He wrote the rule.

"Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy.

"Taylor said his measure shows just the opposite: that Fed policy is appropriate, that central bankers are right to be considering how to withdraw their unprecedented monetary stimulus and that critics who say otherwise are misinterpreting his rule."

The Bloomberg article goes on to describe some haggling over the precise specification of the Taylor rule and what in effect amounts to how fast gross domestic product growth and inflation will throw the rule's prescribed funds rate target back into strictly positive territory. Here's Rudebusch's bottom line:

"According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years."

Taylor argues to Bloomberg:

"My rule does suggest a long time before we raise rates. But it also does suggest an earlier rate increase than you would think."

One puzzler about this debate: How does the Taylor rule work once you hit the point at which the Taylor rule can no longer be applied? How policy can work in such an environment is provided in the Rudebusch article:

"Toward the end of 2008, the recession deepened with the prospect of a substantial monetary policy funds rate shortfall. In response, the Fed expanded its balance sheet policies in order to lower the cost and improve the availability of credit to households and businesses. One key element of this expansion involves buying long-term securities in the open market. The idea is that, even if the funds rate and other short-term interest rates fall to the zero lower bound, there may be considerable scope to lower long-term interest rates."

OK, but doesn't that mean the stance of monetary policy is best characterized in terms of some real interest rate or array of interest rates, not the nominal federal funds rate that cannot possibly fall to the levels that the Taylor rule says it should?

Perhaps, then, ought we recast the Taylor-rule-based "stimulus shortfall" in terms of the real funds rate? That seems like a problem too. Says Rudebusch:

"Typically, changes in the funds rate affect other interest rates and asset prices quite quickly. However, the economic stimulus from the Fed's cuts in the funds rate was blunted by credit market dysfunction and illiquidity and higher risk spreads."

Precisely. But deep behind that Taylor rule formulation is an assumption about the normal chain of transmission from the funds rate to other interest rates and asset prices. Once we surmise that chain is broken or compromised, how does the Taylor rule of thumb help?

My question: Is the Taylor rule the right tool for discussing the stance of monetary policy at present?

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

July 30, 2009 in Monetary Policy | Permalink

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David, here are some of my thoughts on your question.

Posted by: David Beckworth | July 31, 2009 at 04:46 PM

There are two issues that should be kept distinct: 1) is the Taylor Rule useful when interest rates are near zero; and 2) is monetary policy effective when interest rates are near zero.

I've commented that monetary policy can be effective, via quantitative easing, in this post (http://businomics.typepad.com/businomics_blog/2009/01/monetary-policy-with-zero-interest-rates-is-the-fed-done.html).

As for the Taylor Rule, the Fed Funds rate has always been (to monetarists, at least) only a shorthand indicator of the stance of monetary policy. When quantitative easing will no longer affect the Fed Funds rate, then that rate is no longer useful, and the Taylor Rule is no longer useful.

What would be cool is to find a measure based on monetary aggregates that mimics the Taylor Rule.

Posted by: Bill Conerly | August 01, 2009 at 05:03 PM

I don't believe the Taylor rule of thumb should be applied to this recession as it is an extrapolation of the data used to form the rule. Essentially we are in unchartered waters for testing monetary policy, and sticking to a rule that hasn't encountered this territory doesn't seem right. The taylor rule is applicable in substance but quoting corresponding figures doesn't make sense as depressions act severely different to stimulus than recessions or downturns due to the added negativity throughout markets.

Posted by: Nicholas | August 02, 2009 at 09:38 AM

My answer: Yes. The wisest course of action at the moment is to keep monetary policy irrelevant by imposing a lower bound federal funds rate of zero, just as Taylor suggests.

The last thing we want or need is more private debt, and overcoming the banks' refusal to lend and the consumers' refusal to borrow would likely require rates that are much lower than the Taylor rule suggests. We just don't know what ugliness such efforts might cause.


Posted by: Tao Jonesing | August 02, 2009 at 09:03 PM

Interestingly, here is John Taylor on his Taylor Rule today in a Bloomberg article:

http://www.bloomberg.com/apps/news?pid=20601039&sid=aagcZb2nSg10

He summarizes the equation as follows:

target fed funds rate = 1.5*inflation + 0.5*gdp_gap + 1, where inflation = 2, and gdp_gap = -8

Posted by: James Breedlove | August 25, 2009 at 12:06 PM

In an economy with extreme structural imbalances, it seems to me the output gap is (if anything) given too much weight rather than too little in the Taylor "rule," and its strict application would contribute more to serial bubble formation than sustainable growth. Recent financial market behavior seems to support this hypothesis. Treatment of negative interest rates as more than a theoretical exercise will, in my judgment, bring further discredit on the economics profession and do institutional harm to the Federal Reserve. [A non-economist's take.]

Posted by: Namazu | August 28, 2009 at 10:34 AM

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July 24, 2009

A look at the recovery

Earlier this week my boss, Atlanta Fed President Dennis Lockhart, weighed in with his views about the shape of the economic recovery to come while speaking at a meeting of the Nashville, Tenn., Rotary Club:

"The economy is stabilizing and recovery will begin in the second half. The recovery will be weak compared with historic recoveries from recession. The recovery will be weak because the economy must make structural adjustments before the healthiest possible rate of growth can be achieved."

This quote was noted by Rebecca Wilder at News N Economics, along with similar sentiments from Nouriel Roubini and Mary Daly at the Federal Reserve Bank of San Francisco. You might add to the list Tim Duy's comments at Wall Street Pit and this assumption from Moody's Investor Services, reported at Seeking Alpha:

"Moody's predicts a 'hook-shaped' recovery path for banks, 'characterized by an upward tilt that lies somewhere in between a U- and an L-shaped economic recovery, implying a painful journey.' "

Says Dr. Wilder of the prospective recovery: "pathetic."

More colorful language than I would use, but if current forecasts come true, the early stages of the recovery will be as unusual as the recession itself.

