Uncertainty about uncertainty

One of the hotly debated issues among those debating policy in the pages of various Fed publications (virtual and otherwise) is why job creation in the United States cannot seem to break out of its sluggish mode. One potential source is an elevated level of uncertainty about the political and economic future that is damping business enthusiasm for risk and, consequently, holding back the expansion.

Heightened uncertainty as an impediment to growth has intuitive appeal to many and, in our Reserve Bank's experience, considerable anecdotal support from business contacts. Unfortunately, intuition and anecdote don't quite rise to the level of evidence. Fortunately, the work of uncovering the evidence (one way or the other) is under way. One example is a recent entry by Mark Schweitzer and Scott Shane in the Federal Reserve Bank of Cleveland's Economic Commentary series:

"In this Commentary, we empirically examine the hypothesis that 'policy uncertainty' adversely impacts small business owners' expansion plans. To do this, we looked at the statistical association between data on small business plans to hire and make capital expenditures and a measure of 'policy uncertainty.' The data on small business plans cover January 1986 through July 2011 and were collected by the National Federation of Independent Business (NFIB)."

The picture relating the claims of respondents to the NFIB survey and the uncertainty measure employed by the authors is pretty compelling:

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The correlation that can clearly be seen in this chart survives more formal statistical analysis:

"We find statistically significant negative effects of policy uncertainty on small business owners' plans to hire and make capital expenditures over the 1986 to 2011 period. We also find a large effect of the economic downturn on small business plans, but the two effects do appear to be independent. The negative effects of policy uncertainty show up even when we weight the components of policy uncertainty in several different ways. The results also stand up when consumer confidence is controlled for, suggesting that the effects are distinct from consumer sentiment."

The authors note the appropriate caveats but are pretty clear about how they read the results of the analysis:

"While this statistical analysis is informative about the relationship between policy uncertainty and small business expansion plans, we cannot say that 'policy uncertainty' causes small business hiring and capital expenditure plans to decline. That is because a purely statistical model cannot identify fundamental causes. But whatever the fundamental cause, our analysis indicates that adding information about policy uncertainty improves our ability to explain the survey responses provided by the NFIB's survey respondents.

"In that sense, we can say that the correlations between the two are strong enough to reject the argument that policy uncertainty is irrelevant for currently weak small business expansion plans. In our view, policymakers should take seriously the widespread anecdotal reports that policy uncertainty is adversely affecting small business owners' expansion plans."

I think this study is really intriguing, but I would add another caveat to the results, emphasized not too many posts back here at macroblog:

"Talking about the role of the average or typical small business in job creation is problematic. Discussing it is challenging because job creation is highly skewed along the age dimension of small firms."

Smallness per se is not the defining characteristic of the businesses that are responsible for driving job creation. In fact, research shows that once firm age is controlled for, no systematic relationship exists between net growth and firm size. The distinction between young and mature firms—which our own regular poll of small businesses verifies is important—is absent in the NFIB data that Schweitzer and Shane exploit.

Although the Schweitzer-Shane study is a good start to turning anecdotal reports into evidence, the results would be more compelling if they pertained to the actual universe of companies that we would expect to be creating jobs—that is, firms that are young, not just small.

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

 

Is the growth tide turning?

It has been a tough year for forecasters, as the Atlanta Fed's President Dennis Lockhart explained in a speech delivered Tuesday evening:

"The basic story of the first half of this year was one of disappointment versus expectations. At the beginning of the year, the consensus forecast had gross domestic product (GDP) growth for 2011 in the range of 3 to 4 percent. Though the Atlanta Fed's forecast was at the lower end of that range, we generally shared the view that the recovery was firmly established…

"A pretty clear picture of just how bad the first quarter was became apparent toward the end of the second quarter, when the FOMC met in late June. At that point, notwithstanding weakness in the early months of the year, the widely held outlook was that growth would rebound in the second half. Many anticipated that the effects of the price and disaster shocks would quickly dissipate…

"As the summer progressed, the data surprises were unrelenting and on the negative side of expectations.

