September 2005 Archives

Anyone who can make string theory accessible to a mass audience is pretty good in my book. In this NY Times piece, he celebrates famous equation E=mc². He thinks about physics the way I think about economics. Understand the math, but don't consider your understanding complete until you can tell the story. We call that intuition. And I wouldn't trust an economist (or a string theorist) who doesn't think it's important.

Einstein's derivation of E = mc² was wholly mathematical. I know his derivation, as does just about anyone who has taken a course in modern physics. Nevertheless, I consider my understanding of a result incomplete if I rely solely on the math. Instead, I've found that thorough understanding requires a mental image - an analogy or a story - that may sacrifice some precision but captures the essence of the result.

Here's a story for E = mc². Two equally strong and skilled jousters, riding identical horses and gripping identical (blunt) lances, head toward each other at an identical speed. As they pass, each thrusts his lance across his breastplate toward his opponent, slamming blunt end into blunt end. Because they're equally matched, neither lance pushes farther than the other, and so the referee calls it a draw.

This story contains the essence of Einstein's discovery. Let me explain.

Read the rest of the story here.

The economic wing of the blogosphere is expanding. Make room on your blogroll for Adam Smith Lives! The author is Sandra Peart, and it looks like a great read.

Hat tip: Marginal Revolution

From Reuters

Fed Chair Alan Greenspan remarks,

"Because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly," he said.

Prices for both U.S. stocks and government bonds rose a bit after his remarks as traders showed relief he had not signaled higher-than-expected interest rates ahead.

The fact that he did not use the word "irrational" probably helped too.

The whole speech can be read at the Fed's web site.

So I spent much of the last couple days working on a research question. I'm catching up on blog reading and I find PGL (Angry Bear) and Arnold Kling (EconLog) discussing Thomas Nugent's column at the NRO. Obviously, I sat up straight in my chair and took notice.

Nugent says,

How does the federal government pay for the damages caused by Katrina? Does anyone asking that question actually know how the government pays for anything? Essentially, the federal government pays for things in just one way — it credits a member bank account. Let’s review the process: The federal government writes a check to a construction company to pay for a bridge. The construction company deposits the check at a bank. When that check clears, the Fed credits the bank’s reserve account at the Fed, and then the bank credits the company’s bank account with “good funds.” Bottom line: Operationally, virtually all of the federal government’s spending per se consists of the Fed crediting an account — that’s all. The federal government doesn’t have any “box of money” that gets “filled” from tax collections and the proceeds from new Treasury securities and then gets “used up” by spending or lending. This is an operational reality. In today’s world of non-convertible currencies, spending is necessarily nothing more than “score keeping.” (If one football team scores a touchdown, and 6 points are added to its score, does anyone ask where the scorekeeper gets the points?)

Oh dear.

Likewise, tax payments simply reduce account balances in the private sector. Nothing “goes” anywhere; the government doesn’t “get anything.” To reinforce this point, if you pay your taxes in actual cash, or buy Treasury securities (government bonds) with actual cash, the Fed shreds the cash. Likewise, if you donate cash to the federal government for Katrina, it shreds it. In fact, if you take a $100 bill and burn it, you’ve donated that $100 to Katrina! Operationally, the entire spending process is not constrained by government “revenue.” Whether or not the government has collected taxes or borrowed is not a factor in the payment process. Any constraints on the process can only be “self imposed.”

Oh dear, again. Mr. Nugent, meet Mr. Ponzi. He has some land he'd like to sell you.

Gotta love Arnold Kling's response:

I'm sorry, but I've read the preceding paragraph several times, and it makes less sense each time.

Whether public or private in nature, spending allocation decisions involve real resources, not just scorekeeping. The Treasury and the Fed are not operationally equivalent. Nugent may be trying to get past the notion of a static budget constraint and asserting the most extreme form of Ricardian equivalence in an intertemporal budget constraint. But even the intertemporal constraint is subject to a transversality condition. At face value, Nugent's statement seems to ignore that. The transversality condition is not "self imposed". Ponzi schemes are simply not allowed. Hyperinflation is not an option.

Oh, I know. It's a rhetorical flourish. I can see that, and you can too. But still.

Continuing with Nugent:

Will private borrowers be crowded out? Impossible. The causation is “loans create deposits,” as taught on day one of every traditional money and banking class. The act of borrowing itself creates exactly that same amount of new liabilities (deposits). The process is “self funding” and circular, as a matter of accounting. The concept of a “pool of savings” that somehow gets “used up” by borrowers is a throwback to the time of fixed exchange rates and gold standards, and has no application in today’s floating-exchange-rate world.