How unusual? See for yourself:

072409

The chart plots the four-quarter growth rate of gross domestic product (GDP) from the trough of a recession against the depth of the corresponding contraction, as measured by the cumulative loss of GDP over the course of the downturn. The points within the red circle represent all previous postwar recessions, and they form a nice, neat, easily discernible pattern. That is, the pace of growth in the first year after a recession has, in our history, been reliably related to how bad the recession was. The deeper the recession, the faster the recovery.

The points within the blue circle are based on forecasts of GDP growth from the third quarter of this year through the third quarter of 2010, obtained from the latest issue of Blue Chip Economic Indicators (which reports survey results from "America's leading business economists"). From top left of the circle to bottom right, the points represent the 10 lowest forecasts of the most optimistic members of the 50 Blue Chip forecasting panel, the panel's consensus (or average) forecast, and the 10 highest forecasts of the most pessimistic panel participants.

I chose the third quarter as the reference point because nearly two-thirds of the Blue Chip respondents indicate that, in their view, the recession will indeed end in the third quarter of this year. Assuming this occurs, this recovery would appear to be a big outlier. Either we are about to continue making history—and not in a good way—or current guesses about the medium-term economy are way too pessimistic.

On another note, if you would like to do a little prognosticating of your own, I commend to you our new weekly editions of Economic Highlights and Financial Highlights.

By David Altig, senior vice president and research director at the Atlanta Fed

July 24, 2009 in Business Cycles, Economic Growth and Development, Forecasts | Permalink

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I'd be interested to see the recovery estimates of Blue Chip respondents in prior recessions...do economists typically predict a weaker recovery than history suggests (4 qtr GDP growth of ~2-3x the peak-to-trough GDP decline)? I'm also curious about the dispersions of prior recovery estimates versus current.

Posted by: Bryan Lassiter | July 24, 2009 at 06:14 PM

How can you have historical context without 1900-1942 on the graph? I call BS on the whole presentation without including the only relevant period of history in the past century.

Posted by: Able | July 25, 2009 at 02:14 PM

I didn't see 1937 on the scattergram.

Posted by: Alan von Altendorf | July 25, 2009 at 08:10 PM

It's not a recession. We are about to make history, and "not in a good way."

Posted by: Gregor | July 26, 2009 at 11:40 AM

Is the Y axis also inflation adjusted?

Posted by: cubguy | July 26, 2009 at 10:35 PM

A very powerful chart. The statement "the deeper the recession, the faster the recovery" is also consistent with "reverting to the mean" tendency of the stock market.

Posted by: Business Cycle Investor | July 27, 2009 at 09:34 AM

Isn't part of this comparing conditional to unconditional expectations? If these economists assigned probability 1 to the recession ending in Q3 then their forecasts would represent expected post-recession growth and your chart would be fine. If not then they represent an unconditional expectation---mixing anticipated post-recession growth with the possibility of continued recession. Not that this disproves your point of course, but would be interesting to try and more carefully control for this.

Posted by: JGB | July 27, 2009 at 12:39 PM

I'm a semi-retired business economist and do not have the historic data, but the consensus always forecast a weak recovery.

In 1981 I won the NABE annual forecasting contest by forecasting that the recovery from the 1980 recession would be an average recovery. It was the strongest forecast in the contest.

Posted by: spencer | July 27, 2009 at 03:13 PM

Thank you for laying out the playing field in such a succinct manner. The current projections do not fit well with the post-war data base. They are more akin to the decade long glide path of the depression, and why not. Many of the same dynamics are in place including deflationary pressures, unbalanced world trade, a predatory financial industry, and declining personal incomes and the accompanying debt deflation. The impending retirement boom is overhanging in the face of poor fixed income prospects.

This time around, Keynes is leading the charge, supported by loose monetary policy. I think the chart needs at least one data point from the pre-war period.

Posted by: Dan | July 28, 2009 at 07:04 AM

At some point, I will have to stop being surprised by economists who think the current recession should resemble earlier recessions just because they are all called recessions.

Cripes. A recession is a name for a few broad symptoms. If you want to diagnose the disease, you need to look at all the symptoms and consider the patient's history.

If I encountered a doctor who gave the same diagnosis to all patients experiencing nausea and fever, I'd expect that the doctor would occasionally fail to catch a very severe condition. Likewise with economists who consider the recession label to be sufficient for diagnosis.

Posted by: ottnott | July 28, 2009 at 02:20 PM

ottnott,

If you stray away from the tiny bit of information about what economists think in the graph, and bother to read what they say, many think this recession will not be resolved like other recessions. The graph itself shows that Blue Chip contributors do not think this recession will be resolved in similar manner to other recessions. Even the biggest optimists among them think this one is unlike others. So I have to ask, whatever are you talking about? Where do you see evidence here, or in the writings of professional economists, that they simply take "recession" as all the information needed about the current period?

Posted by: kharris | July 29, 2009 at 12:31 PM

Kharris,

"This time its different", its what you hear every time from the so called economists whether it is to explain why the economy should do well despite the dark clouds on the horizont or other way around why the dark clouds are here to stay despite first rays of light making thier way through the darkness.
The Deflation is caused by last years run up in comodity prices. Remeber, there is no deflation in a fiat system. Punishing the savers might not be fair but this the price we pay to avoid deflationary spiral like 1929-33.

Posted by: Buddy Aces | July 30, 2009 at 06:57 AM

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July 23, 2009

Unemployment rate: Count me surprised

Brad DeLong has taken a look at the job market and is counting himself among the economists who admit that, "Well, I just got it wrong." According to DeLong:

"… the rise in the unemployment rate during a recession should be a fraction of the decline we see in GDP relative to trend. According to Okun's Law, the unexpected extra 1.2 percent decline in real GDP in 2009 should have been accompanied by a 0.5 or 0.6 percentage-point rise in the unemployment rate. Instead, we experienced a 1.5 percentage point rise in the unemployment rate. I confess this comes as a surprise to me, but it shouldn't. Because evidence has been mounting that Okun's Law is broken—especially with regard to the retention of workers in a downturn."