By the time of the early August FOMC meeting it was clear to my Atlanta Fed colleagues and me that we had to rethink our position. The momentum of the economy looked a lot weaker than was our assessment earlier in the summer."

That story is well-captured by a picture of the evolution of Blue Chip consensus forecasts over the course of the year:

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As President Lockhart explains, what has been most worrisome is the cumulative nature of the forecast errors implied in the above chart:

"Let me mention parenthetically that, given the complexity and dynamism of the economy, forecasting is fraught with errors and misses. One of my colleagues says the only thing he can forecast with certainty is that his forecast will be wrong. It's when forecasts are persistently wrong in the same direction, and by a substantial measure, that you worry you've missed the real story."

That reality can, of course, work in a positive direction as well as a negative direction. The encouraging news is that the forecasting mistakes have been accumulating in the direction of excess pessimism:

"We at the Atlanta Fed regularly monitor the data series that directly enter into the GDP calculation, along with important other series, including employment… In the months leading up to July, the downside surprises in the data dominated. In August and September, upside and downside surprises were roughly equal. But in October, the surprises have generally been to the upside."

One aspect of this analysis is called a "nowcasting" exercise that generates quarterly GDP estimates in real time. The technical details of this exercise are described here, but the idea is fairly simple. We use incoming data on 100-plus economic series to forecast 17 components of GDP for the current quarter. Those forecasts of GDP components are then aggregated to get a current-quarter estimate of overall GDP growth.

The outcomes of this exercise have been as positive in the third quarter as they were negative for the first two quarters of the year:

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At this point, we'll interrupt this blog post to offer a few disclaimers. First, we wouldn't want to put too much weight on the specific number cranked out by this exercise. Also, beyond the usual warnings about the imprecision of statistical estimates, we'll add that much of the data being used in the estimates are subject to revision—and we don't yet have very much information on activity in October. Finally, even with the improvements in performance versus expectations, the view of the moment is still centered on near-term growth that is less than stellar, as President Lockhart described in his remarks:

"[M]ost private sector forecasters envision growth in 2012 approaching 2.5 percent. In the opinion of many economists, that 2.5 percent approximates the steady-state growth rate of the economy's potential. This rate would certainly be an improvement over 2011 as a whole. The problem is without growth measurably better than 2.5 percent, little progress will be made in absorbing slack in the economy—above all, labor market slack."

But after the long run of negative news that has characterized most of this year, we are for now at least moving in the right direction.

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

 

and

Patrick Higgins, economist at the Atlanta Fed

 

 

Two more job market charts

Correction: One of macroblog's careful readers noted we mistakenly stated that the job creation pace from January 2011 through the date of the blog posting averaged 96,000 jobs per month. The 96,000 jobs per month actually applies to the average job creation pace over the previous three months at the time of the posting. We made this correction in the last sentence of the second paragraph. (10/21/11)

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If you are looking for the full rundown on the September employment report, there is, as usual, plenty of good commentary to be found in the blogosphere. I'll add a couple more graphs to the pile, similar to exercises we have done with gross domestic product in the past.

Payroll employment growth has averaged about 110,000 jobs a month since February 2010, the jobs low point associated with the crisis and recession. This growth level compares, unfavorably, with the 158,000 jobs added per month during the last jobs recovery period from August 2003 (the low point following the 2001 recession) through November 2007 (the month before the recent recession began). One hundred and ten thousand jobs a month compares favorably, however, to the 96,000 job creation pace for the past three months.

Are these sorts of differences material? If the economy can find its way to creating jobs at the same rate as the last recovery—which nobody remembers as particularly off-the-chart spectacular—we would be back to the prerecession level of overall employment by spring 2015. If, on the other hand, we can only eke out the sub-100k pace we've seen this year, that date moves out to 2017:

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So we do eventually get there in terms of recovering the jobs lost during the course of the past four years. The same, unfortunately, cannot be said of the unemployment rate. Because the unemployment rate has more moving pieces—like assumptions about labor force participation rates (or how many people jump in and out of looking for jobs)—back-of-the-envelope calculations are a bit more speculative than the simple employment paths in the previous chart. But with a few assumptions, such as the presumptions that the labor force will grow at the same rate as census population projections (for the aficionados, my calculations also assume that the ratio of household employment to establishment employment is equal to its average value since January of this year), the unemployment rates associated with job growth of 158,000, 110,000, and 96,000 per month would look something like this:

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These paths are just suggestive, of course, but I think they tell the story. The same jobs recovery rate of the prerecession period would get the unemployment rate down below 7 percent in four years or so. But at the pace we have been going this year, things get worse, not better.