Again, I yield the floor to Arnold Kling:

When I was in grad school, I somehow missed the lecture where they said that government deficits are self-funding in a flexible exchange-rate regime.

The savings curve is more elastic, but not perfectly elastic. There is a difference, and I'd hate to learn that the hard way.

Finally, Nugent says,

The true economic cost of Katrina is the real, physical resources committed to repairing the damage that otherwise could have been used elsewhere to expand productivity or improve overall standards of living. But with today’s excess capacity in everything but energy, there is not going to be much of an opportunity-cost to rebuilding, apart from temporary dislocations of building materials and energy production. In other words, shortages of goods and services due to rebuilding should be temporary and modest.

So the private sector faces real trade-offs (but they aren't bad, so don't worry). But the government faces no real trade-offs; its just scorekeeping.

Sorry, governments face real trade-offs too.

UPDATE: MaxSpeak also took notice.

Check out Radioeconomics, an economics Podcast put together periodically by James Reese of the University of South Carolina Upstate. I'm listening to the latest offering--a discussion between John Palmer (The Eclectic Econoclast) and Phil Miller (Market Power).

There is also a discussion between Mark Thoma and Barry Ritholtz that you can listen to.

Radioeconomics is now number 91 on Apple's top 100 Podcasts!

I found these while checking the Chicago Fed website for Michael Moskow's speech.

Bill Testa is blogging on the Midwest economy for the Chicago Fed. He is vice president and director of regional programs in their research department. His latest post is on ethanol.

Tim Schilling is a former high school teacher in charge of the economic education efforts at the Chicago Fed. He is blogging on issues related to economic education.

The home page of the Chicago Fed blogs can be found here.

Both are welcome additions to the economics corner of the blogosphere. Check them out!

In my last post, I asked some questions that have been occupying my mind lately. Keep the comments coming.

Here's an interesting remark from Jacob at Everyone's Illusion, a relatively new blog worth adding to your blogroll.

The danger in pausing is the Fed may be running out of time. The Fed is worried about monetizing the ever growing deficit as well as oil price increases. Oil price (really gas price) inflation makes politicians do odd things, most of which are inflationary. The temptation is for more subsidies, increased payments for exploration companies, cash handouts to alternative sources, in other words more government spending.

Normally the risk of a pause would probably be minimal as it is the cumulative effect of Fed increases that matter, not any particular 25bps. Furthermore, they could always raise 50bps if things were looking like they were getting out of hand. This time there is one major difference; Greenspan is leaving.

...

The Bush administration clearly values loyalty in its appointments. The new Chairman will likely start at a time where the risks of a slow down and inflation are quite high. The Republicans are facing an election in 2006 where they certainly do not need a “fed caused” recession when voters go to the polls. If you don’t think these issues will come up when Bush interviews candidates I think you are being naive.

Greenspan knows the successor will have less cover then he does. There are only 3 more meetings until he retires which brings the rate to 4.50%. If they pause once, the max Greenspan rate is 4.25%, twice and its 4.0%. Even if the Fed thinks 4.25% is enough (or even 4%) they run the risk of the new Chairman being forced into pausing for a few meetings and things getting out of hand. Better to raise too much (possibly) and let the new Chairman gain political favor by being the one who pauses or cuts to starve off recession.

It's an interesting hypothesis, that Greenspan might want to give the new Chairman the ability to pause at some point early in his tenure. It's certainly possible. The one slight problem with it is that while Bush may value loyalty, the job of Fed chair is not the same as a cabinet post. The Fed chair (indeed, any Fed governor) does not serve at the pleasure of the president. He can be removed for cause, but not because of policy disagreements. And furthermore, whoever is picked will be subject to reappointment as chair not by Bush, but by the next president. So I'm not convinced that a pause would logically come after the new chair is in office--especially if the new chair comes in with a reputation as an inflation hawk.

But this much is certainly true. The tension between the Fed and Congress over the deficit is building by the day. That will be the new chair's biggest challenge. If the new chair pauses the rate hikes right away, I'd be worried that market expectations of inflation could come unglued. In the best of all worlds, I'd have Greenspan pause the rate hikes and have an avowed inflation fighter resume them.

I guess we'll see how it plays out. Of course, we still don't have a replacement for Greenspan. So I'll toss out this hypothesis... there will not be a pause until we know who Greenspan's replacement is.

Discuss.