I share Professor DeLong's surprise at the unemployment rate's response to this recession. Though I have never had a lot of faith in Okun's Law as a predictive device, I believe DeLong may be just a little too harsh on himself (and by extension, I guess, me) for not hitting the mark on unemployment prognostications. From what we know at the moment, the unemployment/GDP correlation is going to deviate from any other postwar experience by a fair margin. As noted in today's Wall Street Journal:

"Breaking from historical patterns, the unemployment rate—currently at 9.5%— is one to 1.5 percentage points higher than would be expected under one economic rule of thumb, says Lawrence Summers, President Barack Obama's top economic adviser. Since the recession began in December 2007, the economy has lost 6.5 million jobs, 4.7% of total employment. The unemployment rate has jumped five percentage points, while the economy has contracted by roughly 2.5%."

Below is a chart that illustrates the point. It plots the peak change in the unemployment rate during recessions (which has always been the unemployment rate change from the beginning to the end of the end of the recession) against the cumulative percent loss in GDP in those recessions. (In the chart, the blue dots represent the experience in each postwar recession. The red square represents the current downturn, making the assumption that GDP growth in the second quarter will be –0.5 percent and the recession will end sometime in the third quarter. For the sake of the exercise, I pulled these figures from Macroeconomic Advisers, the forecasting group run by former Federal Reserve Gov. Larry Meyer.)

072309a

The line in the graph above represent the simple statistical estimate of the relationship between changes in the unemployment rate and the cumulative GDP loss during each recession. Using this estimated Okun's Law, you would have guessed that the unemployment rate would have risen by about 2 percentage points. In other words, the best guess for the unemployment rate would be in the neighborhood of 7 percent, not 9.5 percent.

There are a couple of caveats to this analysis, of course. One is that, as is often noted, unemployment is a lagging indicator, so the peak in the unemployment rate can come after the recession ends. This caveat changes the picture somewhat (and misaligns the unemployment and GDP data), but not by a lot.

072309b

The second caveat is that there may eventually be revisions to GDP that make the recession look deeper than it appears at the moment, which would move the current episode closer to historic norms. On the other hand, the charts above assume that the unemployment rate will peak at 9.5 percent, which is not a certainty at the moment. (The "central tendency" projections published by the Federal Open Market Committee suggest that the rate will peak in the 9.9 to 10 percent range.)

Setting aside the possibility of any substantial revision in the data, perhaps one of the questions in the end will be whether the National Bureau of Economic Research Business Cycle Dating Committee was somewhat overaggressive in choosing December 2007 as the beginning of the recession. Though currently measured GDP growth was negative (barely) in the fourth quarter of 2007, GDP did not turn persistently negative until the third quarter of 2008. If we were to assume that the business cycle peak was actually in the second quarter of 2008, the picture would look like this:

072309c

With this alternative timing for the recession, the Okun's Law miss on the unemployment rate projection would have still been to the downside, but the error is quite a bit less dramatic than you get with the official recession dating.

In any event, I'm quite sympathetic to DeLong's theme that the dynamics of U.S. labor markets coming out of recessions appear to have changed starting with the 1990–91 economic contraction. And it might be hard for many people to argue with DeLong's point that the U.S. economy is likely headed toward another so-called "jobless recovery." But until more facts are in and we're able to look back on what transpired, I think we still, at this point, must reasonably count the current run-up in the unemployment rate as a puzzle.

Update: Casey Mulligan (University of Chicago) writes:

There are a host of public policies that discourage the earning of income, and do so more than they did before the recession. IMO, theat's why Okun's law is broken.

More at his blog.

By David Altig, senior vice president and research director at the Atlanta Fed

July 23, 2009 in Business Cycles, Data Releases, Labor Markets | Permalink

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But even when the economy was growing and times were good, business was laying people off left and right. Places like IBM and others would shutdown 5k worth of 'skilled' labor almost overnight.

It seems like steady destruction is the name of the game for many people in this new service economy.

Posted by: Former SS Resident | July 23, 2009 at 07:22 PM

Could simply mean that in the future there will be big downward revisions of gdp data...

Posted by: Daniil | July 24, 2009 at 01:54 AM

Of course you are surprised. Economists have been cheering the sending of American jobs overseas for a couple of decades now. It was supposed to make things better, for the Chinese and other poor folks. It also made Americans poor and unemployed. Oops.

America: no functioning job market, health care market, or education system. America: too corrupt to fix serious problem. America: the fattest 'no-can-do' country in the world.

Posted by: lark | July 24, 2009 at 02:52 AM

In each of the graphs, we can find at least one earlier recession - 1980 - in which the dot is as far from the regression line as in this case. In one graph, there appear to be 2 misses the size of the one we are working on now, with 1990 tossed in with 1980. In those cases, the jobless rate rose too little rather than too much, but it does give the impression that the fit isn't as tight as we are asking it to be. If we insist on one direction - the jobless rate too high - then we have a unique case on our hands. If we allow for the jobless rate being too high or too low, then we simply have one of the more extreme cases.

Posted by: kharris | July 24, 2009 at 08:54 AM

Another "DUH" moment!

Most GDP growth is going to the top spectrum of the economic ladder. That is why a jobless recovery...

Posted by: dr | July 24, 2009 at 12:58 PM

Mulligan is right that there is a disincentive to make earned income relative to investment income. His suggestion that this is new within the time period in question, is dubious, however.

Marginal tax rates on earned income were much higher prior to the reforms in 1986, and there were still ample incentives for investment income (particularly capital gains) relative to earned income at that time. The tax rates themselves also understate that preference because there were, believe it or not, far more loopholes (like passive loss tax shelters) available then than there were immediately following the reform. Estate tax rates have changes a lot during the relative time period as well, but are quite neutral between earned income and unearned income.