Update: Many other fine pictures are available at Angry Bear, Mish's Global Economic Trend Analysis, The Capital Spectator, Modeled Behavior, and lots from Calculated Risk (here and here, the latter with related links). At Econbrowser, guest blogger Mike Duecker delivers forecasts for 150,000 jobs per month—but not until mid-2012.

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

 

Another cut at the postrecession job picture

There is not much to be said about the August employment report released last Friday—or not much good, anyway. The ongoing updates at Calculated Risk provide a chronicle of the questions and challenges that have characterized the postrecession period. An exhaustive set of graphs are spread across several posts, here, here, and here. The last post in the series focused on construction employment specifically and includes this observation, which is based on the addition of 26,000 construction jobs in 2011 through August:

"After five consecutive years of job losses for residential construction (and four years for total construction), this is a baby step in the right direction. However there will not be a strong increase in residential construction until the excess supply of housing is absorbed."

Given the likely pace of turnaround in the housing market, that sounds like a problem. It is not much surprise that employment in the construction sector is, and likely will continue to be, significantly weaker than it was before the recession. Can the same be said of most other sectors? The following chart shows pre- and postrecession, cross-sector average monthly changes in payroll employment, broadly defined according to U.S. Bureau of Labor Statistics' classifications. For reference, the size of the circles in the chart reflect the relative prerecession size of the sector in terms of employment.

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A few points:

• The 45-degree line represents points where average monthly employment changes before the recession (from December 2001 through November 2007, precisely) are exactly the same as the average changes after the recession (July 2009 through August 2011). Consistent with the slow pace of overall employment growth during this recovery, the majority of circles representing different sectors lie below the 45-degree line.

• In general, the pattern of circles is such that those sectors with relatively high employment changes prerecession are those that have exhibited relatively high changes during the recovery. In other words, we have not yet seen a widespread reshuffling of cross-sectoral employment trends outside of the recession. For example, employment changes in the education and health care sector led the pack before the recession, and that sector has led the pack thus far in the recovery. At the opposite end of the scale, job growth in the information sector has remained on a negative trend in the recovery period, just as it was prior to the recession.

• I want to note a few exceptions to the preceding observation, which discusses the sectors with relatively high employment changes before the recession being the same ones that exhibited relatively high changes during the recovery. As noted, employment in the construction sector is well off its prerecession pace. What may be less appreciated is the fact that manufacturing employment, outside of the motor vehicles and auto parts sector, has experienced monthly employment gains that are better than the prerecession rate. Employment in the government sector, on the other hand, has noticeably flipped from positive to negative. This shift is also true of job growth in the financial activities sector, though the change is less dramatic than in the government sector.

Manufacturing and government represent relatively big shares of employment. Including motor vehicles and parts, manufacturing payroll employment was over 11 percent of total U.S. jobs for the period from 2002 through 2007. Government employment was about 16.5 percent (and had the largest single share of sectoral employment in the breakdown used in the chart above). The bad news in the big picture is that the better performance in manufacturing job creation is really a shift from negative job creation in the prerecession period to zero job creation in the postrecession period. And as for government employment, it seems unlikely that the forces will soon align to move job growth in the public sector back into positive territory. (The same could probably be said of financial activities employment.)

I am not pushing any particular interpretation of these facts, but a couple of questions come to mind. Will non-auto manufacturing employment revert to the contracting trend in place prior to the recession? Will employment in the financial activities and government sectors continue to shrink? If so, will these jobs be absorbed by increased employment in other sectors, and how long will that take?

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

 

Is the economy hitting stall speed?