In other Fed news, Michael Moskow says that it is still "necessary to reduce accommodation." He also discusses "flexible inflation targeting" in his speech.

Is the Fed risking recession? In James Hamilton's most recent post, he seems to think so. Tim Duy suggests that the Fed is sending a clear message that it will target price stability rather than full employment growth if forced into an either/or choice. I will simply add that managing expectations will matter a lot here. A little bit of aggressiveness against inflation now will help contain inflationary expectations and prevent an incipient downturn from turning into full blown stagflation. In fact, the Fed's management of expectations, while it hasn't been perfect, has probably already kept inflation expectations fairly (well) contained. (Include the word "well" or not, as you like.) That said, it would not be inappropriate to allow the economy to take a breath sometime in the next few months as long as expectations remain in check. But I'm aware that a pause in the rate hikes is not without it's own set of problems.

I'll throw out these questions to the blogosphere: What are the dangers of a pause in the rate hikes? What are the chances that the market would misinterpret it and see it as a signal that the Fed is done raising rates or that they see recession on the horizon? If you were on the FOMC, what would you do between now and the end of the year to minimize that risk? Do you think that these risks would cause the Fed not to want to pause at all, but treat "measured pace" as meaning 25 b.p. per meeting until they feel they're at the neutral funds rate? Would that be good policy?

Yes, those are tough questions. That's why I'm not answering them all here tonight. It is late as I write this, but these questions will be with us for many weeks. I'll come back to them from time to time with my thoughts.

Have at it.

Mark Thoma spots a debate between Senators Grassley and Harkin, both of Iowa about whether to pay for Katrina rebuilding using tax increase or spending cuts. In case it's not obvious to you who is on which side, read here. I want to address Mark's comments.

First, during the recovery period itself, there is no need to do either, something Grassley seems to implicitly acknowledge elsewhere in his remarks. If the goal is to stimulate the economy during this period, then deficit spending (borrowing) is needed. Offsetting spending on hurricane relief with reduced spending elsewhere or increasing taxes does not provide any short-run stimulus. Arguments about long-run economic growth and tax rates are being mixed up with arguments about the level of GDP in the short-run. Once the economy has recovered, then it’s time to pay the bills. At that point either an increase in taxes or decrease in spending can be used in theory since both reduce the deficit, though in reality tax increases will be needed since spending cuts alone cannot solve our deficit problem. This is where growth considerations come into play and, though there are certainly pockets of fat in government, cuts in spending large enough to dent the deficit will reduce essential spending on infrastructure and social insurance programs and harm rather than enhance our long-run growth prospects and economic security.

I don't totally disagree with Mark. Here's where I take issue with it. I don't find the long run growth argument all that compelling. Unless you can convince me that the government spending being cut is something that enhances aggregate supply as opposed to aggregate demand, then the long run multiplier is probably pretty close to 1. Not to mention the fact that you're just trading one type of spending for another.

If we're talking about one time events, then I can set up a simple opportunity cost question about whether disaster relief is a higher priority right now than a bridge to nowhere in Alaska. (But I wouldn't argue for permanent cuts to Medicaid on that basis.) Permanent tax increases probably wouldn't be necessary. Small spending cuts spread out over time, combined with short term deficits will plug the hole.

But if we're talking about permanent changes and asking for more Homeland Security or FEMA spending then the cuts in other programs would have to be permanent. Cutting the fat out of one highway bill won't be enough. In that case, I would want there to be a real debate about priorities. A tax increase might be more politically realistic in that case, especially if Congress deadlocks over priorities (almost guaranteed).

Of course, using 9/11 as a precedent, I'd be wary of using Katrina as a justification for large, permanent increases in spending. (I'm just sayin'.)

So here's a case where it makes a lot of sense to think about the problem in the context of an intertemporal budget constraint, no matter what your view of the appropriate size of government. Whether this most recent fiscal demand is a one time thing or a permanent shift in priorities is more important to me right now than whether to increase taxes or cut spending. Indeed, the answer to the former would inform my opinion on the latter.

Light posting day today. The weekend is nearly here, and I just gave a departmental seminar. Perhaps you will enjoy this column by Don Boudreaux (Cafe Hayek) in the Pittsburgh Tribune-Review.

The crux of the article is that it is not technology but "personal choice, voluntary exchange, freedom to compete and security of privately owned property" (to use, as he does, the Cato Institute's definition of economic freedom) that has the most critical impact on economic growth. After all, many countries have technology but not economic freedom. See also Stephen Parente and Ed Prescott's work for a more nuanced but not altogether inconsistent outlook.