While the preference for unearned income increased during the George W. Bush Administration (i.e. after the 1990 and 2001 downturns and before the current one), with reduced rates on dividends from C corporations, reductions in top capital gains tax rates, increased importance for stock options and carried interest arrangements, etc. This isn't the whole story.

The portion of the population that is in the income taxed part of the workforce has greatly decreased, and the overall economic impact of income taxes on the working class and middle class has declined dramatically, starting with the reforms of 1986 and continuing since then. This sentiment is reflected in greatly reduced priority for the issue of lowering taxes in opinion polls.

Unemployment, historically, had a far disporportionate impact on members of these social classes. Less educated and less skilled and less experienced members of the workforce are usually hit the hardest, by a large margin, by unemployment. Yet, these are the people most indifferent to the earned-unearned income disparity. The only place where income taxes create much of an incentive is right on the threshold of the line between poor and working class, where the phase out of the earned income tax credit, FICA taxation, and the phase out of eligibility for government benefits like Medicaid, Free/Reduced School Lunch, rent assistance, heating assistance and a host of other programs conspire to reduce a whole host of government tax and non-tax benefits with the highest marginal tax rate of any group. Just above that phaseout range, one hits a point of near zero average taxation, near zero government means tested benefits fairly low marginal taxation rates of earnings by historical standards, and abundant opportuntities to use contribution limited tax preferenced vehicles like IRAs, education savings accounts, HSAs, residential real estate tax preferences, etc. to gain tax benefits that favor investment income, a trend that continues all the way up the line in ever evolving forms.

One plausible alternative explanation is that a lot of the economically important GDP growth before the financial crisis hit, and hence a lot of economically important GDP decline afterwards, never made it onto the GDP books. What is missing from the GDP books is unrealized perceived gains and declines in asset value. The consumption growth we saw during the preceding boom was driven by wealth effects from "on paper" appreciation in financial and real estate assets that was only partially monitized with debt driven spending and cash out transactions. People thought that this wealth was real anyway -- real estate appraisals were often underestimates of real market prices just months after they were made, and financial valuation data was available in real time on the Internet or CNN and could be converted to cash at a moment's notice (or at most, a few day's notice).

If you were to look at decline in apparent GDP, including estimates of housing stock valuation and financial market valuation that weren't reflected in actual transactions at those prices, I think that you would see that the GDP decline in this recession has been deeper than GDP declines in previous recessions, relative to the conventional GDP number.

Employer decisions to lay off workers in this recession have frequently been driven by a desire to control costs due to weak expectations for future growth (something that also explains the rising share in this financial crisis of the ranks of the involuntary part-time work force which can be shed "just in time," with hour reductions, more easily). For employers making these forward looking decisions, who are the group most likely to have experienced on paper wealth losses in the financial crisis, perceptions of economic decline are more important than actual economic decline. So, if paper losses make GDP decline seem much greater than it actually is (the losses too are often unrealized due to the discipline of financial planners who tell people to stay in the market so they don't miss the boom that follows), employers are likely to reduce their workforces and unemployment is likely to be greater.

Just a heuristic explanation, but a more plausible one than the earned-unearned income distinction (particulalry because the pre-tax return on unearned income is very low and the impact of low pre-tax returns swamps any tax preferences).


Posted by: ohwilleke | July 24, 2009 at 03:15 PM

Just as a quick footnote, I confirmed that GDP definitions do expressly and intentionally exclude unrealized capital gains in the secondary financial and housing markets (i.e. sales involving non-IPO financial instruments and sales of homes to someone other than their first owner). These sectors of the economy were, of course, precisely the sectors of the economy that bubbled and then collapsed in the current financial crisis; this off the GDP books action is at the core of what was going on this time.

GDP impacts that have flowed from these off this off the GDP books events have essentially a mere shadow of the driving events in the current economy, so it is not surprising that GDP measures don't work very well to show their true impact.

The distinction between the "real economy" and the "financial/secondary market" economy inherent in the very definition of GDP has never been more relevant than in the 2001-current recession boom. Financial sector firms reaped the lion's share of the economic growth in this boom, and the senior manager-production worker gap in compensatioon was eclipsed by a gap in financial industry senior manager v. real economy senior managers. Not one but two waves of secondary market collapses -- first in the secondary housing market and then in the secondary financial market, preceded the demand driven real economy effects.

Posted by: ohwilleke | July 24, 2009 at 03:37 PM

Personally, I think the IMF unemployment and GDP forecasts are the only ones worth reading. They've been pretty good in their last reports.
Is there any way to see what they use for projections?

Posted by: Dave | July 25, 2009 at 11:17 AM

okun's law does not take into account changes in tech, changes in financial management from longer to shorter time (don't need employees related to future products), nor outsourcing.

Nor does it deal with what requires a more narrative approach, the increased concentration of wealth and what rich people are likely to do with it (buying land in Chile, for example.) Math alone is not a good predictor in economics. A good reporter i also necessary.

Posted by: Doug Carmichael | July 26, 2009 at 03:38 PM

The comment by SS Resident is correct that even in the good times that companies would think nothing of trimming several hundred in headcount at a time in the pursuit of "efficiency" or "core competency."

The thing most puzzling to me is that considering the jobless recovery from the last recession that can be seen in the low participation rate for that time, that there are/were so many jobs left to cut to boost the unemployment rate that much further. This is particularly true in light of the methods used to calculate U3 as opposed to U6.

The questions about GDP and future revisions remain to be seen. I would also question the importance of credit and leverage in the period between the last and this recession and their effects on GDP.

Posted by: Mr.Sparkle | July 26, 2009 at 05:11 PM

Another issue is that there's an historic trend in "inactive" people in the USA which is making comparison of unemployment rate difficult, see this graph made with BLS data 1948-2008:

http://fatknowledge.blogspot.com/2009/01/misleading-nature-of-unemployment.html

Are the inactive taken into account in those models and rules?