The news that the U.S. economy is not only growing slowly but has grown more slowly than anyone even knew has justifiably rattled some nerves. The sentiment is captured well enough by this article from Bloomberg:

"The world's largest economy has yet to regain the ground it lost during the recession and may be vulnerable to a relapse.

"Gross domestic product [GDP] expanded at a 1.3 percent annual rate in the second quarter, after a 0.4 percent pace in the prior period, the worst six months since the recovery began in June 2009, Commerce Department figures showed yesterday. Economists said the slowdown leaves the recovery susceptible to being knocked off course by shocks at home or abroad."

At Reuters, James Pethokoukis makes those concerns quantitative:

"...we're in the danger zone for another recession. Research from the Federal Reserve finds that that since 1947, when two-quarter annualized real GDP growth falls below 2 percent, recession follows within a year 48 percent of the time. (And when year-over-year real GDP growth falls below 2 percent, recession follows within a year 70 percent of the time.")

The research being referred to is work done by the Federal Reserve Board's Jeremy Nalewaik, a careful researcher who is clear that the results should be read with, well, care.

"The dynamics at play in the early part of the 1990s and 2000s expansions may have been different than the dynamics at play in the more-mature part of those and other expansions, and our stall speed models may have omitted an additional phase of the business cycle that has appeared in recent decades, namely the sluggish, jobless recovery phase. If so, the applicability of these stall speed models may be somewhat limited at certain times, such as in the middle of 2010 when the economy evidently slowed while still in the early stages of recovery from the 2007-9 recession."

With caveats like that in mind, Dennis Lockhart, the president of the Atlanta Fed, counseled patience in a speech he delivered on Friday:

"My staff and I have recently been pondering the following questions: Are we experiencing a temporary slowdown—a soft patch—on a recovery path that should return to a rate of 3 to 4 percent GDP growth? Or, instead, are we dealing with an inherently slower pace of economic growth that, because of some combination of persistent economic headwinds and deeper structural adjustment requirements, has the potential to be of much longer duration and more intractable?"

Lockhart said his base case forecast is in line with the greater-strength view.

"I am expecting greater strength in the second half of 2011 and into 2012, accompanied by inflation numbers that converge to around 2 percent. But, as I said, I don't dismiss the possibility that we're in the alternative, more problematic world I described of low and slow growth improving only very gradually. At this juncture, I think we have to wait and see what the incoming data indicate...

"But to try to put some time limit on indecision, I think a continuing flow of weak numbers through the third quarter and into the fourth will call for a serious reconsideration of the situation. The weight of cumulative data could point to a different order of problem—that is, different than just a passing slowdown—if indicators show continued weakness much past year's end."

Of course, Nalewaik's research shows that things could become considerably less comfortable if the 2 percent threshold persists, or the yield curve flattens, or the housing market tanks again. At that point, history is on the side of the recessionists. While Lockhart and our Reserve Bank don't believe we're there yet, it's fair to say we'd feel more comfortable if the incoming third quarter data were a little more positive. And on that count, this morning's Institute for Supply Management report for manufacturing isn't a very promising first step.

By Dave Altig, senior vice president and research director, and

Mike Bryan, vice president and senior economist, both of the Atlanta Fed

Gaining perspective on the employment picture

The employment report released today indicated a moderate increase of 192,000 in nonfarm payrolls and a slight decline in the unemployment rate from 9 percent in January to 8.9 percent. While certainly an improvement over recent months, employment growth still has not reached a level needed to produce significant drops in the unemployment rate.

In a speech given yesterday, Atlanta Fed President Dennis Lockhart addressed some of the underlying issues that have potentially been holding back job growth. On the supply side, President Lockhart addressed three structural issues, including skill mismatch, house lock, and extended unemployment insurance.

"Skill mismatch exists when work skills of job seekers do not match the requirements of jobs that are available. For example, a construction worker is unlikely to have the particular skills needed in the healthcare industry."

This comment is motivated by the research of Federal Reserve economists (Valetta and Kuang and Barnichon and Figura, among others) that suggests while there is likely some evidence of skill mismatch, it's not materially different than what's been seen during past recessions.

