Inflation Under a Microscope

Check out this nifty interactive graphic from the Times decomposing the year's increase in the Consumer Price Index into its component parts. It vaguely reminds me of something one might see in a under a microscope in science class, or maybe a stained-glass window...

In Defense of Bernanke

Macroeconomists often act as Monday-morning quarterbacks of monetary policy, and Ben Bernanke has gotten plenty of criticism, some of it rather harsh. Taking a more favorable view, in Barron's, Randall Forsyth defends Bernanke's handling of the credit crisis:

Importantly, these innovations [the TSLF and PDCF*] obviate the need for the Fed, in the widely cited words of a speech by Bernanke in 2003, to drop dollars from helicopters to stave off a deflationary crisis. The present Fed chairman gets credit (and blame) for that turn of phrase, but it originated with Nobel Laureate Milton Friedman.

Indeed, much of Bernanke's academic work built on the insights of Friedman and his collaborator, Anna J. Schwartz, who pinned the blame of the Great Depression on the Fed for permitting the money supply to contract by one-third. Bernanke's work focused on how that happened; the answer was basically a breakdown in the financial system.

Using that insight, Bernanke has fashioned these new instruments to make sure the 21st century financial system does not break down as the one of the 1930s did. Until now, the instruments were extremely blunt -- as in driving short-term rates down to 1% under his predecessor, Alan Greenspan, and holding them at preternaturally low levels even after the economy and the financial system recovered from the tech-telecom bust.

In essence, Ben Bernanke has come up with an alternative to the monetary printing press to deal with the greatest credit bubble and bust in history...

Hat tip to The Big Picture.
*The Primary Dealer Credit Facility (opening discount window lending to investment banks) and Term Securities Lending Facility (loans of Treasury securities collateralized by mortgage backed securities; see this earlier post). Also, Real Time Economics has a brief guide to the "alphabet soup."

Update (5/4): Paul Krugman writes:

The Fed’s efforts these past nine months remind me of the old TV series “MacGyver,” whose ingenious hero would always get out of difficult situations by assembling clever devices out of household objects and duct tape.

Now that is high praise, indeed!

0.6 + 5.0 + 2.0 = recession-ish

The BEA's advance estimate of real GDP reported growth at an annual rate of 0.6% - slow, but positive - for the first quarter of 2008 (the same rate as the last quarter of 2007). Consumption contributed positively (growth in services consumption outweighed a decline in goods consumption), as did government purchases (especially federal defense expenditures) and net exports (partly thanks to the weak dollar). Declining investment - particularly residential (i.e. new housing, down 26.7%!) was a drag. Inventory accumulation made a large positive contribution, which is somewhat worrisome because it suggests firms are piling up unsold goods and therefore might reduce output in the future. However, it should be noted that inventories were falling in the fourth quarter of '07, so the increase might partly reflect a return to normal stocks.

Since output is not falling, this would not meet the NBER's definition of a recession. However, by a useful rule of thumb - Okun's law - the economy needs to grow around 3% to keep unemployment from rising (because the labor force is growing and productivity growth increases the amount of output each worker can produce). So while economics professors who are being careful in their choice of words won't call it a "recession" we are in what Brad deLong is calling a "recession-like episode" and, as Paul Krugman puts it:

...[T]he official definition of recession has become delinked from peoples’ actual experience. Right now, we’re in an economy with deteriorating employment and incomes, collapsing home prices, and business retrenchment. Is it also an economy in recession? Who cares?

This Tom Toles cartoon makes a similar point. And, of course, the GDP numbers are subject to revision, as Menzie Chinn notes.

About that deteriorating employment.... the April report from the BLS reported a decline in the unemployment rate from 5.1% to 5.0% (which suggests a GDP growth rate >3% in April), and, in this case it is not an artifact of discouraged workers leaving the labor force. In the household survey, the number of people employed increased by 360,000, the number unemployed decreased by 189,000 while labor force participation was basically unchanged (increasing from 66.00% to 66.02%). The establishment survey reported a decline in "nonfarm payroll employment" of 20,000; the result of a decrease of 110,000 jobs in goods producing sectors and an increase of 90,000 in service employment. Not as bad as expected, but the overall picture is still un-good, according to the Times:

Companies are cutting working hours, even as many avoid layoffs. Those working part time because of slack business or out of failure to find full-time work swelled from to 5.2 million in April from 4.9 million in March. In percentage terms, employees working part time involuntarily climbed to the highest level since 1995.

