macroblog

Where, Exactly, Is The Atlanta Fed?

Well, I'm not exactly announcing the permanent return of macroblog just yet, but this item from the Wall Street Journal's Real Time Economics blog caught my eye:

Does a local housing market’s performance influence how a Federal Reserve Bank president feels about interest rates? An analysis by J.P. Morgan economist Michael Feroli suggests it might.

Mr. Feroli looked at home prices in headquarters cities for each of the Fed’s regional districts and found that five of the six with housing markets faring the best didn’t originally request discount-rate cuts last month. “All (Fed) politics is local,” Mr. Feroli writes.

Ahead of the Fed’s most recent policy meeting, seven of the 12 regional banks submitted requests to the Federal Reserve Board to lower the discount rate, for direct loans by the Fed to commercial banks, by half a percentage point. Some of the five that didn’t request the discount-rate reduction — Atlanta, Chicago, Dallas, Philadelphia and Richmond — may have been less enthusiastic about an aggressive cut in the benchmark federal-funds rate.

Here's a version of the picture illustrating Mr. Feroli's assertion:

   

   

That's interesting, but as everyone knows the Federal Reserve Bank districts are a bit larger than the cities in which they are based. Here, for example, is a map of the area represented by the Federal Reserve Bank of Atlanta (my current home base):

   

   

Hmm. What do you suppose happens if I take Feroli's chart and replace Atlanta with Miami (the residents of which have exactly the same claim on the attentions of the Atlanta Fed as those who live in Georgia)? 

   

   

I trust you get the point.

Why Central Bankers Worry About Fiscal Policy

Today I again hand the keys to Mike Bryan -- now a fellow adjunct faculty member in the University of Chicago's Graduate School of Business -- who provides us with a contemporary example of why it behooves central bankers to speak out when a nation's fiscal situtation gets out of whack:

The reports from Zimbabweover the past year and a half are the stuff that makes for good Money and Banking lectures. It seems that inflation in that country, as officially reported, topped 1,300 percent last year and may now exceed 3,700 percent, with some unofficial reports putting the country’s inflation rate even higher.  Let’s put this inflation in perspective.  If the last reported inflation number can be believed (the country’s Central Statistical Office recently stopped reporting the inflation numbers as it reviews its methodology), prices in Zimbabwe are doubling every month. Inflation of this magnitude renders the government-issued money virtually worthless, wrecking trade and financial institutions in the process.   

While the rate of inflation in the African nation isn’t known for certain, there is little doubt it is extraordinarily high.  Also not in doubt is its cause.  All inflations originate from the same phenomenon—too much money chasing too few goods.  In this case the Reserve Bank of Zimbabwe is rapidly printing Zimbabwe dollars in order to “pay” for a large fiscal shortfall. 

In a recent IMF paper on the Zimbabwe situation the author argues that the Reserve Bank of Zimbabwe’s (RBZ) inflation problems stem not from the usual monetary or fiscal laxness that has triggered other “hyperinflations,” but rather “quasi-fiscal” losses incurred by the central bank itself.  Still, the report concludes that these losses, which stem from some combination of credit subsidies, realized and unrealized exchange losses, and losses from open market operations, were nevertheless incurred to support government policies, and the failure to address these losses has interfered with the monetary management, independence, and credibility of the RBZ.

The immediate “solution” to the Zimbabwe inflation has been the imposition of price controls, an approach that has been attempted by governments ancient and modern, including our own.  I can think of no better source on this topic than economist Hugh Rockoff of Rutgers.  Zimbabwe’s controls are actually retroactive, in the sense that merchants have been asked to reduce prices to earlier levels.  Predictably, the problem seems to have gotten worse—now there are even fewer goods for the Zimbabwe dollar to chase.  When and where will the Zimbabweinflation end?  I certainly don’t know.  But I’ve got a pretty good idea how it will end, by a sharp curtailment of their currency expansion.  And that’s the Money and Banking lesson.  If a central bank wants to end inflation, either they better start producing goods, or stop producing money. 

And that, I would add, will be a hard row to hoe unless the fiscal house is put in order.

Setting Gene Epstein Straight

Some of you may be aware -- though most of you probably not -- that the proprietor of macroblog finds himself in a period of transition.  As the first sign of stress is referring to one's self in third person, let me apologize retrospectively and in advance for a period of slow blogging.  Things will, I hope return to normal productivity soon, but for today I will turn to my friend and colleague Mike Bryan, writing at the Cleveland Fed website:

Last week, Federal Reserve Board Chairman Bernanke made his midyear appearance on Capitol Hill to testify about the economy and monetary policy. Among his duties at these semiannual events is the release of the economic projections, the most recent vintage of which can be found here.

Gene Epstein of Barron’s offered his perspective on the projections (available by subscription here). He argues that, in retrospect, Chairman Bernanke’s outlook for 2006 was fairly wide of the mark in all three of the major variables—real growth, the rate of unemployment, and core inflation... But these were fortuitous errors, says Mr. Epstein, because had the Chairman seen that growth was coming in at 3.1 percent rather than the 3.5 percent projected, he might have projected unemployment to be higher and inflation to be lower, weakening “his resolve to keep hiking the interest rate,” which would have been “ill-advised.”

Mike has some problems with that take on the situation:

First, the central tendency of the semiannual economic projections reported by Gene Epstein is not necessarily the Chairman’s personal view. All Reserve Bank presidents and Fed governors offer a projection, and where the Chairman’s view lies in that set of projections cannot be determined.

In other words, the semiannual economic projections are not the prognostications of an individual, but the wisdom of a crowd:

... one article of particular interest... [authored by the St. Louis Fed's Bill Gavin] is worth repeating here. Gavin demonstrates that the midpoint taken from the full range of policymakers opinions is a better predictor of future outcomes than the group’s central tendency (which is calculated by Federal Reserve Board staff by excluding projection outliers.) While Gavin didn’t speculate on why the midpoint of the full range of Federal Reserve forecasts is superior to the group’s central tendency, I will.

Economic forecasting is a hard business and no thoughtful forecaster enters the forecasting arena without a healthy skepticism about his or her ability to see the future—a future full of unknowns. And these unknowns—risks—can sometimes be revealed by the range of opinions coming from people who see and judge them differently. In the case of the 2006 outlook, the outcomes were within the full range of Federal Reserve officials opinions for unemployment and core inflation, and just marginally under the bottom end of the range of opinions for real GDP growth (3.1 percent vs. 3.25 percent).

Most importantly, thinking that policymakers slavishly base their decisions on the point estimates derived from a forecasting exercise is -- well, wrong thinking:

Perhaps the real usefulness of economic forecasts is not their ability to see what will come next, but rather their ability to identify the risks that stand the best chance of causing the projection to go amiss. And these risks are also articulated in the Chairman’s testimony. In his February 2006 testimony, Chairman Bernanke described three such risks in the 2006 outlook. First, there was a potential for slower real growth due to problems associated with housing; second, high rates of resource utilization could add to inflation pressure; and third, “[a]dditional steep increases in the price of energy [c]ould intensify cost pressures and weigh on economic activity.”

Well, we can quibble over the accuracy of last year’s economic projections, but it’s hard to find fault with the assessment of the risks we faced.

Exactly.

