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October 27, 2010
Real estate and municipal revenue
It's no secret that state and local governments are currently experiencing substantial revenue declines. One popular explanation is that deteriorating local real estate conditions are responsible for a portion of that decline, but it turns out that this explanation is not the main cause, at least not yet. One of the sessions in the conference featured attempts by three economists from the Federal Reserve Board of Governors (Lutz, Molloy, and Shan) and two from Florida State University (Doerner and Ihlanfeldt) to estimate the direct impact of the decline in real estate values on local tax revenues. Both papers examined the multiple channels of influence between the decline in real estate values and local revenues.
The largest channel, of course, is the decline in property tax income related to declining assessed property values. Of course, property owners don't pay property taxes based on the current value of their home. They pay based on an assessment that is at least a year old. Thus, the decline in property values takes considerable time to work its way through the assessment process and into property tax revenues. Consequently, declines in property values have only more recently started to be reflected in lower property tax revenues. Experts expect the decline in those revenues to continue for another couple of years, with the worst shortfall two or three years out. Some of the assessments are fairly gloomy.
To illustrate that point, I've pulled a few charts from the Lutz, Molloy, and Shan paper. The first chart illustrates the decline in revenues led by individual and sales taxes. Notably, property tax collections grew at an increasing rate in 2009 over 2008.
The next chart directly depicts the relationship (or the short-run lack thereof) between housing price growth changes and property tax revenue. Lags in changes in assessments and the ability of local governments to change property tax rates can go a long way in explaining why overall property tax revenue continues to grow.
Finally, Lutz, Molloy, and Shan broke down the data by some states, and I include the case of Georgia below. (The Ihlanfeldt and Doerner paper does something similar—and in great detail for the state of Florida.) The Georgia case clearly shows the effect of the lags: property values rose through the first part of the last decade and, even though tax rates were falling, overall tax revenue rose. Post-2007, however, market values of homes declined while the aggregate assessed values continued to rise through 2009 (along with property tax revenue).
It is hard to imagine the trend of aggregate increased assessed valuation continuing. If the assessed values begin to track the market values, pressures will emerge on the government entities that depend on property taxes. The picture suggests that tax rates and/or spending on programs are likely to change notably during the coming few years.
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October 20, 2010
A good time for price-level targeting?
Though the idea arises periodically, interest in price-level targeting is a hot topic again thanks to recent comments from Federal Reserve Bank of Chicago President Charles Evans. The essence of Evans's approach (and described in his own words) is this:
"If the Federal Reserve decided to increase the degree of policy accommodation today, two avenues could be: 1) additional large-scale asset purchases, and 2) a communication that policy rates will remain at zero for longer than ‘an extended period.'
"A third and complementary policy tool would be to announce that, given the current liquidity trap conditions, monetary policy would seek to target a path for the price level. Simply stated, a price-level target is a path for the price level that the central bank should strive to hit within a reasonable period of time. For example, if the slope of the price path, which I will refer to as P*, is 2 percent and inflation has been underrunning the path for some time, monetary policy would strive to catch up to the path: Inflation would be higher than 2 percent for a time until the path was reattained. I refer to this as a state-contingent policy because the price-level targeting regime is only intended for the duration of the liquidity trap episode."
The challenge presented by short-term interest rates near zero is one clear motivation for this policy proposal. Again, from President Evans:
"Risk-free short-term interest rates are essentially zero. Both households and businesses have an excess of savings relative to the new investment demands for these funds. With nominal interest rates at zero, market clearing at lower real interest rates is stymied."
By allowing inflation that is "higher than 2 percent for a time," inflation-adjusted short-term interest rates would fall, presumably moving real interest rate close to their market-clearing levels.