The average weekly pay for rank-and-file workers — about 80 percent of the American work force — fell $3.55 in April, to $602.56 in inflation-adjusted terms. This figure has been generally falling since the end of 2006. Gains in pay have been canceled out by the soaring costs of food and energy.

“The punch line is that you don’t have to lose your job to get pinched in a recession,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute in Washington. “Understandably we focus on layoffs and job losses, but most people keep their jobs in a recession. People who held their jobs are losing ground both in terms of hours and hourly wages.”

The Fed, though, may be done helping for now. On Wednesday, they announced a reduction in the Federal Funds rate target of 0.25% to 2.0%. Their statement hinted that we may have reached the end of the easing cycle (which began last September when the rate target was cut from 5.25% to 4.75%):

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Since monetary policy affects the real economy with a lag, there should be a boost in the pipeline for this summer and fall, and the Fed may need to turn its attention to shoring up its anti-inflation credibility. Or, in the statement's Fed speak:

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The Presidents of the Dallas and Philadelphia Feds, Richard Fisher and Charles Plosser, voted against cutting for the second consecutive time, apparently thinking the Fed has gone too far already. That also seems to be what Allan Meltzer thinks, according to the Times: “My view is that the Fed is back doing the silly things it did in the 1970s, of trying to make judgments that have long-term consequences based on short-term data.” The futures markets expect the Fed to hold the line at 2.0% at the June meeting.

Gas Tax Pander Bears

Hillary Clinton is following John McCain's lead again, the Times reports:

Senator Hillary Rodham Clinton lined up with Senator John McCain, the presumptive Republican nominee for president, in endorsing a plan to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for the summer travel season. But Senator Barack Obama, Mrs. Clinton’s Democratic rival, spoke out firmly against the proposal, saying it would save consumers little and do nothing to curtail oil consumption and imports.

Politically, it seems like an odd moment for Obama to eschew a cheap pander (somewhere, Paul Tsongas is smiling), but on the substance he is right, as Dean Baker explains:

Actually, almost all economists would agree that the tax cut proposed by Senators Clinton and McCain would save consumers nothing. With the supply of gas largely fixed by the capacity of the oil industry (they claim to be running their refineries at full capacity), the price will not change in response to the elimination of the tax. The only difference will be that money that used to go to the government in tax revenues will instead go to the oil industry as higher profits.

As Baker notes, the public is ill-served by coverage that fails to make clear the impact (or lack thereof) of this proposal.

The Tax Policy Center's Len Burman and Eric Toder are also critical. They write "unless the plan's aim is to boost short-term profits for petroleum refineries, the proposal makes no sense."

Update: More from the Washington Post's Fact Checker, Thomas Friedman, Howard Gleckman and Paul Krugman (who seems to have a hard time saying anything positive about Obama).

Update #2 (5/2): Apparently I'm not the only one having a Paul Tsongas flashback. Meanwhile, Clinton campaign official Howard Wolfson says: “There are times that a president will take a position that a broad support of quote-unquote experts agree with. And there are times they will take a position that quote-unquote experts do not agree with.” Ugh.

Ex-Fiscal Conservatives

In the Times, David Leonhardt profiles McCain economics advisor Douglas Holtz-Eakin. Although the tone is sympathetic, Leonhardt cannot avoid asking the awkward question "are there any fiscal conservatives anymore?"

Holtz-Eakin headed the Congressional Budget Office when it took a stab at "dynamic scoring." Though that sounds like something Billy Dee Williams might do, it actually means trying to incorporate "supply side" effects into estimates ("scoring") of the revenue losses associated with tax cuts. Leonhardt writes:

When Douglas Holtz-Eakin took over in 2003 as the director of the Congressional Budget Office — the nation’s bean counter in chief — he walked right into a firestorm.