Core Blind?

Barry Ritholtz is unimpressed by Chairman Bernanke's latest speech:

Peter E. Kretzmer, senior economist for Bank of America, explains (more or less) what the Fed means  by relating "inflation expectations" to the ability of the Fed to impact price rises (i.e., stability):

“This Fed much more so than prior Feds puts a very heavy emphasis on the role of inflationary expectations,” he said. “They believe, and research shows, that inflation expectations and the Fed’s inflation-fighting credibility has a large impact on private sector wage- and price-setting behavior.”

In other words, the Fed's emphasis on Core inflation -- jawboning, PR, propaganda, whatever -- is every bit as important to future prices as the actual underlying causes (excessive monetary creation, demand exceeding commodity supplies) of inflation.

I am not sure I buy that. Surely, psychology is important, and the collective expectations of either higher or lower prices can impact subsequent price behavior. 

But this approach puts the Fed into the role of a low price cheerleader, and runs the dangerous risk of well, artificially emphasizing the irrelevant core rate of inflation rather than dealing with reality of the actual price increases as experienced by consumers.

That representation is not really wrong, but (as I have said here before) it rather stubbornly misses the point of the FOMC's intent in focusing attention on core inflation measures.  The Chairman, in an earlier speech:

A commonly used analogy takes the U.S. economy to be an automobile, the FOMC to be the driver, and monetary policy actions to be taps on the accelerator or brake. According to this analogy, when the economy is running too slowly (say, unemployment is high and growth is below its potential rate), the FOMC increases pressure on the accelerator by lowering its target for the federal funds rate, thereby stimulating aggregate spending and economic activity. When the economy is running too quickly (say, inflation appears likely to rise), the FOMC switches to the brake by raising its funds rate target, thereby depressing spending and cooling the economy. What could be simpler than that?...

[One] problem with the automobile analogy arises from the central role of private-sector expectations in determining the impact of monetary policy actions. If the automobile analogy were valid, then the current setting of the federal funds rate would summarize the degree of monetary stimulus being applied to the economy, just as the pressure a driver exerts on the accelerator at any particular moment determines whether the automobile speeds up or slows down. However, in fact, the current level of the federal funds rate is at best a partial indicator of the degree of monetary ease or restraint.

Barry seems to prefer what Ben described as a "simple feedback rule"...

... Under a simple feedback policy, the central bank's policy instrument--the federal funds rate in the United States--is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy's full-employment level of output)...

A classic example of a simple feedback policy is the famous Taylor rule... In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to "lean against the wind"; for example, when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range...

... but the Chairman emphasized that there is another way:

The second general approach to making monetary policy is what I am today calling a forecast-based policy... As the name suggests, under a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term--say, over the next six to eight quarters--to alternative plans for monetary policy....

Taking both their baseline forecast and the various risks to that forecast into account, policymakers then choose the plan that seems most likely to produce the best results overall. Their current choice of interest rate corresponds to the first step in implementing the preferred plan. This process is to be repeated at each meeting, with the policy plan being modified as necessary in response to new information or new knowledge about the economy.

The role of inflation forecasting was a prominent feature of BB's speech yesterday, and it is precisely in a forecast-based policy framework that the rationale for core inflation takes root.  From today's Real Time Economics blog:

The Federal Reserve’s focus on core inflation has renewed attention to alternative measures that aim to separate the underlying inflation trend from month-to-month volatility, and some such measures are suggesting higher prices ahead.

Both the Cleveland Fed and the Dallas Fed produce “trimmed mean” price indexes that generally exclude the most volatile categories in a given month. The presidents of both banks have expressed concern that core inflation may not adequately capture current inflation risks.

Michael Bryan, an economist at the Cleveland Fed, says the bank’s trimmed mean consumer price index does a better job in the short term at predicting future overall inflation than core inflation does. “It’s really reducing the noise and improving the signal,” Bryan said. “There’s almost no signal in the overall month-to-month CPI.”

In his comments yesterday the Chairman made it perfectly clear that the general idea is to get a bead on the inflation trend:

The forecasting procedures used depend importantly on the forecast horizon. For near-term inflation forecasting--say, for the current quarter and the next--the staff relies most heavily on a disaggregated, bottom-up approach that focuses on estimating and forecasting price behavior for the various categories of goods and services that make up the aggregate price index in question. For example, we know from historical experience that the prices of some types of goods and services tend to be quite volatile, including not only (as is well known) the prices of energy and some types of food but also some "core" prices such as airfares, apparel prices, and hotel rates... Conceptually, one might think of this effort to distinguish transitory from persistent price changes as a more nuanced way of estimating the underlying inflation trend, analogous to the trend measures provided by more mechanical indicators such as trimmed-mean or weighted-median inflation rates.

An accurate forecast of very near-term inflation is important not only for its own sake but also because it provides a better "jumping-off point" for the longer-term forecast. Because inflation continues to exhibit some inertia, improved near-term forecasts translate into more-accurate longer-term projections as well.

Barry is not swayed...

... all of the prior chatter about removing volatile food energy prices due to their erratic price behavior was quite simply [bovine excrement]. Based on yesterday's Bernanke speech, we learn that the emphasis on the Core rate of inflation is about influencing psychology and sentiment -- not smoothing out volatile data.

... but I think that Mr. Bernanke's words speak for themselves.

Bad News Bulls

From the Wall Street Journal (page A2 in the print edition):

Economic growth in the U.S. is likely to recover as the year goes on, but that might not be an entirely good thing, according to the latest Wall Street Journal survey of forecasters.

The Journal's seers are feeling rather chipper about the near-term prospects for economic growth... 

Having run a veritable gantlet of threats to its health, the nation's economy is in a better place than it was just a few months ago...

The 60 economists who took part in the survey, conducted in mid-June, offered a mostly upbeat outlook for an economy that has recently sustained declines in both manufacturing and business investment, and that still faces a deepening housing slump.

With consumer spending holding up, a weaker dollar propelling U.S. exports and a pickup in production and investment, they expect real gross domestic product -- a broad measure of economic activity, adjusted for inflation -- to grow at an annualized rate of 2.6% in the second half of this year and 2.9% in 2008. That is down from 3.3% in 2006, but much better than the 0.7% pace of the first quarter of 2007.

... but worry that the Fed might ruin the party:

Forecasters, however, also see a mounting risk: Thanks to longer-term shifts in the U.S. and global economic landscapes, even a little growth could lead to a resurgence of inflation, which would be painful for American consumers and could cause the Federal Reserve to ride the brakes by keeping short-term interest rates higher.

The real-side rationale is pretty straightforward:

With consumer spending holding up, a weaker dollar propelling U.S. exports and a pickup in production and investment, they expect real gross domestic product -- a broad measure of economic activity, adjusted for inflation -- to grow at an annualized rate of 2.6% in the second half of this year and 2.9% in 2008. That is down from 3.3% in 2006, but much better than the 0.7% pace of the first quarter of 2007.

It is probably worth pointing out that the survey was conducted over the period from June 8th through  the 18th, before last week's run of negative news in the housing market.  And looking at the most recent spending data, Calculated Risk -- not a member of the survey panel as far as I know -- is skeptical that consumer spending is "holding up":

You can use the monthly series to exactly calculate the quarterly change in PCE [Personal Consumption Expenditures]. The quarterly change is not calculated as the change from the last month of one quarter to the last month of the next (several people have asked me about this). Instead, you have to average all three months of a quarter, and then take the change from the average of the three months of the preceding quarter...