Another possible explanation mentioned by President Lockhart for persistently high unemployment is the existence of  what is sometimes referred to as "house lock."

"Currently many people owe more on their homes than their homes are worth. It's claimed that job seekers don't accept jobs available in other geographic locations because of the difficulty or cost of selling their homes."

Here too, President Lockhart says there is evidence indicating house lock is not a large contributor to the current high level of unemployment (For example, see Schulhofer-Wohl, Kaplan and Schulhofer-Wohl, and Molloy et al.)

More convincing is the argument pointing to the impact of extended unemployment insurance benefits. Research from the most recent recession and recovery—for example, see Valetta and Kuang and Aaronson et al.—suggests extended benefits have added to the unemployment rates, with estimates ranging from 0.4 percentage points to 1.7 percentage points. If that's the case, then President Lockhart says these extended benefits may be acting "as a disincentive to accept an offered job, especially if the job pays less than the one lost."

As President Lockhart indicates, however, standard skill mismatch, house lock, and unemployment insurance disincentives do not provide the full answer. So, he offers some additional factors:

"On the demand side, it's been argued that credit constraints affecting small businesses are holding back hiring. Banks are blamed for this situation and so are regulators. Getting credit at an affordable cost was a challenge during the recession. But credit conditions for established small businesses have been steadily improving for some time now. Recent surveys suggest that most small businesses are cautious about hiring more because of slow sales growth rather than lack of access to credit.

"Furthermore, a recent National Bureau of Economic Research study showed that job creation is more correlated to young businesses than the broad class of small businesses. Start-ups and young businesses are often financed in ways other than direct business loans. Difficulties getting home equity loans and other personal credit appear to have reduced formation of new businesses.

"Strong productivity growth is another much-discussed potential impediment to hiring. Stated simply, increases in productivity allow businesses to support a given level of sales with fewer people. In the longer term, rising productivity expands the economy's output, which in turn generates jobs. But in the short run, productivity investment can be the enemy of employment growth.

"Productivity growth was unusually high during the recession and in the early stages of the recovery, limiting the need for additional workers. Recently, however, productivity growth has slowed below the pace of business sales. If this trend continues, the need to hire additional workers will increase.

"Finally, in recent months, reluctance to hire has been attributed to heightened uncertainty, a common theme among my business contacts. A few weeks ago I argued that uncertainty has abated somewhat with the improving economy, the resolution of the November elections, the extension of tax cuts, and the apparent containment of the European sovereign debt crisis. I said that before Tunisia and before the fiscal struggle in Congress gathered steam. The restraining influence of uncertainty persists, to some extent."

Outside of productivity, it is difficult to measure the impact of these issues. (For example, it is difficult to survey people who did not start up a firm to determine if credit was an issue.) However, the theme of uncertainty has been a consistent factor in discussions on employment with our contacts here at the Atlanta Fed. If a simple explanation for persistent weakness in labor markets has proven elusive, there is little argument with President Lockhart's observation that "the recovery has brought little relief to the labor market."

Should today's employment release change any opinions about the strength of the labor market? In my mind, not really. There are still 7.5 million fewer jobs than at the start of the recession. There are also still over 8 million workers employed part time for economic reasons, and almost 6 million of the unemployed have been so for more than 26 weeks.

But the numbers released today did provide some additional evidence that the labor market is moving in the right direction with a level of growth consistent with at least a modest decline in unemployment. Furthermore, as consumer expenditures continue to rise, profitability increases, and the amount of uncertainty diminishes, hiring should increase. However, as President Lockhart alluded to in his speech, it will likely take time before the labor market recovery catches up to the overall economic recovery.

By Melinda Pitts
Research economist and associate policy adviser at the Atlanta Fed

A curious unemployment picture gets more curious

UPDATE: One of our eagle-eyed macroblog readers thought something was fishy-looking in the second chart of yesterday's (July 15) post. He was right—the chart was in error. This post is an updated, edited version with the erroneous chart replaced. There have also been some text revisions to better reflect the revised chart. The new text is bolded in this post.