Hat tip: Division of Labor

Arnold Kling at EconLog noticed the WSJ Econoblog yesterday. He poses the discussion question:

If your goal were to have first-year economics understand, say, the role of markets in addressing the disruption in gasoline supplies caused by a hurricane, how would you propose to teach this?

See the comments over there for discussion.

Roberts responds to a critic at Cafe Hayek.

Gavin Kennedy checks in with a comment and a link to his site on Adam Smith's Lost Legacy. He blogs on that site as well. I'll be adding that to the blogroll.

On Smith, please notice the link in the Econoblog piece where I talked about Smith. If you missed it, here it is again.

My study of Adam Smith was influenced tremendously by Deirdre McCloskey. I was fortunate enough to be a part of a graduate seminar in which Deirdre and a handful of us grad students read The Theory of Moral Sentiments, beginning to end. It was there that I came to appreciate Smith like never before. The seminar was great. Dinner at Deirdre's house was always a welcome change for a grad student. But most of all, her thoughts on Smith and the virtues outlined in his various works really resonated with me. I carry it with me to this day.

So read the piece by McCloskey. Just to give you a little teaser, here you go...

The businessmen wearing the Adam Smith ties need to do a little reading of The Wealth of Nations and especially The "Theory of Moral Sentiments" on the train from Westport. Smith did not say, ever, that Greed is Good. And the Christians and other opponents of the sin of avarice need to stop conceding the point to the men of Westport. There is no paradox of thrift, not in a properly Christian world. Nor even in the world we have.

Now, go read the whole thing.

Lynne Kiesling finds that this issue just will not go away.

Many thanks to jeffrey.d for alerting me to the letter signed by eight governors asking for a federal gasoline pricing probe, and possible refunds of "excess profits" (remind me to add that to the list of economic non-concepts, right behind "price gouging" and "windfall profits").

The WaPo article mentions a study by Don Nichols at the University of Wisconsin, but because I could not find any such study online I cannot comment on it. I can comment on what the WaPo article says, though:

Historically, Nichols said, the markup between the price of a gallon of crude and a gallon of gasoline is about 85 to 90 cents a gallon, including refining, distribution and taxes.

The study estimated that for pump prices to reach $3 a gallon, the price of crude oil would have to be about $95 a barrel, but crude prices have been holding around $65 a barrel, and Katrina has not caused a surge in crude oil prices.

"The disconnect between gasoline and crude oil prices is quite remarkable," Nichols said.

On its face I find this statement naive. People who study this industry have known for the past seven or so years that increasingly the refining capacity in the US is a bottleneck. If you are analyzing price effects along a vertical supply chain, and you have a capacity bottleneck in the middle of that chain, how can you expect historic relationships between the price of the initial input and the price of the final product to persist? That is incredibly naive and reflects a lack of understanding of how vertical supply chains work.

Shall we review? Stephen Karlson said this about three weeks ago.

There are conditions on the elasticities of supply, demand and resource supplies sufficient to ensure that the equilibrium retail price maintains a constant ratio to the wholesale price of a single input. Those sufficient conditions are unlikely to hold in the presence of at the moment inelastic supplies of gasoline, particularly summer grades in ozone-impact areas, and relatively inelastic demands for gasoline.

Keep that quote at the top of the pile. I have a feeling we'll be able to re-use it often.

The latest Wall Street Journal Econoblog is up. I had the pleasure of discussing economic literacy with Russell Roberts of George Mason University who co-blogs over at Cafe Hayek with his GMU colleague Don Boudreaux. We had a very stimulating discussion on the causes and consequences of the lack of economic understanding in the public and the media. I hope you enjoy reading it and trust that it will spark some further discussion.

Let me also take this opportunity to publicly thank Professor Roberts for such engaging conversation. And let me also welcome any new readers who have found their way here from the Econoblog site. Glad to have you along for the ride.

Today's FOMC statement was clearly a bit on the hawkish side. Let the blogtalk commence on what it means. I'll start with this.

What is a neutral fed funds rate, and how soon should we try to get there? This is pretty much equivalent to asking, when and at what rate to the hikes finally stop. A year ago, I said 3 to 4% in the next 12 to 18 months. We're there and not stopping. More recently I've been thinking 4 1/2% next spring. Now, 5% by summer is a real possibility, and if someone gave me even money on an over/under bet, I'd have to give serious consideration to "over".