... in general, the two month estimate is pretty accurate. Maybe June was exceptionally strong, or maybe April and May will be revised upwards, but the two month estimate suggests real PCE growth in Q2 will be about 1.5%.

That seems entirely plausible, but month-to-month and quarter-to-quarter changes in specific categories of spending tend to jump around:

    :

Thus, to CR's initial question on perusing the May PCE numbers...

Is this just a one quarter slowdown? Or is this the beginning of a housing related slump in consumer spending?

... I'd side with those saying not slumpy enough to cause real problems -- at least not so far as we can tell at this point.  No, what the Journal's experts really seem concerned about is the price picture:

An increasing number of economists worry that the battle with inflation isn't over, despite the benign message sent by recent data. As of May, the Fed's preferred measure of inflation -- the "core" index of personal-consumption prices, excluding food and energy -- was up only 1.9% from a year earlier. That compares with 2.4% as recently as February.

It seems to me that The Skeptical Speculator has about the right take on the issue:

The Federal Reserve Bank of Dallas publishes two other measures of inflation based on personal consumption expenditures. The first is the overall personal consumption expenditures price index that is already reported by the Commerce Department. The other is the trimmed-mean price index that excludes components of personal consumption expenditures that have the highest and lowest rates of change.

The latest data provided on the Dallas Fed website show that these other measures of inflation remain above the Federal Reserve's comfort zone. The 12-month inflation rate based on the overall PCE price index was 2.3 percent in May and the inflation rate based on the trimmed-mean measure was 2.2 percent...

Based on this observation the Skeptical One draws this conclusion...

...  with the economy expected to recover from the second quarter onward, further moderation is likely to be limited. In fact, many economists think inflation will re-accelerate as the level of resource utilisation in the economy remains high despite the recent slowdown.

... an opinion that is shared by the WSJ panel:

In the survey, one in five forecasters saw a resurgence of inflation as the greatest risk facing the economy. That is more than twice the proportion who saw it as the No. 1 risk six months ago. As a result, they now see little chance that the Fed will lower its target for short-term interest rates from the current 5.25% by December. They do, however, lean toward a cut to 5% by June 2008. Six months ago, they were betting the Fed would cut rates to 4.75% by December.

December is, of course, a long way away.

Come Again?

There seems to be some slight disagreement about what information the Federal Open Market Committee meant to convey with today's post-meeting statement.  MarketWatch, for example, had no problem covering a lot of territory with its collection of expert opinion:

The statement was "mildly hawkish," said Bill Sullivan, chief economist at JVB Financial. "They don't want investors to get complacent about the inflation outlook even though we've had some good data recently."

The Fed softened its tone about inflation, said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., who cautioned against overanalyzing the statement, "which continues to paint a picture of monetary policy that is likely to be little changed in the months ahead."

Kevin Logan, senior market economist at Dresdner Kleinwort, disagreed. He said the Fed "haven't backed off at all" on its inflation worry.

The "softened tone" interpretation got a little support at The Wall Street Journal's Real Time Economics blog:

ING economist Rob Carnell said the FOMC, in acknowledging improvement in core inflation, took “a slight step in the direction of a neutral bias to policy...

But most of the votes were lining up in the "hawkish" camp: At FX Daily:

This language is more hawkish than the May statement, where the Fed simply said that “economic growth has slowed.”  In terms of inflation, the Fed isn’t convinced that the battle has been won.  Instead, they expect inflation to remain a problem.

... at Bloomberg ...

"The Fed is signaling it wants it proven first that inflation is down and will stay down,'' said Gerald Lucas, senior investment strategist in New York at Deutsche Bank AG, one of the 21 primary U.S. government securities dealers that trade with the Fed. "Inflation and the perception that the Fed will remain on hold is what the market is reacting to''...

"The market is pricing in a higher probability, though it's still very small, that the next Fed move is a tightening,'' said Scot Johnson, who manages $2.1 billion of government bonds in Houston at AIM Capital Management Inc. Inflation is still ``not low enough that everybody's happy.'

... and at Forbes.com...

"The statement suggests that the Fed has a ways to go in containing inflation," [Drew Matus, economist at Lehman Brothers] told Forbes.com. "But they acknowledge progress. The Fed is no closer to raising or cutting rates. They will be on hold for some time, and that is what we should continue to expect."

There were, in fact, warnings about reading too much of anything into the changes in the Committee's language.  Again from The Wall Street Journal:

... Drew Matus notes that the FOMC removed the word “elevated” from its latest description of inflation. The fact that the year-over-year inflation rate is likely to be unchanged from the readings before the May meeting “suggests that the removal of the word had less to do with a change in the FOMC’s view on the inflation outlook and more to do with removing a word that was garnering unwanted attention.”

The net change in the Fed’s position is “trivial” given the view of moderating growth and the risk that inflation won’t moderate, said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

And elsewhwere at the WSJ's Real Time Economics, there is the suggestion that the language is ambiguous because the Committee is feeling -- uh, ambiguous:

With core inflation at 2% in April and perhaps about to go lower, Thursday’s policy statement by the Fed dropped its reference to inflation as “somewhat elevated.” Some analysts saw this as acknowledgement of an inflation target somewhere around 2%.

More likely, the Fed simply punted on the question...

Dropping the reference to “elevated” without replacing it with anything may have been necessary to satisfy those who don’t buy into the 1% to 2% comfort zone without arousing objections from those who do.

If you are feeling puzzled, you can always look forward to July 19 -- and the release of the meeting minutes. 

Would Subtracting Housing Make Inflation All Better?

I really did not need another must-read blog added to my list, but the Wall Street Journal's Real Time Economics feature has left me no choice.  In last Friday's edition, Greg Ip detected some pebbles coming from the direction of glass houses: 

The Federal Reserve has come under fire increasingly for focusing on “core” inflation rather than headline inflation. Excluding food and energy made sense, critics said, when those two were volatile but trendless. In recent years, however, they’ve mostly headed up, and thus core inflation has consistently lagged headline inflation.

This week’s issue of The Economist joins the criticism of core inflation, saying “Bond investors are living in a world where nobody eats or drives.” It notes Bank of England governor Mervyn King earlier this month said “measures of ‘core inflation’ that strip out certain prices can be highly misleading.” The bank’s chief economist Charles Bean leveled the same criticism last year in the heart of Fed territory, the annual symposium at Jackson Hole...

Yet when the Fed hears these criticisms from the British, it may wonder if the pot is calling the kettle black. The Bank of England targets a price index that excludes almost all housing costs, notably mortgage payments. And in the U.K. overall inflation, at 4.3% in May, is notably higher than the 2.5% inflation rate as measured by the index targeted by the Bank of England. The European Central Bank also excludes owner-occupied housing from the price index it targets, though that represents more than 10% of total consumption. Given housing’s sizable contribution to U.S. inflation last year, the Fed might have preferred the British target.