Thanks in advance,

Laurent

Posted by: Laurent GUERBY | July 27, 2009 at 03:26 AM

*looking at revised gdp data*

I told you so!

Posted by: Daniil | August 01, 2009 at 01:38 AM

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July 17, 2009

When cycles collide

Yesterday we saw that initial claims for unemployment insurance declined rather sharply again last week, another hint that U.S. labor markets may be beginning to mend. But the improvement came with a word of caution from the folks at the Department of Labor, who note that these numbers are being affected by seasonal adjustments to the data that may present a misleading picture.

Virtually all of the economic information that gets reported by the data agencies has been seasonally adjusted. That is, the data are being reported after the agency has adjusted them for their usual variation for that time of year. The unemployment insurance claims data are a useful example. On an unadjusted basis, the initial claims data showed a fairly large increase last week—up 86,000 workers. But claims for unemployment compensation typically rise in early July as auto plants shut down to retool for the new model year. The jump in claims this July hasn't been as large as in years past since many of the auto plants were waylaid earlier in the year. So on a "seasonally adjusted" basis, the data showed a drop in claims of 47,000 workers.

Here we have that statistician's equivalent of an old existential puzzle: Do seasonal layoffs in the auto industry make a sound if there is no one there to lay off? We invite you to write up your own answer to that one. There is a long literature, perhaps most notably the work of Jeffrey Miron, that documents the interplay between the business cycle and the seasonal cycle. The thrust of this research is to help us better understand the general nature of economic cycles. But there are also more mundane issues we need to wrestle with. For instance, how accurate are seasonal adjustments to the data during times of severe cyclical disruption?

To provide some perspective, let's take a deeper look at the recently released June consumer price index (CPI) report. Last month, prices, as measured by the core CPI, were up 2.4 percent (annualized) from a 1.7 percent rise in May. There are a few bits of data that might cause you to scratch your head a little, given what we've been hearing about the economy lately. For instance, apparel prices jumped an annualized 8.8 percent last month. And new car prices were up 8.2 percent. So are department stores and car dealers having a better time of it than they are letting on? I don't think so. I believe the seasonal adjustments in the data offer a more reasonable explanation.

Apparel prices rose 8.8 percent on a seasonally adjusted basis but fell a whopping 25.5 percent (annualized) on an unadjusted basis. And new car prices? Well, they rose on an unadjusted basis, but not nearly as much as the seasonally adjusted data indicated (5.1 percent versus 8.2 percent). Indeed, this pattern seems to be consistent across many of the core components of the CPI in June. On a seasonally adjusted basis, the core inflation measure rose 2.4 percent. But on an unadjusted basis, the core CPI was largely unchanged for the second month in a row (up a slight 0.9 percent, annualized).

Here's a conjecture on my part. Many of the price declines that ordinarily occur in June didn't occur this year. Why? Perhaps it's because the sharp decline in business activity has resulted in such severe production and price cuts already that usual seasonal price discounts have been disrupted. In other words, in the current economic environment, there may not be much "season" to adjust for.

This isn't a criticism of seasonal adjustment. In fact, seasonal adjustment is an entirely appropriate—and necessary—transformation of the data if you are trying to see emerging trends. But it's certainly important to exercise caution when interpreting seasonally adjusted data during a period of strong cyclical movements. If the business cycle alters the usual behavior of the seasonal cycle in the data, seasonal adjustment could produce a misleading snapshot of the data. And I suspect we saw a bit of that in the June CPI report.

In closing, I want to put in a plug that the second weekly postings of the Atlanta Fed's Economic Highlights and Financial Highlights are now available on the Bank's Web site. These summaries of national economic and financial statistics complement our monthly REIN reports on the Southeastern economy.

By Mike Bryan, vice president and senior economist in the Atlanta Fed's research department

July 17, 2009 in Business Cycles, Data Releases, Inflation, Labor Markets | Permalink

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In a low inflation era firms tend to raise prices once a year-- typically at the start of the year or season.

This produces a very strong seasonal pattern to the not seasonally adjusted (NSA)core cpi.

Some 55% of the annual increase in the NSA core cpi occurs in the first quarter and another 25% happens in the third quarter.
The third quarter consist largely of home owners rent, tuition and autos.

Moreover, if the first quarter nsa core cpi is less than( or greater than) in the first quarter of the prior year that the annual change is generally less( or greater) than in the prior year.

This rule has worked in 15 or the last 16 years.

Posted by: spencer | July 17, 2009 at 02:07 PM

It's called seasonally mal-adjusted. One should alwasy ignore seasonal figures. These flucuations originate from the FED's mandate to "SUPPLY AN ELASTIC CURRENCY". I.e., the FED's technical staff follows the fallacious "real bills" doctrine.

Posted by: flow5 | July 18, 2009 at 02:10 PM

Contrary to the economic fraternity monetary lags are uniformly fixed in length. The statistical analysis of these crests and troughs are not random. The rates-of-change in these monetary lags (for real-growth, & for inflation), literally oscillate (along the Y axis), between their maximum and minimum levels (as demonstrates by the clustering on a scatter plot diagram).

These oscillations do however suffer from errant data. Errant data may originate from faulty theoretical interpretations, flaws in the data’s definition, and errors in the computation, collection, and reporting of data.

It is instructive that the FED has never cooperated by supplying continuous, comparable, and timely data. Supporting data is required for the proper investigation, the subsequent proof, and ending conclusion, for any economic research (“History is full of bad jokes”).

Posted by: flow5 | July 18, 2009 at 02:11 PM

This article suggests that seasonal adjusted data can lead to misleading snapshots of the economy. The reason is that in estimating the seasonals, the data producers have not taken into account of lower seasonals due to lower trend or trendbreak. In other words, the key assumption is that the seasonals are more or less constant.

However, this key assumption of near-constant seasonal may not be true.

First, DOL or BLS may be using X12-ARIMA (a seasonal procedure) that allows adjustment for sudden trendbreak. Seasonals will change if trendbreaks are adjusted in the seasonals estimation process.