For years, Republicans had been pushing the budget office to change the way it estimated the cost of a tax cut. Rather than looking only at the revenue lost, they argued, the office should also consider how tax cuts would change behavior. With lower tax rates, businesses would invest more, workers would work more — and the government would thus get a tax windfall. This, in a nutshell, is supply-side economics.

A bearded academic, Mr. Holtz-Eakin had just finished a stint in the Bush administration and had spoken favorably about dynamic analysis. So his appointment excited Republicans almost as much as it scared Democrats. Senator Kent Conrad went so far as to call it “a mistake.”

But it turns out that both parties underestimated Mr. Holtz-Eakin. He did indeed begin using dynamic analysis, which makes a lot of sense, since tax rates really do alter people’s behavior. Yet he used it as it should be used.

What the budget office found, as study after study has shown, was that any new revenue that tax cuts brought in paled in comparison with their cost....

Now Holtz-Eakin is working for a candidate who opposed the 2001 and 2003 Bush tax cuts, but now wants to extend them, and go further. McCain's vague promises of spending cuts to keep the deficit under control are reminiscent of David Stockman's "magic asterisk." Leonhardt:

To deal with the deficit, Mr. McCain has said that he will get tough on year-to-year spending, both in military programs and domestic ones. Then he will try to remake Medicare and Medicaid so that, as Mr. Holtz-Eakin puts it, they no longer pay doctors “based on what they do to people, instead of what they do to make people well.” It’s a fine idea.

The problem is that the campaign has been far, far more detailed about its tax cuts, which would worsen the deficit, than its spending cuts, which would reduce it. Mr. McCain has proposed the elimination of the alternative minimum tax (at a cost of $60 billion a year), new child tax deductions ($65 billion), a corporate tax cut ($100 billion) and faster write-offs for corporate investments in new equipment ($50 billion to $75 billion).

Of course, there are some who are in denial about the budgetary consequences of a tax cut, still peddling the claim that somehow revenues will rise - and one of those cranks, Arthur Laffer, is also advising McCain (as is Kevin Hassett, co-author of "Dow 36,000;" see Jeff Frankel's comments). Given the varied quality of his advisors, and his flip-flops on the issues, what McCain really thinks - and really would do in office - is anyone's guess. Washington Post columnist Ruth Marcus believes we're not getting straight talk:

Call it McCainsian Economics. Its seminal treatise: "The General Theory of Getting Elected."

In the space of just a few years, McCain has morphed from someone who worried about the cost of the Bush tax cuts into a rabid tax-cutter. You don't need a fancy equation to explain this turnabout. McCain is running for president at the helm of a party that's deathly allergic to taxes and highly suspicious of him on this score. His campaign-trail buddy is Phil Gramm, the former Texas senator. When it comes to fiscal responsibility versus more tax cuts, Gramm is what your mother would call a bad influence.

McCain 2001 said he could not "in good conscience support a tax cut in which so many of the benefits go to the most fortunate among us, at the expense of middle-class Americans." McCain 2008 pushes a tax policy that makes Bush's plan look like a soak-the-rich scheme....

Although some respectable economists do believe that tax cuts can alter incentives and induce additional labor supply and capital accumulation, the notion that those effects would be large enough to increase revenues is well known to be fantasy. For example, this analysis by Greg Mankiw, a Republican and former Bush advisor, and Matthew Weinzerl used a neoclassical growth model to find that, in the long run, the supply side effects reduce the revenue impact of capital and labor taxes by 50% and 16.7%, respectively (that's after a transition to a new steady state; the effects are much smaller at, say, a 10-year horizon). What their analysis appears to leave out is the impact of deficit spending, which reduces capital accumulation through the "crowding out" effect (i.e. the government borrows some of the saving that otherwise would have financed investment).

This Jeff Madrick column from 2003 has more on the CBO study of the dynamic effects of tax cuts, and is also a nice example of the way in which macroeconomists use a grab-bag of different types of models.

Mark Thoma comments on Leonhardt's story, as does The Economist's Free Exchange.