Or maybe not.  Though the inflation rate measured by the CPI less its shelter component might have provided some comfort, the overall story remains pretty much the same:

   

   

I personally prefer to look at inflation over the "medium-term," say three to five years.  Any help there?  Nope.

   

 

   

What if that picture had turned out better?  You might have said "so what", and I would have been with you.  As far as I can tell -- and as I have said here many times before -- the predominant view among those of us who spend a lot of our lives thinking about such things is that core measures are useful insofar as they help us get a clearer real-time picture of where the overall inflation trend is headed.  The Economist's jibe that "Bond investors are living in a world where nobody eats or drives" willfully ignores the real reason that core inflation is discussed in the first place. 

Putting The Money Back In Monetary Policy?

The Wall Street Journal's Joellen Perry reports (page A8 in the print edition) on the latest debate within the European Central Bank:

With euro-zone interest rates near a six-year high, European Central Bank policy makers are clashing over the role of the swollen supply of money in pushing up prices.

That rare break in the bank's public facade of unity suggests policy makers are divided about how high to push interest rates in the 13-nation currency bloc, and it could rekindle a global debate on the merits of monitoring money supply...

Years of low interest rates have fueled a global liquidity glut that has inflation-wary central bankers world-wide paying attention to money-supply data. The ECB, as the only major central bank to give money-supply growth an official role in its decision-making, has led the charge. But other policy makers, including at the Bank of England and Sweden's Riksbank, have also cited strong money-supply growth as a reason for recent interest-rate rises.

Actually, Claus Vistesen was thinking about this last week, while I was in Frankfurt attending a joint conference on Monetary Strategy: Old issues and new challenges, jointly sponsored by the Deutsche Bundesbank and the Federal Reserve Bank of Cleveland.  The question of whether or not central bankers ought pay attention to money, and talk about it when they do, did come up. Gunter Beck and Volcker Wieland, both from the Goethe University Frankfurt (and the latter formerly of the Federal Reserve Board), offered up a theoretical argument for why the money-guys in the ECB might be on to something:

... we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output.

... We assume that the central bank checks regularly whether a filtered money growth series adjusted for output and velocity trends averages around the inflation target. If the central bank obtains successive signals of a sustained deviation of inflation from target it adjusts interest rates accordingly.

Our simulations indicate that persistent policy misperceptions regarding potential output induce a policy bias that translates into persistent deviations of inflation and money growth from target. In this case, our “two-pillar” policy rule may effectively overturn the policy bias. Cross-checking relies on filtered series of actual money and output growth without requiring estimates of potential output. Indirectly, however, it helps the central bank to learn the proper level of interest rates.

Some of the conference participants noted that there are lots of alternative (and established) statistical techniques for forecasting in the face of uncertainties about concepts such as potential output and the equilibrium real interest rate, but another of the conference papers -- from the Bundesbank's Martin Scharnagl and Christian Schumacher -- suggested that Beck and Wieland may just be on to something when they say the ECB money-guys may just be on to something:

This paper addresses the relative importance of monetary indicators for forecasting inflation in the euro area. The analysis is carried out in a Bayesian framework that explicitly considers model uncertainty with potentially many explanatory variables...

The empirical results show that money is an integral part of the forecasting model... The key finding of the paper is is that the majority of models include both monetary and non-monetary indicators.

To paraphrase, when it comes to short-run forecasts, the kitchen sink works best.  But the result that got my attention was Scharnagl and Schumacher's finding that, in their experiments, the trend in the money supply is the only factor that appears useful in forecasting inflation once you get out beyond about 6 quarters.

That may surprise you, but it probably shouldn't.  The Scharnagl and Schumacher study is on the technical side, but some years ago economists George McCandless and Warren Weber offered up some evidence which was pretty easy to grasp:

   

   

That's a graph of the relationship between average money growth (measured by M2) and average inflation for a large cross-section of countries, over the period from 1960 through 1990.  If you are an old hand on this topic, you probably remember that it was around 1990 that both the ECB and the Federal Reserve lost confidence in the money measures they were tracking.  The ECB responded by moving from a narrow measure of money to the very broad M3 concept.  The Federal Reserve responded by more-or-less abandoning monetary measures all together.

OK, let's take a look at the McCandless and Weber picture post-1990:

   

   

Hmm.  The Wall Street Journal article correctly notes that there is still a great deal of skepticism about the usefulness of monetary measures in formulating monetary policy:

The U.S. Federal Reserve is among the doubters. Fed Chairman Ben Bernanke said in November that a "heavy reliance" on money-supply data as a predictor of U.S. inflation was "unwise."

I don't think either the Beck-Wieland or Scharnagl-Schumacher work contradicts that skepticism about "heavy reliance." But maybe money deserves just a little more love on this side of the Atlantic than it currently gets?

Like Ben Said

Calculated Risk makes an interesting observation:

The trade deficit, ex-petroleum, appears to have peaked at about the same time as Mortgage Equity Withdrawal in the U.S.

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account."
Alan Greenspan, Feb, 2005

... Declining MEW is one of the reasons I forecast the trade deficit to decline in '07. And a declining trade deficit also has possible implications for U.S. interest rates; as the trade deficit declines, rates may rise in the U.S. because foreign CBs will have less to invest in the U.S.. This is why I forecast rates to rise in '07.

I think that CR has the causation running from the housing market to the trade deficit, but as always there is another interpretation.  I take you back to one of my favorite Fed speeches of all time, from the current Fed chairman:

What then accounts for the rapid increase in the U.S. current account deficit? My own preferred explanation focuses on what I see as the emergence of a global saving glut in the past eight to ten years...

The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment...

After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. The textbook analysis suggests that, with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving. Indeed, real interest rates have been relatively low in recent years, not only in the United States but also abroad. From a narrow U.S. perspective, these low long-term rates are puzzling; from a global perspective, they may be less so.

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low--and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower...

The direct implication, of course, was that the reversal of U.S. current account deficits would likely be associated with higher real interest rates, a weakening of foreign-capital financed investment, and higher saving in the U.S. (of which a slowdown in mortgage equity withdrawals could be a part). It is worht noting that Chairman Bernanke was decidedly less than sanguine about the consequences of such adjustments:

... in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

Whether or not Mr. Bernanke believes that we find ourselves in the process of meeting those burdens I cannot say.  But those who buy the global saving glut story -- as I do -- have acknowledged all along that the day of adjustment would look pretty much like it does at the moment.

Why Not Just Ask?

I'm home at last from the Conference on Price Measurement for Monetary Policy that has absorbed my attention over the past couple of days, but I have one more post on the topic left in me, not least because the topic of the last several papers -- the measurement of inflation expectations gleaned from survey data -- is one in which I have a particular interest.  As far as I know, the review of the ECB Survey Professional Forecasters (SPF) (by authors from the European Central Bank too numerous to mention here) is the first large-scale overview of its kind, and thorough it is.  Among the copious information is this, which I found particularly interesting:

... average long-term expected inflation has remained quite stable since the beginning of the survey. On average, it stood at 1.88% with a standard deviation of ±0.04 percentage point. The average long-term inflation expectation was 1.9% at the start of Stage III of EMU in 1999. It declined to 1.8% in 2000 and then shifted upwards to stand at 1.9% again at the end of 2002. Since then, it has remained broadly stable at below, but close to, 2%, confirming the stability of SPF long-term inflation expectations.