They seem very comfortable with 25 b.p. at a time. The fact that they are not changing the measured pace language makes me confident that 50 b.p. moves are out of the question unless core inflation really makes a move. So to be "hawkish" right now seems to mean extending the time horizon for the increases rather than squeezing tighter and faster.

I suspect that many in the market, and many of you, probably have the same assessment. Does this mean that they are doing a pretty good job of managing expectations? Are expectations about the length of time the rate hikes will continue easier to manage than expectations about how big the steps will be or when there will be a pause? Is there anything, short of a drop in GDP, that would induce a pause before year's end?

My answers are yes, maybe, and I'm beginning to wonder. Comments are open.

Let's dig in. Full FOMC statement here. First, there is a paragraph and a sentence about Katrina.

Output appeared poised to continue growing at a good pace before the tragic toll of Hurricane Katrina. The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term. In addition to elevating premiums for some energy products, the disruption to the production and refining infrastructure may add to energy price volatility.

While these unfortunate developments have increased uncertainty about near-term economic performance, it is the Committee's view that they do not pose a more persistent threat.

This is consistent with what we've been hearing. Then we have the outlook.

Rather, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained. (my emphasis on new language)

Interestingly, they continue to characterize productivity growth as "robust". Yet, the supply side pressure from energy prices and other cost pressures is enough to warrant special mention.

And, not to parse words too much, but I don't think this is accidental. The wording used to be that "longer term inflation expectations remain well contained." The word "well" is gone. I have to believe that is deliberate.

On the balance of risks:

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

No change. None. But here's something new...

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Donald L. Kohn; Michael H. Moskow; Anthony M. Santomero; and Gary H. Stern. Voting against was Mark W. Olson, who preferred no change in the federal funds rate target at this meeting.

I believe the last dissent was June 2001 when William Poole (St. Louis) voted against a decrease in the funds rate. I'll look into it and ask if anyone knows the last time someone voted against a rate increase. I'll do some checking myself.

The 10 year bond went down at first, and at this writing is barely on the plus side. At this moment, the Dow is about steady as well. Could it be that the market had this pegged? Steady-as-she-goes? The changes in the wording were stronger in some ways than I would have anticipated and not as strong in others. I think it is very consistent with what Tim Duy and I both said about the possibility that the eventual target (nebulous though it may be) for the funds rate is inching up (while keeping a "measured pace"). That future decisions are going to be data dependent goes without saying. Whether a measured pace includes a pause or not--and at least one member thinks it should--we may still have some distance to go.

Partly because I've been preoccupied with monetary policy, I've held off commenting much on the $200 billion bill for rebuilding after Katrina that President Bush outlined in his speech a few days ago. As I sit in front of a blank screen about to write this post, the words of Andrew Samwick ring loudly in my head:

Where to begin?

My first concern is the precision of the estimate of $200 billion. While Katrina was much more devastating (especially when you consider the damage to the levee system in NOLA) than any other hurricane in modern memory, the $200 billion is orders of magnitude higher than for any other rebuilding operation of its kind, at least according to information I've been able to scrounge up. Where will it go? The potential for waste and fraud is staggering. We already know that disaster aid is fraught with abuse. The thought of opening p the purse for an amount equal to about half of the annual defense budget is, well, unnerving.

But suppose we are in a perfect world where these early estimates are precise and fraud is not an issue. What then? The importance of New Orleans as a port is enough to make me sympathetic to plans to strengthen the levees and make it safe to live and conduct business there. People will return; they will rebuild. But it is incumbent on us (read, the government) to make sure it is done in a sensible way. I say this with some trepidation as a non-resident, but some parts of the city probably should not be rebuilt. There should be some care and thought put into this. I fear that with an open purse, care may not be exercised.

There is precedent for a flooded and burned out city rebuilding in a sensible way. Grand Forks, ND suffered a flood in 1997. They have since bought out over 600 properties in the flood plain. According to this document, $12.5 million in FEMA hazard mitigation grants were spent in the buyout. Sure, Grand Forks (pop. 52,000) is smaller than NOLA, and the number of affected properties in NOLA is much larger. But even multiplying the Grand Forks FEMA grants by a factor of 100 would give you a number that is less than 1% of the $200 billion now being requested. Do we need something on the scale of 10,000 Grand Forks disasters?

Rebuilding and strengthening the levee system is worthwhile and because of the value of NOLA as a port, we all benefit. In a perfect world, I'd say this is a good candidate for deficit financing. It's a capital expenditure--something that will hopefully last for generations if done right. Hence it may be appropriate to ask future generations to share in the burden. Perhaps an even better case could be made for this type of spending than on other spending in the budget. That's a topic for another day.