At first blush, the second quarter statistics from the Job Openings and Labor Turnover Survey (commonly referred to as JOLTS and released Tuesday by the U.S. Bureau of Labor Statistics) suggest little has changed recently in U.S. labor markets:

"There were 3.2 million job openings on the last business day of May 2010, the U.S. Bureau of Labor Statistics reported today. The job openings rate was little changed over the month at 2.4 percent. The hires rate (3.4 percent) was little changed and the separations rate (3.1 percent) was unchanged."

Despite a slight step backward in May, the overall trend in job openings has been positive—Calculated Risk has the picture—but in a sense this fact has just deepened the puzzle of why the unemployment rate is so darn high. As we wrote in the first quarter issue of the Atlanta Fed's EconSouth:

"The disconnect between the supply of and demand for workers that is reflected in statistics such as the unemployment rate, the hiring rate, and the layoff rate can be dynamically expressed by the Beveridge curve. Named after British economist William Beveridge, the curve is a graphical representation of the relationship between unemployment (from the BLS's household survey) and job vacancies, reflected here through the JOLTS."

Since the second quarter of last year, the unemployment rate has far exceeded the level that would be predicted by the average correlation between unemployment and job vacancies over the past decade. Tuesday's report indicates that the anomaly only deepened in the first two months of the second quarter.

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The dashed line in the chart above, which is estimated from the data from 2000–08, represents the predicted relationship between the number of unemployed persons in the United States and the number of job openings. That simple relationship would suggest that, given the average number of job openings in April and May, the unemployed would be expected to number about 10.4 million—not the nearly 15 million we actually saw.

Some analysts have suggested the unemployment benefits policies of the last couple of years may be responsible for abnormally high unemployment rates. Estimates generated by several researchers in the Federal Reserve—here and here, for example—suggest that extended unemployment benefits may have increased the unemployment rate by somewhere between 0.4 and 1.7 percentage points. But even if we accept those numbers and adjust the Beveridge curve by assuming that the number of unemployed would be correspondingly lower without the benefits policy, it's not clear that the puzzle is resolved:

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If you tend to believe the higher end of the benefits-bias estimates, no puzzle emerges until the second quarter of 2010. And, of course, some estimates apparently deliver an even larger impact of the extended benefits policy. Let's call the question unsettled at this point.

The most tempting explanation for the seeming shift in the Beveridge curve relationship (to me, anyway) is a problem with the mismatch between skills required in the jobs that are available and skills possessed by the pool of workers available to take those jobs. The problem with this tempting explanation is that it is not so clear that the usual sort of structural shifts we might point to—for example, only nursing jobs being available to laid-off construction workers—are so obviously an explanation (an issue we explored in a previous macroblog post).

But these sorts of subplots may miss the truly big part of the story. I have noticed a recent spate of articles repeating a theme we hear anecdotally from many sources, in many industries. For example, this from a June USA Today article…

"…the [auto] industry is poised to add up to 15,000 this year and could need up to 100,000 new workers a year from 2011 through 2013.

"…Automakers need workers with more and different skills than in the past on the factory floor.… Among priorities: computer skills and the ability to work with less supervision than their predecessors. That likely means education beyond high school."

… or more recently, this one from the New York Times:

"Factory owners have been adding jobs slowly but steadily since the beginning of the year, giving a lift to the fragile economic recovery…

"Yet some of these employers complain that they cannot fill their openings.

"Plenty of people are applying for the jobs. The problem, the companies say, is a mismatch between the kind of skilled workers needed and the ranks of the unemployed."

Now I realize that a few anecdotes don't make facts, but I have been in more than a few conversations with businesspeople who have claimed that the productivity gains realized in the United States throughout the recession and early recovery reflect upgrades in business processes—bundled with a necessary upgrade in the skill set of the workers who will implement those processes. This dynamic suggests that the shift in required skills has been concentrated within individual industries and businesses, not across sectors or geographic areas that would be captured by our most straightforward measures of structural change.

The data necessary to test this proposition are not easy to come by. That challenge is unfortunate, because the return on figuring out what is beneath those Beveridge curve graphs is very high.