The picture, proving the point:

Contrast this with a fascinating observation from the National Bank of Belgium's Luc Aucremanne, Marianne Collin and Thomas Stragier, contrasting actual inflation with perceived inflation based on surveys of consumers:

While there is clearly no doubt about the accuracy of official inflation measures in the euro area during the recent period, there is plenty of anecdotic evidence that since 2002 consumers have tended to perceive that inflation is high, while in reality it was relatively low, albeit slightly above the quantified definition of price stability for the euro area. Apparently a perception gap has grown in the euro area since the euro cash changeover in January 2002.

The pictures are striking:

The kicker is that no such divergence in perceptions occurred in comparable European countries that did not adopt the euro:

I'm not sure what to make of that, other than that there is an awful lot we don't know about what consumers are telling us when they answer these survey questions -- an observation that is confirmed in a review of survey responses from the Czech Republic, Hungary, Poland, and Slovakia by Ryszard Kokoszczynski, Tomasz Lyziak, and Ewa Stanislawska (of the National Bank of Poland). 

Until we more clearly understand household responses to the questions we ask, it appears that surveys of professional forecasters represent the best available source for obtaining direct information about inflation expectations.  There is growing literature on how to get the most out of these surveys, and I'll close with a word of praise for the paper "What Can Four Decades of Probabilistic Inflation Forecasts Tell Us About Inflation Risks?" by the ECB's Juan Angel Garcia and Andres Manzanares.  As the title of the paper makes clear, the idea is to characterize, for example, whether survey respondents see the balance of inflation risks as weighted to the upside or downside.  The literature to which the Garcia-Manzanares paper belongs tends to the technical, but it is well worth a look if you have a stake in knowing which way the forecaster winds are blowing.

Not Quite Live From Dallas -- Inflation Expectations Day

Day 2 of the Cleveland/Dallas Fed Conference on Price Measurement for Monetary Policy, and the topic on the table is measuring inflation expectations.  Regular readers of macroblog know that I have particular affection for expectations derived from inflation-indexed Treasury securities, especially those adjusted for liquidity premia reported by the Cleveland Fed.  In the Cleveland series the adjustments are, by design, quick and dirty. If, however, you have been hoping for a more sophisticated approach, now you have it for the U.S. courtesy of Stefania D'Amico (and co-authors from the Federal Reserve Board of Governors) and for the euro area thanks to Peter Hohrdahl (Bank of International Settlements) and Oreste Tristani (European Central Bank). 

The methodologies of these two papers differ somewhat -- for the aficionados among you, D'Amico et al use a latent factor approach, while Hohrdahl and Tristani employ a more structural strategy -- but the conclusions are essentially the same: For both the U.S. and the euro area, extracting inflation expectations by comparing yields on inflation-indexed securities with those on non-indexed securities requires some sort of adjustment for liquidity or risk premia.  The picture that tells the story for the euro area (based on French inflation-indexed bonds specifically):

      

The thing to focus on in that picture is the solid thin line, which represents expectations estimated without including adjustments for liquidity/risk premia, and the dark solid line, which represents the premia-adjusted expectations calculations.  (The dashed lines delimit the statistical confidence intervals about the expectation estimate, and the dotted line represents consensus survey expectations.)  The unadjusted series suggests that inflation expectations in the euro area have fluctuated considerably since 1999, and are at historically high levels today.  The adjusted series tells quite a different story: Correcting for risk premia -- Hohrdahl and Tristani prefer the designation "risk premia" to "liquidity premia -- generates estimates of expected inflation that have been remarkably stable since the inception of the eurosystem.

The D'Amico et al analysis suggests a similar conclusion for the U.S. though, as with the simpler Cleveland Fed procedure, it appears that liquidity premia have all but vanished in the last several years:

 

The balance of the day moved from the extraction of expectations from market asset prices to discussions of expectations derived directly from surveys.  More on that to come.

Almost Live From Dallas

Today and tomorrow finds me in the fine state of Texas, at a conference on "Price Measurement for Monetary Policy," co-sponsored by the Federal Reserve Banks of Cleveland and Dallas.  First up was a paper by Diana Weymark and Mototsugau Shintani from Vanderbilt University, titled "Measuring Inflation Pressure and Monetary Policy Response: A General Approach Applied to US Data 1966-2001." The idea is take a particular model of the economy and monetary policy, and ask the following sort of questions: How responsible was the central bank in determining inflationary outcomes, where the central banks influence covers both active policy (or interest rate) choices, as well as the evolution of inflationary expectations.

The experiment is a tricky one, and several people commented on whether the precise nature of the measures used to answer this question exactly captured what the authors had hoped.  But the results are certainly  provocative:

One of the most striking aspects of [our results] is the similarity of the Fed’s policy response over the 35 year period under study. The [policy stabilization] index measures the proportion of inflationary (or deflationary) pressure removed by monetary policy. The average [index] values show that under all five chairmen, the Fed countered positive inflationary pressures and magnified deflationary pressures...

Volcker and Greenspan are now generally credited with having taken a tough stand against inflation. However, our... indices show that monetary policy under Martin and Burns was also effective in counteracting inflation pressure... monetary policy under Miller was much less effective in combating inflation than under the previous two Chairmen. However, according to [our results], inflation pressure during Miller’s tenure as Fed Chairman was 3 times higher than it had been during the previous eight years... that Miller did try to use periods of deflationary pressure to bring about significant reductions in inflation. However, these efforts were not very successful because... the deflationary episodes were considerably weaker than the inflationary pressures that developed during this period...

... the Fed’s lack of success under Miller may in part be attributable to an inability to convince economic agents of the Fed’s commitment to price stability.

I'm not sure that result would be robust to other approaches to measuring Fed effectiveness -- and certainly the management of inflation expectations can be mainly placed upon the doorstep of the central bank -- but, heck, might as well let the rehabilitation of G. William Miller's reputation get its due.

UPDATE, Paper 2: Wherein Lafyette College's Julie Smith asks the question "Better Measures of Core Inflation?" "Better" here means a more accurate forecast of CPI inflation one or two years out than you can get with the median or trimmed-mean CPI.  The answer the author gives is "yes", and the key (for you stat geeks) is to (a) individually estimate models for the individual component prices of the CPI market basket, but (b) estimate your statistical models for the components jointly. If you are interested in such forecasting issues, the paper is worth a look.

Paper 2, Update 2: Asked from the floor: If what we are interested in is a good forecast of future inflation, why not use a full forecast model, based on all kinds of data, rather than a core inflation measure?  And if forecasting is not what we are nterested in, what's the point of core inflation in the first place?  Good question that.

Update, Paper 3: One answer to that last question is provided in the paper "Policy-Sensible Benchmark Core-Inflation Measures for the Euro Area and the U.S.", by Stefano Siviero and Giovanni Veronese from the Bank of Italy.  The essence of the argument is that we are not primarily interested in doing forecasting well, but in doing policy well.  A central bank should focus on core inflation if doing so helps them better achieve its ojectives (typically taken to be some combination of low headline inflation, maintaining GDP growth near its potential, and relatively smooth interest rates).  Although the results are tentative, Siviero and Veronese shout out a warning to fans of the usual core inflation suspects:

Our findings suggest one cannot recommend that the most popular core inflation measures be used to support monetary policy-making. Specifically, we find that it is arguably inappropriate to remove all erratic components from headline inflation: by reacting to core inflation measures that do so, monetary policy effectiveness may be seriously impaired, even if one's reaction is designed in such a way so as to be optimal on the basis of standard welfare criterion.