Update (4/26): Krugman says "it’s really sad to see Holtz-Eakin lending his reputation to this sort of thing."

Brauchli Chopped?

Or so I think Rupert Murdoch's New York Post might have headlined this Times story about change at one of his other properties. The Times' editors were, naturally, more restrained:

Wall St. Journal Editor Expected to Resign

Marcus W. Brauchli will step down as the top-ranking editor of The Wall Street Journal after less than a year in the job, four people briefed on the matter said on Monday, just four months after Rupert Murdoch took control of the paper.

Mr. Brauchli, 46, will announce his resignation soon, according to friends and current and former colleagues, all of whom requested anonymity because they were not authorized to discuss the matter. They differed as to whether he was being forced out as managing editor of The Journal, one of the most coveted posts in journalism, or leaving out of frustration.

Perhaps Murdoch was inspired by this classic song: (sorry, couldn't resist...)

Screech of the Inflation Hawks

A good resource for monetary policy tea leaf reading is the Wall Street Journal's Real Time Economics Blog, which does yeoman work tracking the utterances of Fed officials. RTE reported Thursday that some of the regional Fed Presidents are hinting that they have had enough of the rate cuts:

Federal Reserve Bank of Dallas President Richard Fisher has for several months now been among the central bank’s outspoken critics of the way the Fed conducts monetary policy. He stuck to his guns Thursday, saying he had a “strong reluctance” to cutting rates again. “The answer, to be curt, is not to compound the bad by repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later,” Fisher said, speaking at an event in Chicago. He reiterated his belief the Fed’s best tools to combat the current threat to the economy rests in its expanded or newly launched initiatives aimed at providing liquidity to financial markets. Fisher is currently a voting member of the interest rate setting Federal Open Market Committee, and he formally opposed the Fed’s last two rate cuts.

Another official has also suggested he’d be uncomfortable with a move to lower interest rates further. Federal Reserve Bank of Richmond President Jeffery Lacker told reporters at a conference on credit held by his bank in Charlotte, N.C., Thursday that “inflation is a problem now. It’s too high.” The official, who isn’t a voter this year, leaned against the dominant view among policy makers, which is that moderating, if not contracting, economic activity, will lower price pressures. “I’d be uncomfortable just waiting for economic slack to bring [inflation] down.”

On Friday, Philadelphia Fed President Charles Plosser also expressed concern about inflation.

How concerned one is about inflation depends, in part, on the measure chosen (or perhaps the choice of measure depends on one's concern).
The most-watched measure of inflation, the rate of change of the Consumer Price Index (CPI, in green), has risen above 4% - some ammunition for the inflation hawks in the upcoming FOMC meeting. However, the CPI is believed to slightly overstate inflation - an alternative is to use the deflator for personal consumption expenditure (i.e. the deflator for the C part of GDP, in red) - which makes the inflation picture less alarming, but only slightly so. If we take out the prices of food and energy and look at "core" inflation (blue), then the inflation picture doesn't look so bad.

The FOMC's next scheduled meeting is April 29-30. The Cleveland Fed calculates the probabilities of different outcomes of the meeting implied by prices of options traded on the Chicago Board of Trade. The markets are betting that the inflation hawks will not have the upper hand in the committee; they forecast a cut in the target, to 2.0% (or, possibly 1.75%):

Bryanism Comes to the WSJ

By eroding the real value of debts, unanticipated inflation redistributes wealth from creditors to debtors (nominal interest rates incorporate expected inflation). In the late 19th century, the populists, led by William Jennings Bryan, argued for an inflationary policy - adding silver to the monetary base - to benefit indebted farmers. Arguably, the crushing deflation of the time provided a reasonable justification for faster money growth, as farmers faced fixed nominal debt payments while the price of their crops fell year after year.

The populists were opposed by conservative eastern moneyed interests who supported the gold standard behind the banner of "sound money." These days, we trust the Wall Street Journal opinion pages to represent conservative moneyed interests, so it was a bit of a surprise to read this:

The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street.

The writer is associated with the conservative American Enterprise Institute, no less. Hat tip: Mark Thoma.