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

Another look at consumer sentiment and consumer spending

In the most recent economic forecasting survey by the Wall Street Journal, 23 percent of the surveyed economists said consumers spending more readily than anticipated is the biggest upside risk of their growth forecast for the second half of the year. So anything that can shed light on future spending habits is of particular interest. Two of the most commonly cited measures of consumer attitudes are the Conference Board's Consumer Confidence Index and the Thomson Reuters/University of Michigan's Index of Consumer Sentiment. A key question is, do these indicators improve consumption forecasts?

Previously, economic researchers have looked at the predictive power of these indexes for consumer spending, and they generally found that the ability of consumer confidence measures to predict consumer spending largely disappeared once some other measures of economic conditions were taken into account. One such example is a study by Sydney Ludvigson, which examined the forecasting record of these confidence measures through 2002 (for other examples, see here and here). Much has happened since then, of course, and a simple inspection of the two series reveals that both confidence measures fell fairly steadily starting in August 2007 until reaching near-record lows by June 2008. Therefore, a look at the more recent predictive track record of these indicators seems warranted.

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For this examination, we conducted an out-of-sample forecasting experiment using a pair of statistical models (technically, Bayesian vector autoregression models). The first model predicts real personal consumption expenditures as a function of its own past values and past values of other variables such as real measures of stock market prices and disposable personal income. The second model includes all of these variables augmented by the two measures of consumer attitudes. At each point in time we use only the data that would have been available to forecast real consumption data anywhere from one to 12 months out. (For example, in the middle of February 2009, consumption data would have been available through December 2008 while some of the other variables would have been available through January or February 2009. The experiment is not "real time" in the sense that we use the latest vintage of data, which include revisions to the historical data that would not have been available to forecasters at the time.) Forecasts of consumption are made for the 1990–2003 period and then again for the period from 2004 to the present. The root mean squared forecast error is used to gauge the accuracy of the forecasts, with smaller numbers corresponding to smaller misses on average. As the accompanying chart shows, adding the two measures of consumer attitudes improves the forecast much more in the post-2003 sample than in the earlier period.

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We experimented with some variations in specifications of the model, and we were unable to overturn the general finding that adding attitude measures to the model resulted in an improvement in forecasts in recent years. We found this fact intriguing and somewhat surprising.

A recent paper by Barsky and Solon argues that the Index of Consumer Sentiment reflects the public's awareness of economic conditions. In fact, the survey used to construct this index asks respondents about recent news they have heard related to changes in economic conditions. From August 2007 to June 2008, news of "unfavorable higher prices" was frequently mentioned in the survey. A study by James Hamilton showed that part of the deterioration in the Index of Consumer Sentiment during this period could be explained by rising energy prices. However, adding a measure of oil prices to our model did not overturn the basic finding of improved consumption spending forecasts in models that included measures of consumer attitudes.

It remains an open question why these measures of consumer attitudes have become more useful in recent years. A statistical anomaly, greater or more accessible news coverage of the economy, and a generally more aware public are all possibilities. If it is just luck, then time will eventually overturn the result. But if these consumer attitude indicators have become a more useful summary of a wide variety of developments in the economy, then their forecasting power will persist. Time and further research will help sort this out.

By Patrick Higgins, an economist at the Atlanta Fed

Sticky-price CPI up slightly in April... Wait, what?

No matter how you cut the April report on consumer prices, retail inflation keeps coming up zero. Here are the key points:

• The consumer price index (CPI) fell a tiny bit in April but has remained essentially unchanged since January.
• The core CPI (excluding food and energy) hasn't posted a significant increase dating back to last October, and its 0.9 percent rise from a year ago is its smallest 12-month increase since 1966.
• The Federal Reserve Bank of Cleveland's median CPI continued a trend of essentially no change since October and is up a mere 0.5 percent from a year ago—a new year-over-year low for the series.

Oh, and the sticky-price CPI was up only 1.25 percent (annualized) in April. Maybe we ought to explain this last one a little more.

When you look at the headline CPI, what you're really looking at is a constellation of price movements that are a mixture of various forces. For example, there are changes in market conditions that are specific to particular goods—dairy prices fell sharply in April, presumably in response to an unanticipated jump in milk production. Stripping away these idiosyncratic price movements is, in large part, what the core inflation measures, including the Cleveland Fed's median CPI, are designed to do.