The message here is one that ought to be communicated more clearly by monetary policymakers: It can be quite appropriate for a central bank to focus on some measure of core inflation, not because it is something the central bank thinks you should care about but because it helps to control the thing you do care about -- in this case, overall or "headline" inflation.   

UPDATE, Paper 4: Next up -- Core Inflation as Idiosyncratic Persistence: A Wavelet Approach to Measuring Core Inflation , by Richard Anderson,* Federal Reserve Bank of St. Louis; Fredrik Andersson, Lund University; Jane Binner, Aston University; Thomas Elger, Lund University.  Here we find another shot at motivating core inflation as something a central bank uses to better control overall inflation, and control it in a way that generates the best outcomes for its customers -- i.e., you and me.  The actual game in this paper is, nonetheless, straighforwardly statistical.  The idea is essentially the following familiar idea: Every individual price in the economy is a combination of an underlying trend and temporary ups and downs, and the statistical problem is to separate the two. 

The application of the idea, however, is not so simple, or familiar.  Unless you are conversant in things like wavelets, neo-Edgeworthian index numbers, and stuff like that -- or are interested in finding out about them -- you are likely to find the paper a bit of a slog.  However, the authors do offer up what is becoming a theme at this conference:  Whatever a core inflation measure ought to be, something like the CPI ex food and energy is not likely to be it.

Update, Paper 5: Looking for horse race?  Rob Rich and Charlie Steindel are your boys.  Here's what they do, in "A Comparison of Measures of Core Inflation"...

This paper examines several proposed measures of U.S. core inflation: an ex food and energy series, an ex energy series, a weighted median series, and an exponentially smoothed series. We evaluate the performance of the candidate series using criteria such as ease of design, accuracy in tracking trend inflation, as well as explanatory content for within-sample and out-of-sample movements in aggregate inflation. The empirical analysis principally focuses on the methodologically consistent Consumer Price Index (CPI) which is only available starting in 1978. As a check for robustness, we also provide a summary for Personal Consumption Expenditure (PCE) inflation starting in 1959.

... and here is what they find:

... we find no compelling evidence to focus on a particular measure of core inflation, including the series that excludes food and energy prices. We view the results as consistent with the diversity of findings reported in previous studies, and suggest they are a consequence of the design of the individual core inflation measures and their inability to account for the variability in the nature and sources of transitory price movements.

In other words, if what core is all about is disentangling longer-run trends in price movements from temporary ups and downs -- the idea of the Anderson et al paper in the previous update -- none of the stanard simple measures of core are uniquely (or consistently) qualified for the task.

UPDATE, papers 6 and 7:

The Rich and Steindel paper in the previous update did not include trimmed-mean measures of core as part of the analysis.  If your core-inflation jones is aching as a consequence, Andrea Brischetto and Tony Richards (Reserve Bank of Australia) and Mike Bryan (Federal Reserve Bank of Cleveland) will ease your pain in "The Performance of Trimmed Mean Measures of Underlying Inflation" and "Monitoring Inflation in a Low Inflation Environment," respectively.  (In case you have forgotten, an x-% trim just means lopping of the x-% most extreme prices within a distribution of prices, whatever they may be.) Brischetto and Richards look at various trims (corresponding to different percentages of the price-distribution which are excluded) for the Australia, the Euro area, Japan, and the U.S.  They find:

Based on data for four economies, we find that trimmed means tend to outperform headline and exclusion-based core measures on a range of different criteria, which indicate that trimmed mean measures can be thought of as having a higher signal-to-noise ratio than either of the other measures. This makes trimmed means more useful for extracting information about the current trend in underlying inflation from the relatively noisy monthly or quarterly CPI data.

This does not seem entirely consistent with the Rich and Steindel analysis, but Mike Bryan stressed that, first, trimmed-mean estimators represent a technique for reomoving high frequency -- that is, very short-term -- noise in the inflation process.  Looking for improved forecast performance over a longer horizon is not likely to be productive.

Second, Mike stressed that it is precisely in low inflation environments that trimmed-mean core measures really shine.  Here's what I found really interesting: If you apply statistical tests to find when the inflation trend changed in the United States, you will find there was a change September 1981 -- when the average inflation rate fell from 9.4 percent per year to 4.1% per year -- and January 1991 -- when the trend fell from 4.1 percent to 2.7 percent.  Now consider ask the question"if you were watching a measure in core inflation in real time, when would you have picked up theses changes in trend?"  It turns out, the choice of core or headline, this core or that core, wouldn't have mattered much when the change was big, as in 1981:

   

   

When the change was small, however -- as in 1991 -- you could pick the shift up fairly quickly with core measures -- trimmed measures in particular -- and not for nearly six years with the headline number:   

 

Steve Cechetti (Brandeis University) reacted to all of this, and closed things with this observation: A core inflation measure should be smooth, track the trend in inflation, and give you information about breaks in trend relatively quickly.  Core inflation measures should not be the target for monetary policy, or (necessarily) be the best possible forecast for inflation.

An interesting end to an interesting day.   

Pondering The FOMC

The experts seem to be of mixed minds about the real meaning of yesterday's FOMC statement. Most commentators seem to think that we are in for constant funds-rate sailing as far as the eye can see. From the Wall Street Journal Online...

... The bottom line is steady as she goes. It's beginning to feel as if the Fed is never going to change policy in either direction, and the group of economists who are calling for an easing by August are beginning to run short of time. --Stephen Stanley, RBS Greenwich Capital

... This statement is very much in-line with our outlook of a Fed on the sidelines until year-end, as it continues to monitor the evolution of U.S. economic growth and inflation. --Scott Anderson, Wells Fargo Economics

... If the economy continues to grow as the FOMC expects -- slow but not dangerously low growth -- and inflation moderates as they anticipate, then the current stance of monetary policy is likely to still be in place at year-end. --Steven A. Wood, Insight Economics

The same sentiment surfaces at FXStreet.com...

Bottom line is that FOMC’s baseline scenario remains unchanged. The committee still views moderate growth and gradually ebbing inflation as the most likely medium-to-long term outcome. This suggests that FOMC’s current wait-and-see attitude is likely to remain unchallenged for yet some time.

... and from John Berry at Bloomberg:

Unless there's a definitive shift in economic data before Federal Reserve officials meet next month, they might just as well issue the same statement they put out yesterday when they left the interest rate at 5.25 percent...

For officials to begin thinking seriously about reducing the lending rate target, as more than a few analysts are projecting for later this year, there would have to be both a distinct softening of the labor market and some evidence that inflation indeed is moderating.

Others, however, sense a rate cut on the horizon.  Back to the Wall Street Journal...

Bottom line: Until the unemployment rate starts to move or payrolls tank, they're on hold. August, the first ease. --Ian Shepherdson, High Frequency Economics

... and from The New York Times:

“If it were us, we would adopt a more balanced stance,” said Jan Hatzius, chief economist at Goldman Sachs, who has predicted that slow growth will force the Fed to reduce the overnight Fed funds rate to 4.5 percent from 5.25 percent by the end of this year.