President Evans contemplates implementing the price-level targeting approach for "the duration of the liquidity trap episode," after which the Fed's objective would revert to a straight inflation target. Many believe a permanent price-level targeting approach, however, has a lot to recommend itself as an ongoing policy framework. The case rests on the presumption that, in the longer run, the goal is to limit uncertainty about the purchasing power of money, thereby reducing the risk premium associated with inflation volatility and lowering the real cost of borrowing. In principle, a price-level target is a stronger commitment to this goal than is an objective based on a target for the inflation rate.
Consider, for example, an annualized inflation target centered on 2 percent, with 1 percentage point tolerance range on either side of that target. This approach would be similar to the policy framework of the Bank of England, which describes the 1 percentage point tolerance level this way:
"A target of 2% does not mean that inflation will be held at this rate constantly. That would be neither possible nor desirable. Interest rates would be changing all the time, and by large amounts, causing unnecessary uncertainty and volatility in the economy. Even then it would not be possible to keep inflation at 2% in each and every month. Instead, the MPC's [Monetary Policy Committee] aim is to set interest rates so that inflation can be brought back to target within a reasonable time period without creating undue instability in the economy."
That flexibility would inevitably be a part of any reasonable inflation-targeting approach, but it comes at a cost. Because the hypothetical objective does not preclude the rate of inflation running as high as 3 percent or as low as 1 percent for a string of several years, the acceptable variation in the price level grows as time expands:
Of course, a price level growing at 2 percent annually is exactly the same as a 2 percent inflation target if the target is hewed to too consistently. And that seems to be exactly the story of U.S. monetary policy over the past 15 years.
The following chart shows the growth of the PCE price index since 1995 (the blue line), shown with a hypothetical 2 percent price level target (the green line). The upper and lower red lines represent hypothetical tolerance limits (set to two standard deviations of the actual PCE price series over the period since 1995).
I have a couple of observations to make here:
One observation is that I chose the year 1995 to start the chart above because it roughly corresponds to that last major break in the U.S. inflation trend. This timing is also near the beginning of the period when the notion that Fed policymakers had in mind an inflation goal near 2 percent became conventional wisdom.
Although the upper and lower limits of the hypothetical price level target were, in a statistical sense, chosen to bracket most of the actual path of the price level, the bounds are quite tight: The price level has almost always been within 2 percentage points of the implicit 2 percent growth path. If you still wonder why inflation expectations have appeared so remarkably stable even in light of the impressive amount of monetary stimulus applied over the course of the past several years, part of the answer may well be in the chart above. In fact, if in January 1995 you bet that the PCE price level would be within 30 basis points of a target 2 percent price level path as of August 2010, congratulations. You're in the money.
A second observation is that President Evans presents his case for allowing some pick-up in the inflation rate by noting that the current price level would be low relative to a 2 percent target implemented as of the beginning of the past recession (December 2007). As the second chart makes clear, where the current price level is relative to a long-run path is clearly dependent on the starting point. If the initial conditions for the price-level target path were chosen well in the past, it would not necessarily be the case that the price level would be sitting well below the target.
To some, that observation might weaken the case for a permanent price-level targeting framework, as it would seem to remove some of the justification for a higher short-term inflation path that would assist in generating desirable short-term real rates when the zero nominal bound problem is in play. But as the chart above illustrates, a price-level target with reasonable tolerance bounds is quite capable of accommodating the sort of inflation outcomes that President Evans suggests will assist in promoting the recovery.
Some commentators have expressed concern that President Evans's proposal could encounter difficulties with credibility and communications as a shift is made from the price-level targeting period to a permanent phase that focuses on more familiar inflation rate objectives. Here's Jim Hamilton:
"Although communicating from the beginning what the exit strategy from the price targeting is supposed to be in specific quantitative terms might seem attractive, I worry it could run into a similar embarrassment as the infamous graph of the projected consequences of the economic stimulus package. Even in the best of times, the inflation rate will differ substantially from forecasts and policy objectives. And when the inevitable miss comes, one could imagine that the public would be less rather than more assured as a result of the Fed's specificity in communication."