But economists tend to think of two general forces that drive all prices: (1) the amount of "slack" in the economy influencing the pricing power of firms and workers and (2) inflation expectations, which affect forward-looking price and wage decisions.

Of course, these two forces are unlikely to affect all prices in the exactly same way. Economists have long accepted the idea that some prices are "sticky," meaning they may not be particularly sensitive to changing market conditions, including economic slack. But if these sticky prices are, in fact, insulated from the ups and downs of the marketplace, might they be more forward looking?

In recent work, we used data on the price flexibility of specific goods to separate the CPI into two components: a flexible-price CPI and a sticky-price CPI. What we found was that flexible-price goods represent roughly 30 percent of the CPI market basket, and these goods tend to respond to the state of the economy. However, the sticky-price goods that make up the remaining 70 percent of the CPI market basket don't appear to respond to economic conditions. Consider the figure below, which shows the correspondence between the flexible-price CPI and the sticky-price CPI to the amount of slack in U.S. labor markets—the so-called Phillips curve relationship.

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But what the sticky-price CPI lacks in responsiveness to the economy, it seems to make up in terms of its ability to capture inflation expectations. In other words, the sticky-price CPI seems to be more forward looking.

What does all this have to do with the April CPI report? Well, not any more than you already know; this most recent CPI report doesn't have a hint of inflation in it. The flexible-price portion of the CPI that seems most responsive to the state of the economy fell last month, as it has, on average, during the past three months (–0.7 percent on a core basis.) And the sticky-price part of the CPI that seems to be most forward looking is only limping ahead, up 1.25 percent in April, and is less than 1 percent on a year-over-year basis.

By the way, if you want access to these data back to 1967, we've made them available to you on the Atlanta Fed's Inflation Project.

By Mike Bryan, vice president and senior economist at the Atlanta Fed, and Brent Meyer, senior economic analyst at the Cleveland Fed

The inventory question

Mark Thoma asks a very good question:

"I hadn't looked at this for awhile—should I interpret the return of the inventory-sales ratio to near normal levels as good news?"

Here's the picture Thoma was looking at, updated to incorporate today's U.S. Census Bureau release on February manufacturing and trade inventory and sales:

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Tim Duy has taken a look at these data and comes to this conclusion:

"Increasingly, the recovery looks sustainable—sustainable in the sense that a double dip recession looks unlikely. As Bloomberg reports, this is the message of the inventory cycle, which appears to have largely run its course. Inventories surged as the recession intensified, leaving firms scrambling to bring output in line with the new level of sales. Now, firms have inventories under control."

I have been pondering those data as well, ever since the advance fourth quarter gross domestic product report indicated that 3.4 percentage points of the then-reported 5.9 percent annualized growth rate was accounted for by a slowing in the pace of inventory decumulation. (The numbers have subsequently been revised to 3.8 percentage points of a 5.6 percent growth rate.) It certainly appears that inventory-sales ratios have reverted to the prerecession norm, justifying Duy's sense that inventories will not be a big part of the economic story as we move through 2010.

That conclusion does rest, of course, on the likelihood that a downward trend in the ratio truly did break in the middle part of the decade. As the chart shows, the same pause in the trend occurred in the mid-1990s, only to commence its southward trek on the other side of the 2001 recession.

But the situation is even more curious than that. If you dig a little deeper, you find that not all inventory-sales ratios tell the same story. In particular, inventory-to-sales ratios at the retail level look very lean relative to prerecession levels while manufacturer's inventories still appear to be relatively bloated.

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What, exactly, is that chart trying to tell us? Does it represent some shift in supply-chain management, with inventory holdings being pushed down from the retail level to manufacturers? If not, can we expect some resurgence in retail inventories (as the Duy-cited Bloomberg article suggests), coupled with continued decumulation at the manufacturing level? And what would be the net effect of such developments on aggregate inventory levels?

Those are good questions, too. If you have any insights, I'd love to hear them.

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