But Mr. Hatzius said he had not expected the Fed to give up its precautionary tilt against inflation just yet. “The argument from their side is that they gave themselves a lot of flexibility at the last meeting,” Mr. Hatzius said.

But wait -- yet others are placing their bets on a future of rate hikes.  From the Journal once again:

... the Fed has no rate cut cards hidden up its sleeve. Instead, in order to play catch-up with inflation and prop up the sagging greenback, the Fed will be forced to deal a series of rate hikes. --Peter Schiff, Euro Pacific Capital

... Our forecast is that core inflation will gradually rise and end the year at 2.5% on core PCE price inflation and we think that eventually the Fed will have to adjust rates modestly higher. We see the funds rate at 5.5% by year-end and 5.75% by the middle of 2008. --Bear Stearns U.S. Economics

The Financial Times suggests the Committee itself is of many minds:

... it is not entirely clear how the Fed would respond to moderately softer data. Some committee members, who appear anxious to drive inflation down towards 1.5 per cent in the none-too-distant future, might welcome the added disinflationary impetus.

Others, who could apparently live with inflation a fraction below 2 per cent for at least a lengthy period of time, might prefer to respond to further soft data by taking the opportunity to cut rates to restore growth to trend more quickly.

Well, I guess that settles it.

Long-Term Capital Management And The Fed

My colleague Joe Haubrich writes about "Some Lessons on the Rescue of Long-Term Capital Management":

... the LTCM episode raises many key issues about the resolution of financial crises: How far should the involvement of the central bank extend, what is the scope of action each of the various players should be responsible for, and what are the costs and benefits of the differing options? ...

Joe starts with two distinct views of the event and the Federal Reserve's involvement.  First, from Myron Scholes:

Although the Federal Reserve Bank (FRB) facilitated the takeover, it did not bail out LTCM. Many debtor entities found it in their self-interest not to post the collateral that was owed to LTCM, and other creditor entities claimed to be ahead of others to secure earlier payoffs. Without the FRB acting quickly to mitigate these holdup activities, LTCM would have had to file for bankruptcy—for some, a more efficient outcome, but a far more costly outcome for society. If there was a bailout, it failed: LTCM has been effectively liquidated.

On the other side of the fence is Kevin Dowd:

The Fed’s intervention was misguided and unnecessary because LTCM would not have failed anyway, and the Fed’s concerns about the effects of LTCM’s failure on financial markets were exaggerated. In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained.

After more discussion of arguments pro and con, Dr. Haubrich concludes with his own take on the lessons learned:

Lesson 1: Context matters. Large losses at a financial firm do not by themselves create a need for Federal Reserve action: there must be a systemic component...

... Federal Reserve Board Chairman Alan Greenspan explained:

The scale and scope of LTCM's operations, which encompassed many markets, maturities, and currencies and often relied on instruments that were thinly traded and had prices that were not continuously quoted, made it exceptionally difficult to predict the broader ramifications of attempting to close out its positions precipitately.

In that passage, Mr. Greenspan continued:

It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liqudiation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the FRBNY's judgment that it was to the advantage of all parties--including the creditors and other market participants--to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults.

Joe goes on:

Lesson 2: Details matter.

That the problem was resolved successfully depended, in a large part, on “the orderly continuation in the risk arbitrage business of the newly recapitalized LTCM” (Bank for International Settlements, 1999, p. 9) which in turn depended on getting the details of the recapitalization right. In the LTCM case it meant retaining the management, giving enough stake in the firm to provide an incentive for efficient liquidation, and bringing in outside oversight.

Even after taking the intermediate step of “providing good offices,” the amount and type of moral suasion had to be decided on. Each choice in turn faced trade-offs...

Which brings us to:

Lesson 3: Look for the minimum effective intervention; or work with the market not against it.

... there is some evidence that even more reliance could have been placed on the market in the LTCM case. Stock prices and federal funds rates incorporated substantially correct information about exposures to LTCM. Fed intervention, despite its limited character, may have indeed increased moral hazard by increasing the perception of too-big-to-fail.

Oops.

Mervyn King Reflects

The Financial Times records some thoughts from Bank of England Governor Mervyn King, reflecting on the Bank's performance over the past ten years:

He regards one of the Bank’s biggest achievements over the past 10 years as grasping early on the scale and significance of migrant labour from eastern Europe after the enlargement of the European Union in 2002.

“It’s our equivalent of [former US Federal Reserve chairman] Alan Greenspan [realising] the faster growth of output in the late 1990s was the result of faster productivity growth.”

He continued: “That was an absolutely correct judgment at the time and that’s what we have to do with every variable that we look at, work out why it’s growing faster or slower than it was before and not to use some rather mindless regression.”

What were those insights of which King is so proud?  From the Telegraph:

Immigration from eastern Europe has helped keep inflation - and therefore interest rates - low, the Governor of the Bank of England Mervyn King said last night.

Speaking to business leaders at a dinner outside Bradford, Mr King praised globalisation as a way of increasing productivity and transferring new ideas, goods and services across borders.

In particular, he said immigration had reduced wage inflation in Britain: "If the increased demand for labour generates its own supply in the form of migrant labour then the link between demand and prices is broken, or at least altered. Indeed, in an economy that can call on unlimited supplies of migrant labour, the concept of the output gap is meaningless."

The output gap is a measure used by economists to see how much spare capacity is left in an economy.

"Increasing productivity and transferring new ideas" is certainly equivalent to the Greenspan insight.  But on the output gap bit, a better comparison is to Federal Reserve Bank of Dallas President Richard Fisher:

One key capacity factor is the labor pool. There is a shibboleth known as the Phillips curve, which posits that beyond a certain point too much employment ignites demand for greater pay, with eventual inflationary consequences for the entire economy...

How can economists quantify with such precision what the U.S. can produce with existing labor and capital when we don’t know the full extent of the global labor pool we can access? Or the totality of the financial and intellectual capital that can be drawn on to produce what we produce?

As long as we are able to hold back the devil of protectionism and keep open international capital markets and remain an open economy, how can we calculate an “output gap” without knowing the present capacity of, say, the Chinese and Indian economies? How can we fashion a Phillips curve without imputing the behavioral patterns of foreign labor pools? How can we formulate a regression analysis to capture what competition from all these new sources does to incentivize American management?

Until we are able to do so, we can only surmise what globalization does to the gearing of the U.S. economy, and we must continue driving monetary policy by qualitative assessment as we work to perfect our quantitative tool kit. At least that is my view.

And, apparently, Governor King's view as well.  Back to the FT:

“The secret of good policy is to try and think through what are the economics of the shocks hitting the economy at present,” he says. “That in a nutshell is my philosophy of how you should do policy. Don’t rely on regressions from the past.”

OK, but I'm not sure I would recommend entirely forgetting those recessions from the past either, lest we find ourselves repeating their lessons. 

Does Globalization Make Monetary Policy Harder?

According to the Financial Times, the answer is "maybe", but the message is a bit tricky.  On the one hand:

... Take the renewed worries about how energy costs might contribute to broader price pressures...