Some potential benefits of simply sticking with a price-level target is that it (a) is clearly consistent with longstanding Federal Open Market Committee (FOMC) behavior (as attested to by the second chart above); (b) avoids a potentially confusing impression that the central bank is jumping from one framework to another to serve whatever is convenient at the moment; and (c) gives the public a clearer way to monitor if and when the long-term price-level objective is being compromised (as can be seen by comparing the implied tolerance bounds in the two charts above).
In a speech earlier this week, Atlanta Fed President Dennis Lockhart offered this view:
"I am also open to a move that I believe would strengthen the effect and compensate for potential risks of the policy action [another round of quantitative easing]—that move is the adoption of a more explicit inflation objective by the committee. I believe doing so might serve as a further step to ensure the anchoring of public expectations about long-term inflation and the response of the FOMC to adverse price developments. I consider a more explicit inflation target as something the public could easily understand, and I believe it would reduce uncertainty at a time when it is badly needed."
Making that "explicit inflation objective" a price-level target is an option some believe is worth considering.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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October 07, 2010
Using TIPS to gauge deflation expectations
In the recent Survey of Professional Forecasters, economists were asked to give their subjective probability of deflation during the next year. Specifically, they were asked about the chances that the quarterly consumer price index excluding food and energy (core CPI) will decline in 2011. According to the respondents, the probability of core CPI deflation in 2011 was only 2 percent.
This rather sanguine view of the probability of deflation is encouraging. But is it a view shared by noneconomists? While there are many sources used to measure inflation expectations, there aren't many that gauge inflation uncertainty or the risk of deflation. However, one might estimate a probability of deflation as seen by investors by exploiting the different deflation safeguards of a pair of Treasury Inflation Protected Securities (TIPS), which have about the same maturity date but different issue dates.
Here's the idea: A TIPS cannot pay less than its face value at maturity, so the principal repayment of a five-year TIPS issued today is not reduced if the five-year rate of inflation is negative over the life of the security. But a 10-year TIPS issued five years ago will have its capital gain from accrued inflation reduced if there is a net decline in the CPI over the next five years. As a result, part of the real yield spread between the 10-year and five-year TIPS issues should reflect the value of the better deflation safeguard of the latter security.
In a comment on a paper by Campbell, Shiller, and Viceira, Jonathan Wright derives a very simple formula for calculating a lower bound on the probability of deflation using this real yield spread. (The lower-bound formula is rm/ln(CPI5yr/CPI10yr), where r is the yield spread between the 10-year and five-year TIPS real yields, m is the number of years until the midpoint of the maturity dates of the two TIPS, and CPI5yr/CPI10yr are the levels of the NSA CPI on the issue dates of the five-year and 10-year year TIPS. These reference CPIs are available here. Deflation is defined as the level of the CPI being lower than its value on the issue date of the five-year TIPS.) Wright's calculation makes a number of simplifying assumptions, some of which are counterfactual, but it is easy to compute—almost literally a back-of-the-envelope calculation if you have two real TIPS yields in hand. The formula also has the advantage that it does not require any assumptions about the probability distribution of inflation.
To get exact probabilities of deflation instead of a lower bound, I developed a simple model for TIPS pricing. The model is an extension of the TIPS pricing model developed by Brian Sack. One has to make a lot of assumptions to derive these estimates—which you can read about in the appendix to this post (link provided in last paragraph)—but let's get to the main results. The figure below plots the probability that the level of the reference CPI on April 15, 2015, is lower than its April 15, 2010, level. (The reference CPI is the nonseasonally adjusted consumer price index interpolated to a daily frequency; it is calculated by taking a weighted average of the CPI two months ago and three months ago.) If the April 2015 reference CPI ended up below this threshold, then the deflation safeguard for the five-year TIPS would kick in. Also included in the graph is the lower bound of this "deflation probability" calculated using Wright's formula.
An alternative way of generating deflation probabilities is to exploit the estimated "confidence interval" from a forecasting model of inflation. When I use a variant of the inflation model proposed by Stock and Watson (for those interested in more detail, the model I am using is the Stock-Watson unobserved components with stochastic volatility, or UC-SV model), it says there is about a 10 percent chance that average CPI inflation over the next five years will be below zero.