Second, if multiplicative (or log) model is used to estimate the seasonals, lower trend will lead to lower seasonals.

The seasonal-adjusted data may not be much misleading if possible trendbreaks are adjusted for and multiplicative models are used.

Suggest that Alanta Fed check with the DOL or BLS, and see if they agree with your post. It's better to get views from both parties, the data users and the data producers.

Posted by: low | July 28, 2009 at 10:03 PM

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July 15, 2009

Some meaty minutes

I know that some of you are avid consumers of the minutes published following each Federal Open Market Committee (FOMC) meeting. Others not so much, but even if perusing the minutes is a taste you have yet to acquire, you might find the latest edition worth a look as it includes commentary on a number of issues that I believe are on people's minds—at least based on questions I've received following speeches.

A quick summary of what I would pick as highlights:

  • The Fed's balance sheet is likely to get bigger before it gets smaller, but it will get smaller.
  • The planning for managing to a smaller balance sheet is under way.
  • Whatever the future brings for the balance sheet, the time has not yet come to remove policy accommodation—either by adjusting the federal funds rate target, by removing the backstop of most liquidity programs, or by making adjustments in the FOMC's asset purchase programs (described here, here, and here).
  • With respect to those asset purchase programs, the point is to improve "market functioning," not target long-term market interest rates.

Of course, I don't expect you to take my word for it. Here it is, straight from the source:

On where the Fed's balance sheet is headed:

"Staff projections suggested that the size of the Federal Reserve's balance sheet might peak late this year and decline gradually thereafter."

On confidence in managing the balance sheet:

"… the staff briefed the Committee on a number of possible tools that the Federal Reserve might employ to foster effective control of the federal funds rate in the context of a much expanded balance sheet. Some of those tools were focused primarily on shaping or strengthening the demand for reserves, while others were designed to provide greater control over the supply of reserves. In discussing the staff presentation, meeting participants generally agreed that the Federal Reserve either already had or could develop tools to remove policy accommodation when appropriate."

On the commitment to keep an "exit strategy" front of mind:

"Ensuring that policy accommodation can ultimately be withdrawn smoothly and at the appropriate time would remain a top priority of the Federal Reserve."

On the timing of exit strategy implementation:

"… participants viewed the availability of the liquidity facilities as a factor that had contributed to the reduction in financial strains. If the Federal Reserve's backup liquidity facilities were terminated prematurely, such developments might put renewed pressure on some financial institutions and markets and tighten credit conditions for businesses and households. The period over year-end was seen as posing heightened risks given the usual pressures in financial markets at that time. In these circumstances, participants agreed that most facilities should be extended into early next year. However, participants also judged that improved market conditions and declining use of the facilities warranted scaling back, suspending, or tightening access to several programs…

"In their discussion of monetary policy for the period ahead, Committee members agreed that the stance of monetary policy should not be changed at this meeting. Given the prospects for weak economic activity, substantial resource slack, and subdued inflation, the Committee agreed that it should maintain its target range for the federal funds rate at 0 to ¼ percent. The future path of the federal funds rate would depend on the Committee's evolving expectations for the economy, but for now, members thought it most likely that the federal funds rate would need to be maintained at an exceptionally low level for an extended period, given their forecasts for only a gradual upturn in activity and the lack of inflation pressures. The Committee also agreed that changes to its program of asset purchases were not warranted at this time."

And a clarification of what those asset purchase programs were designed to accomplish:

"The asset purchase programs were intended to support economic activity by improving market functioning and reducing interest rates on mortgage loans and other long-term credit to households and businesses relative to what they otherwise would have been. But the Committee had not set specific objectives for longer-term interest rates, and participants did not consider it appropriate to allow the Desk discretion to adjust the size and composition of the Federal Reserve's asset purchases in response to short-run fluctuations in market interest rates."

There is a lot of other interesting information in the minutes, including a discussion of how the size and composition of the balance sheet might impact Federal Reserve income streams and the Committee's latest gross domestic product growth and inflation forecasts.

Not bad work for a couple of days.

By David Altig, senior vice president and research director at the Atlanta Fed

July 15, 2009 in Monetary Policy | Permalink

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July 14, 2009

A funny thing happened update

More than a week has passed since the Regulation D changes went into effect, and it appears that the changes are having a noticeable, if not dramatic, impact on pricing in the funds market—see the updated effective funds rate chart below.

071409

The funds rate did fall last week, and it is possible that the softening was related to an increased supply of fed funds by Federal Home Loan Banks as they sought to reduce their excess reserve balances because they no longer earned interest on those balances. But if that is in fact the explanation, the effect was not large: Fed funds are still trading in a relatively narrow range between about 5 and 40 basis points each day. Though, as the chart shows, the effective fed funds rate has drifted lower so far in July—it was at 15 basis points on Friday, July 10, down from 20 basis points on July 1. The current rate is well above the January low of 8 basis points.

Despite the large increase in supply of funds in the market that might have resulted from the Reg D change, it seems to me that the opportunity for arbitrage profits is helping keep the effective funds rate hovering in the neighborhood of the interest rate paid by the Fed to eligible institutions on their reserve balances.

By John Robertson, vice president in research at the Atlanta Fed

July 14, 2009 in Interest Rates, Monetary Policy | Permalink

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Trivia. If the FOMC wanted rates to fall, and insured member banks to lend, the policy makers would lower the renumeration rate on excess reserves. It's too high relative to the target FFR.

Posted by: flow5 | July 14, 2009 at 06:43 PM

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July 10, 2009

Economic and financial data, neatly wrapped

In the course of an average week, the research department of the Atlanta Fed goes over a lot of data. We periodically bundle the standard data releases into a document that we use as background for our monetary policy discussions.

We thought if these summaries are useful internally, then a wider audience will also find them valuable. So beginning today we will publish our Economic Highlights and Financial Highlights, exclusive of any proprietary data, on our Web site. We anticipate updating these digests weekly.