Update (4/15): Sound money is restored to its rightful place: on today's WSJ opinion page, Martin Feldstein says "Enough With The Rate Cuts."

Evidence on the Savings Glut Hypothesis

A country's current account is the difference between its saving and investment: a country with a current account surplus is saving more than necessary to finance its domestic investment. The difference goes to purchase foreign assets, a so-called "capital outflow." In recent years, the US has been running large current account deficits ($739bn or 5.3% of GDP in 2007), which means US savings is not sufficient to finance domestic investment and the difference is made up by selling US financial assets to foreigners (i.e. the US has a net capital inflow).

In 2005, Ben Bernanke offered a novel hypothesis that the US current account deficit was driven by a "savings glut" in the rest of the world, especially in emerging market countries. The current account surpluses of the emerging countries were used to purchase US assets, contributing to high US share prices and housing values (due to long-term interest rates kept low by the inflow of foreign saving into the US bond market). This increase in the wealth of US households drove the low savings rate - i.e., US households felt they could consume more because of the increases in home equity and stock prices.

On his blog, Brad Setser provides some evidence in favor of the savings glut hypothesis:

In 2007, the savings rate of the emerging world savings was almost 10% of GDP higher than its 1986-2001 average. Investment was up as well – in 2007, it was about 4% higher than its 1986-2001 average. However the rise in the emerging world’s savings was so large that the emerging world could investment more “at home” and still have plenty left over to lend to the US and Europe. That meets my definition of a “glut.”...

The big drivers of this trend. “Developing Asia” and the "Middle East." Developing Asia saved 45% of its GDP in 2007 -- up from 33-34% in 2002 and an average of 33% from 1994 to 2001 (and 29% from 86 to 93). Investment is up too. Developing Asia invested 38% of its GDP in 2007, v an average of between 32-33% from 1994 to 2001. Investment just didn't rise as much as savings. The Middle East also saved 45% of its GDP in 2007 – up from 28% of GDP back in 2002 and an average of 25% from 1994 to 2001 and an average of 17-18% from 1986 to 1993. Investment is up just a bit -- at 25% of GDP in 2007 v an average of 22% from 1994 to 2001.

The Middle East oil producers appear to behaving in a manner consistent with the permanent income hypothsesis - if the current high oil prices represent a transitory increase in their income, an increase in saving will allow them to spread the increase in consumption over a longer time period.

The current account surpluses of "Developing Asia" (most prominently, China) are harder to make sense of. If these countries expect higher income in the future, the logic of consumption smoothing implies they should be borrowing today. Moreover, conventional assumptions about production technology imply the returns on capital should be higher where capital is scarce - i.e. capital should flow from the US (with has a large capital stock and therefore should have a low marginal product of capital) to the developing countries, rather than in the other direction (this previous post discussed the perversity of a poor country - China - lending to a rich one - the US).

Carry On Wayward Yen

A recent Econ 317 homework problem (ch. 10, problem #5 from Greg Mankiw's intermediate macro book) illustrated the concept of uncovered interest parity (UIP). One of the major puzzles in open-economy macroeconomics is the fact that this condition fails to hold in the data. On his blog, Mankiw muses on whether there is money to be made in the "carry trade," which relies on the violation of UIP:

It is rare that I leave an economics conference with information that will change my personal financial decisionmaking. But I was close yesterday. A fascinating discussion of a paper on the carry trade made me wonder whether I should put a little money there.

The carry trade refers to the act of borrowing from countries with low interest rates, lending to countries with high interest rates, and profiting from the interest rate differential. It is based on the hope that exchange rates will not move too much against you to wipe out the profit. In other words, it is gambling that a condition known as uncovered interest parity will not hold. In the past, this strategy has been a money-maker. That is, uncovered interest parity is a plausible hypothesis that empirical studies usually reject.

We don't have the UIP violations quite figured out yet, but surely a brilliant economist like Mankiw would not entertain the thought that there any large bills on the sidewalk to be picked up. Besides, he already knows a much less risky way to get rich. (and yes, the title of this post is a Kansas reference)