Is this the last word on estimating deflation probability? Of course not; there are more than a few pitfalls in this method of calculating a deflation probability, some of which are described in the aforementioned technical appendix posted on the Atlanta Fed's Inflation Project. But this approach does have the advantage of exploiting information from market prices on traded securities. As such, it may prove a valuable addition to our toolkit of indicators. Consequently, we intend to update these estimates and post them on the Inflation Project web page every Thursday afternoon.
By Patrick Higgins, an economist in the Atlanta Fed's research department
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October 01, 2010
What does "structural" mean?
On Wednesday, Federal Reserve Bank of Atlanta President Dennis Lockhart summed up one of the hot policy questions of the moment this way:
"A necessary debate is jelling on the diagnosis of our economic troubles and the appropriate prescription. As I think about it, there are three lines of argument. One argument maintains there is not enough spending occurring—in economists' terms, a shortfall of aggregate demand—and that this shortfall can be reduced by further stimulus. A second argument is that the economy is undergoing deep structural adjustments in industry composition, labor markets, and household finances, especially the level of debt, and these adjustments will take considerable time to play out. Finally, it can be argued that much of the uncertainty has to be dealt with in other areas of government, and monetary policy can't do much about this kind of problem. This characterization doesn't do full justice to the complexity of the matter, but it lays out in broad strokes what questions are in play."
In some quarters, the opinion seems to be that the debate is effectively over. On the day of President Lockhart's speech, Mark Whitehouse wrote this piece in the Wall Street Journal:
"In recent months, policy makers have puzzled over the inadequate rate at which job searchers and job vacancies are coming together. By some estimates, if openings were turning into hires at the rate they typically do, the unemployment rate should be about three percentage points lower than the current 9.6%....
"A new paper, though, suggests employers themselves are at least part of the problem. The authors—Steven Davis of Chicago Booth School of Business, R. Jason Faberman of the Philadelphia Fed and John Haltiwanger of the University of Maryland—take a deep dive into Labor Department data and come up with an estimate of what they call 'recruiting intensity,' a measure of employers' vacancy-filling efforts including advertising, screening and wage offers.
"Their finding: Employers haven't been trying as hard as they usually do. Estimates provided by Mr. Davis suggest that over the three months ending July, recruiting intensity was about 12% below the average for the seven years leading up to the recession. Their lack of effort probably accounts for about a quarter of the shortfall in the hiring rate."
Paul Krugman made note of the same issue a few days earlier:
"Job openings have plunged in every major sector, while the number of workers forced into part-time employment in almost all industries has soared. Unemployment has surged in every major occupational category."
Whitehouse mentions a solution that comes from the Krugman (and many others') playbook:
"Depressing as it might seem, the finding is in some ways encouraging. It suggests that the trouble with hiring might be more a 'cyclical' function of low business confidence than a chronic, 'structural' ailment that will last for years to come."
The "low business confidence" part sounds right, but does that make the problem "cyclical"? I'm not so sure. Let's say an employer is reluctant to post a job opening because, just for example, the cost of the new employee potentially will expand by an amount that is unknowable until the details of healthcare reform legislation are clarified. Would you call that cyclical or structural? If "low confidence" reduces the search intensity of businesses, wouldn't it be reasonable to describe the resulting drop-off in job openings "structural"?
I think a reasonable answer comes down to whether the reluctance to create a job opening would be overcome by a pickup in business activity. But that may in turn depend on whether or not businesses think they can meet that demand by expanding productivity, something they have shown great aptitude for over the course of the past three years.
Maybe businesses have reached their capacity to grow through productivity gains rather than job creation. So maybe additional policy-induced demand will be enough to overcome the uncertainties that are clearly plaguing private decision makers. But I don't see that the evidence in hand so clearly tips the scales one way or the other.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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