These summaries of national economic and financial statistics complement our monthly REIN reports on the southeastern economy.

If you find these weekly digests useful—or not—please drop us a note with your feedback.

By Mike Bryan, a vice president and senior economist in the Atlanta Fed’s research department.

July 10, 2009 in Data Releases | Permalink

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July 08, 2009

Markets work, even when they don’t

Remember when it used to be cool to be an advocate of free markets? I do, but after the events of the past year or so maintaining that position feels a bit like being an ice cream vendor in a snowstorm—a peddler of a product that just doesn't suit the environment.

Joseph Stiglitz, skeptic and 2001 recipient of the Nobel Prize in Economic Science, put it this way in his most recent Vanity Fair entry:

… historians will mark the 20 years since 1989 as the short period of American triumphalism. With the collapse of great banks and financial houses, and the ensuing economic turmoil and chaotic attempts at rescue, that period is over. So, too, is the debate over "market fundamentalism," the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth. Today only the deluded would argue that markets are self-correcting or that we can rely on the self-interested behavior of market participants to guarantee that everything works honestly and properly.

I'm not sure how many people identifying themselves as "market fundamentalists" actually subscribed to the notion that markets "guarantee that everything works honestly and properly," but at the very least the ranks of the "no new regulation" camp are growing pretty thin. This shift is undoubtedly appropriate, but that is not quite the same thing as throwing out this following major tenet of "market fundamentalism" thinking: Markets are, everywhere and always, one step (or more) ahead of regulators.

The cautionary examples are legion, but a recent one has been on my mind for a couple of weeks. Writing, about a month ago, on the minimum wage, UC-Irvine professor David Neumark noted the following:

Despite a few exceptions that are tirelessly (and selectively) cited by advocates of a higher minimum wage, the bulk of the evidence -- from scores of studies, using data mainly from the U.S. but also from many other countries -- clearly shows that minimum wages reduce employment of young, low-skilled people. The best estimates from studies since the early 1990s suggest that the 11% minimum wage increase scheduled for this summer will lead to the loss of an additional 300,000 jobs among teens and young adults. This is on top of the continuing job losses the recession is likely to throw our way.

The reduction in jobs for youths might be an acceptable price to pay if a higher minimum wage delivered other important benefits. Many people believe, for instance, that it helps low-income families. Here, too, the evidence is discouraging.… Research I've done with William Wascher of the Federal Reserve Board and Mark Schweitzer of the Cleveland Fed indicates that minimum wages increase poverty.…

How can this be? Because the relationship between being a low-wage worker and living in a poor family is remarkably weak. Many low-wage teenagers and young adults are in higher-income families, and many poor families have no workers.…

In addition, when deciding which low-wage worker to retain following a minimum wage increase, employers may opt for a teenager, who may have high potential, over an adult who, because he still earns a low wage, likely has much lower potential. Thus, the job-destroying effects of minimum wages fall particularly hard on low-skilled adults in poor families.

I added the emphasis on the last part because it is the relevant bit for my present purpose. Labor markets are arguably imperfect—and could hence fail to guarantee that everything works properly—because information is asymmetric. Indeed, it was for the exploration of the economic effects of imperfect information that Professor Stiglitz won his well-deserved Nobel citation.

What is the essential informational imperfection in our labor market example? Workers have attributes—innate skills, adaptability and maturity, preferences between shirking versus expending effort—that are difficult for employers to observe. As a consequence, employers look for signals about these things. Professor Neumark offers one such signal: If you are an adult and still in a minimum wage job, chances are you have those attributes that are associated with low productivity. If you are a teenager, on the other hand, there is still a chance you are a high-productivity type. Faced with a government mandated hike in the wages paid to workers in minimum-wage jobs, the percentages dictate you go with the teenager. Which leaves in the cold the people we probably most want to help.

My point is an obvious one (and the one I associate with advocates of "market fundamentalism"): Markets may not "guarantee that everything works honestly and properly," but neither does regulation. I'll turn again to Professor Stiglitz, who had this to say in an earlier (and oft-cited) Vanity Fair article:

As an economist, I certainly possessed a healthy degree of trust, trust in the power of economic incentives to bend human behavior toward self-interest—toward short-term self-interest, at any rate, rather than Tocqueville's "self interest rightly understood."

That particular article was provocatively titled "Capitalist Fools," an interesting choice as the primary objects of the Stiglitz barbs were not "capitalists" but regulators. And there remains the thorny question of how to keep at bay the unintended consequences of regulatory policy when human behavior gets bent by incentives and market forces—a phenomenon clearly evident in the perverse impact on low-skill adult workers as a result of the minimum wage.

Something to keep in mind as we go about the job of addressing the very real problems in financial markets that past two years have revealed.

By David Altig, senior vice president and research director at the Atlanta Fed

July 8, 2009 in Labor Markets, Regulation | Permalink

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David, It's an interesting thought. I've often observed the 'inefficiencies' of labor and the market for labor. How many folks work for several years before starting their own business or changing companies, only to find how held down they were at their old gig. The dynamics are complex, it's like an eco-system.

What regulation may do is limit the choice available. If so, then the unintended consequence could be less people finding out just what they're capable of economically. 10 years at a firm with 1 year of experience comes to mind.

Did you guys see what the pope had to say about markets? Goes with that de Tocqueville theme.

Posted by: Former Sandy Springs Resident | July 08, 2009 at 06:13 PM

Faced with a government mandated hike in the wages paid to workers in minimum-wage jobs, the percentages dictate you go with the teenager.

Actually no. The reason is the older worker has experience while the younger one usually does not. The older one may have earned more and may be taking a cut to find work. The younger one hasn't and isn't. Why would an employer spend money to train someone when there are already abundant workers with experience? They won't and don't.

Posted by: Lord | July 08, 2009 at 08:17 PM

Ah, yes. Higher minimum wage laws could make teenagers more attractive employees, therefore it must be true.

I think it's about time to legalize prostitution, and ban economics.