Such cost contagion is, of course, not enough to cause inflation expectations to rise. Rather, it broadly shows markets doing their job in reacting to changes in relative prices. Higher oil prices encourage the use of substitutes. They also shift demand to goods and services less affected by the shock. As long as monetary policy remains steady, the end-result would still be painful but not inflationary.

That is right on target, but:

... According to conventional wisdom, globalisation has been one of the chief reasons why the loose monetary policy of the past decade has not translated into swifter consumer price inflation. Cheap imports from India and China were said to have eroded the pricing power of, say, US companies at home.

That view always raised a few questions, such as how long any such damping effect might last. Intriguingly enough, rising oil prices may already have caused it to wane.

Since the "cheap import" phenomenon is just another variant of "changes in relative prices", the article's first observation is perfectly apt: "As long as monetary policy remains steady, the end-result would still be painful but not inflationary."  But the author of the article apparently has something a little more complicated in mind:

Recent research by two economists, Paul Bergin and Reuven Glick, suggests prices of a wide range of goods did indeed converge globally – until about 1997. Since then, prices have drifted apart again, perhaps owing to rising transport costs.

Here, more specifically, is what Bergin and Glick uncover:

This paper documents significant time-variation in the degree of global price convergence over the last two decades. In particular, there appears to be a general U-shaped pattern with price dispersion first falling and then rising in recent years, a pattern which is remarkably robust across country groupings and commodity groups... However, regression analysis indicates that this time-varying pattern coincides well with oil price fluctuations, which are clearly time-varying and have risen substantially since the late 1990s. As a result, this paper offers new evidence on the role of transportation costs in driving international price dispersion.

The implication seems to be that globalization -- increasingly open trade, more precisely -- has introduced patterns in observed prices that make it more difficult to disentangle relative price changes from trend inflation.  There does not yet appear to be much evidence of such a problem appearing in the behavior of long-term inflation expectations:

   

   

Nonetheless, it is worth thinking about the FT's suggestion that the types of influences identified by Bergin and Glick "could make monetary policy a lot trickier going forward."      

Is The Fed Losing Ground On The Expectations Front? Take 2

This installment comes courtesy of former Federal Reserve Governor Lawrence Meyer's Macroeconomic Advisors, in MA's most recent inflation newsletter (subscription required for all that follows):

Breakeven inflation rates have moved up sharply this year, particularly at shorter maturities. The two-year BEI rate, for example, has risen about 100 basis points on net since its trough in November. A sizable portion of that increase is attributable to higher expected energy prices. However, that is not the whole story, as our ex-energy measure of the two-year BEI rate has increased about 50 basis points over that interval.

A bit of background.  Breakeven inflation rates are variants of the adjusted TIPS-derived inflation expectations calculated by the Cleveland Fed (discussed yesterday).  Explains MA:

Breakeven inflation rates provide a signal about the market’s outlook for inflation and its concerns about inflation risk. Specifically, the BEI rate at a certain maturity is equal to the expected CPI inflation rate over that horizon plus an inflation risk premium (the expected excess return that investors demand for holding the nominal security).

And:

Breakeven inflation rates can be substantially affected by actual and expected movements in energy prices, reflecting the fact that TIPS are indexed to headline CPI. These effects are particularly pronounced at shorter maturities. In this commentary, we use oil futures prices to estimate the contribution of energy prices to breakeven inflation rates. By adjusting for this contribution, we can compute measures of ex-energy breakeven inflation rates. These measures allow for a better interpretation of the market’s perceptions of inflation pressures and for a better assessment of whether TIPS valuations are appropriate.

Returning to the latest analysis, then:

This [year's] increase in ex-energy BEI has presumably been driven by a string of unfavorable inflation news, including several months of elevated readings on core CPI inflation, evidence that the labor market has remained taut, a new surge in energy prices that raises the prospect of renewed pass-through effects to core inflation, and another blip in non-petroleum import price inflation.

These are certainly all good reasons for the two-year BEI rate to move higher on an ex-energy basis. But what is unusual about this episode is that this increase has not shown through to forward BEI rates beginning two years ahead.

... In contrast to the sharp run-up in the ex-energy measure of two-year BEI rate, the two-year three-year forward BEI rate is basically unchanged over this interval.

In fact, this measure is currently lingering around the lowest

level seen over the past several years. Thus, whatever the markets view as the source of inflationary pressure in the near term, they do not expect it to continue at longer horizons. That is, recent inflation developments have been seen as unfavorable, but transitory.

Is The Fed Losing Ground On The Expectations Front?

UPDATE II:  Oh, Lord. The daily picture was right to begin with -- or I managed to sneak in another mistake.  Anyway, I swear its right now.  Thanks to jfund (in the comment section) and Bethany (my favorite RA named Bethany ever.)

UPDATE: My colleague Chuck Carlstrom caught a mistake in the original post -- I had mislabeled the  series in the chart based on daily TIPS yields.  All fixed now.

Bloomberg's Daniel Kruger thinks so (hat tip to Ken Sutton, Chicago XP77er and Senior Partner, Quantimetric Systems LLC):

Rising oil prices, Mideast conflicts and a U.S. president perceived as ineffective contributed to the stagflation of the 1970s. Today, in the bond market, where Yogi Berra's immortal lines are increasingly invoked, "it's deja vu all over again.''

Nowhere is that more evident than with Treasury inflation- protected securities. The difference in yields between 10-year TIPS and conventional notes has widened to about 2.5 percentage points, a seven-month high, and up from 1.43 percentage points in 2002...

Investor confidence in the Federal Reserve's ability to restrain inflation, as measured by TIPS, peaked in October 1998, when the difference between the inflation-linked notes and 10- year Treasuries narrowed to a record low 0.647 percentage point.

I've discussed potential problems with the standard TIPs-based measure of inflation expectations before, but I guess this would be an ideal time to revisit that argument.  From the Cleveland Fed:   

In theory, the yields on two different kinds of Treasury securities—nominal treasury notes and treasury inflation-protected securities (TIPS)—can be used to calculate a market-based estimate of expected inflation. Nominal treasury notes earn a fixed nominal rate of interest on a fixed amount of principal, whereas the principal of TIPS is adjusted for inflation (and thus so are the coupon payments). Because the return on nominal treasuries is vulnerable to inflation, it most assuredly contains compensation to investors for any losses they expect to incur from inflation if they hold the bond. TIPS therefore protect the bondholder from losses due to inflation, but nominal treasuries do not. Whereas nominal treasury notes earn a fixed nominal rate of interest, TIPS earn a fixed real rate of interest. In principle, one ought to be able to simply subtract the real yield on TIPS from the nominal yield of treasury notes of the same maturity to derive expected inflation...

There are actually 2 different factors that cause TIPS to be a biased predictor of expected inflation: an inflation-risk premium and a liquidity premium. To make matters more difficult, these biases likely go in different directions. We attempt to correct for both of these biases.

If you are interested in how those corrections are made you can follow the link above.  If you are in a trust-without-verify mood, here is the history of TIPS-derived inflation expectations, with and without adjustments for inflation risk and liquidity premia: 

   

   

The jump in inflation expectations commencing in mid-2003 only shows up in the unadjusted calculations: If you believe the Cleveland bias adjustments, expectations have been