Posted by: Markel | July 09, 2009 at 09:13 AM

Enh, nobody's talking about the dynamic effects of moving from a society of workers to a society of serfs. If we continue to allow labor to be sold cheap, we will encourage methods of organization founded on cheap labor.

And none of this takes into account the experiences of illegal immigrants, who are by definition incapable of seeking enforcement of existing laws.

Posted by: Michael | July 09, 2009 at 06:23 PM

As a small business owner, I definitely would keep the teenager, as they would bring the least "bad habits" to the job. Experience means nothing if it's "bad" experience.

Posted by: Tommy | July 09, 2009 at 09:26 PM

Let me just throw one thing out there, to raise some speculation:

While it's true that experience is positively correlated with productivity, this might operate differently in the minimum wage sector. There, I bet 2 years of experience might be as good as 10 - there's not a lifelong learning curve like in more high-skilled industries - so an employee might "plane out", productivity-wise, after 2 years of experience. If that's the case, then older employees aren't categorically better, as they don't have productivity gains in the future that the employer could benefit from. Younger workers still would have these gains in the future. So, if younger and older were about on par productivity-wise, then it would make sense for the employer to keep the younger worker, who has the possibility of future gains from experience, and lose the older worker, who has already planed out.

~fischer

Posted by: fischer | July 10, 2009 at 07:11 AM

Assuming a minimum wage of $8.

You have a worker able to produce $20 in sales now and one that is able to produce $20 in the future, which do you chose? Of course you chose the teenager that may produce $20 in the future thinking that he will produce $30 in the future, but forgetting that he will have long moved on to a new job before he even hits your $20 target.

Posted by: jgoodguy | July 12, 2009 at 12:37 PM

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July 03, 2009

A funny thing happened on the way to the federal funds market

Since the beginning of this year, the effective funds rate in the market for reserve balances has varied between zero and about 15 basis points below the interest rate the Federal Reserve pays on those reserve balances (see chart below, which runs through July 2). A vexing issue has been the fact that the interest paid on reserve balances at the Fed has not set a floor on the funds rate traded in the funds market, but rather it has acted more like a magnet (see, for example, this PrefBlog post from early this year).

070309

On July 2, the Federal Reserve Board’s latest amendments to Regulation D (Reserve Requirement of Depository Institutions) went into effect. Included in these changes are two that could materially affect the fed funds market and that vexing gap between the fed funds market rate and the deposit rate.

The first is the authorization for correspondent banks to create Excess Balance Account (EBA) programs on behalf of their respondent financial institution clients. The second is the nullification of an exemption that allowed ineligible institutions (such as the Federal Home Loan Banks) to earn interest on their reserve balances as a result of providing reserve management services for banks.

This change is good news for the 20 or so bankers' banks that provide respondent banks, usually community banks, with services, such as managing the respondent’s reserve balances at the Fed. Prior to the change in Regulation D, a bankers' bank was required to pool all the respondent’s reserve deposits into its own reserve account. This task is a bit of a problem when excess reserves are at high levels because reserves are a bank asset that counts against regulatory capital-to-asset ratios. Partly because of this financial leverage concern, bankers’ banks have had to sell some of their respondent excess reserves into the fed funds market and earn less than the 25 basis points offered for reserve balances at the Fed. But with the change in Reg. D, they will be able to deposit respondent balances at the Fed in the EBAs, and this approach will alleviate their balance sheet pressure.

What does this change mean for the funds market? Well, one source of supply of funds will be reduced, and that should put upward pressure on the fed funds rate. That’s good news for closing the deposit/market rate spread, although it should be said that bankers’ banks represent only a small fraction (about 5 percent) of daily fed funds market activity, so the impact will probably be equally small.

The second change could be a more significant one and will tend to put downward pressure on the effective funds rate. Nine of the 12 Federal Home Loan Banks (FHLBs) provide respondent banking services (like bankers’ banks) for some of their member institutions. These FHLBs had been pooling their own reserve balances with their respondents’ balances, thus earning interest on their own reserves as well. Technically, the FHLBs, like other government-sponsored enterprises, are ineligible to earn interest on their own reserve balances held at the Fed, but the FHLBs were given an exemption under the interim rule published last year, which did not distinguish between an FHLB’s own reserve balances and those of their respondents. With the amended Reg. D, the pooling of reserves will no longer be allowed. Thus, the FHLBs will not be able to earn interest on their own reserve balances.

Will this change matter to them? A look at the FHLB consolidated balance sheet suggests it could. For instance, as of Sept. 30, 2008, the FHLBs were sellers of some $94 billion of fed funds and held zero on deposit at the Fed. But as of Dec. 31, 2008, after the Fed started paying interest on reserves, the FHLBs sold only $40 billion of fed funds and held $47 billion on deposit at the Fed. In a funds market that has been experiencing relatively light volumes in 2009 year to date, the potential additional supply of dollar reserves by the FHLBs could materially affect rates in the fed funds market.

What happened when the regulation changes took effect yesterday? Well, the fed funds effective rate yesterday declined from 20 to 17 basis points. Thus, it appears the softer funding conditions expected as a result of the changes generally failed to materialize. But it still may be too early to determine the full impact of the regulation changes, and more definitive changes in trading could materialize in coming days. Fed funds market nerds stay tuned.

By John Robertson, vice president in research at the Atlanta Fed

July 3, 2009 in Interest Rates, Monetary Policy | Permalink

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Why have a peer-to-peer inter-bank market at all? Why not redesign the system using a hub-and-spoke model with the Fed being intermediary to overnight unsecured lending. The whole reserve ratio requirement is obsolete in the current system.

Posted by: Zaid | July 05, 2009 at 05:35 AM

This was an obvious gap. It should have been dealt with 29 years ago - with the DIDMCA of March 31st 1980.

Zaid is exactly right. Pass-thru's should be eliminated.

Posted by: flow5 | July 06, 2009 at 04:18 PM

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