As for the Ricardian equivalence argument, I have some reservations. First, you might recall that I argued that when it comes to Social Security reform, a version of Ricardian equivalence might approximately hold. I'm more confident about a version of Ricardian equivalence applying when it comes to a trade-off between a tax financed and a private savings financed retirement system. The decision problem for the household is much more transparent. Portfolios will adjust. In general, however, when the political system introduces a huge amount of uncertainty as to the duration and amount of the spending on cleanup/war/homeland security, etc. I think it is at the very least marginally harder to argue Ricardian equivalence. Samwick puts it thusly,

There are circumstances under which a higher public deficit would be completely offset through higher saving in the private sector. I've never been convinced that these circumstances apply in practice, even though they closely approximate the behavior of the Samwick household (consumption is set at a level far below permanent income and is unaffected, so far, by changes in tax policy). There are simply too many people not saving enough in the present generation to meaningfully offset the debts we are passing along.

To the extent that for some four years now the lower taxes and higher deficits have not wreaked havoc with interest rates is at least partly attributable to open global capital markets. Of course, Brad Setser, for one, worries about the potential for adjustment somewhere down the road.

That adjustment has the potential to be non-trivial. To really argue Ricardian equivalence with a straight face at this fork in the road, you have to argue that consumer savings could turn on a dime in the event that other nations slow down their bond binge. I can't argue that right now. The adjustment in savings would not come overnight. We would need to be prodded by higher interest rates.

And that brings us full circle to monetary policy, the topic du jour given the FOMC meeting just hours away. The Fed must be looking at this situation and shaking their head as well. Ideally, there is a separation between monetary and fiscal policy, but if we are indeed stretching to our limits as The Eclectic Econoclast believes, there could be a real butting of heads. Something for the next Fed chair to deal with, and it has the potential to be a real trial by fire.

This is no small matter. The whole idea of a soft landing was predicated on the ability of the Fed to manage aggregate demand to smoothly meet up with potential GDP on the upswing. A jarring fiscal shock has the ability to upset that delicate balance, putting us at risk of overshooting or undershooting the goal as the differing fiscal and monetary policy lags worth through the system.

And is anyone else thinking that we might be one $200 billion disaster/war/terrorist attack, etc. away from even bigger problems?

No small matter indeed.

Northern Illinois University has a staff meteorologist. His concern is obvious in what follows. (Hat tip: Cold Spring Shops)

Note, I'm not sure if the link is stable of if it always updates to give the lastest info. In any case, I'll quote from the 3:30CDT brief.

Rita. I looked at the latest model data and I just shook my head. Here's what the media and the National Hurricane Center (NHC) AREN'T telling you: the model late this morning shifted the track eastward from what they are showing here as of 11 AM Monday:

http://www.nhc.noaa.gov/refresh/graphics_at3+shtml/153924.shtml?5day

The latest GFDL model, one of the best hurricane models out there, is in fact showing a 150 MPH hurricane (strong category 4) slamming into New Orleans on Friday, with the NHC model taking it right through the city as well. The official NHC track will be adjusted eastward later today; they like to be conservative and want to make sure this thing is heading into Louisiana before they cause inevitable alarm along the Gulf coast. However, they should have 60 hours of lead time on this one, wherever it heads inland. The Gulf of Mexico has recovered almost completely from Rita; the coolest water temperatures are at 86 degrees, and 85 degrees will easily support a major hurricane. All indications are that Rita will intensify rapidly once it gets by Florida and increase to a category 4 or 5 hurricane on the Saffir-Simpson intensity scale with sustained winds of 135 MPH and higher. Barring unforeseen miracles, this should hit the U.S. as a potentially catastrophic hurricane around Friday somewhere along the Texas or Louisiana Gulf coast, potentially as strong as Katrina.

As of 1 AM, here were the forecast model and NHC forecast tracks of Rita. The latest GFDL, not shown, is further east and is near the track of the "NHC98" model which also takes it into New Orleans.

http://weather.admin.niu.edu/rita.gif

Again, since this image was produced, most of the models that have just been run have shifted the forecast further eastward.

Here's the latest from the National Weather Service. The forecast track has indeed been revised eastward. Remember, the east side of the eye wall has the strongest winds and the strongest surge because of the combined speed of the rotation and the forward movement.

Ordinarily, a day like today should be fairly quiet in the financial markets. The Fed meets tomorrow. Most agree on what they will do, but apparently a subset is not convinced. You would expect market participants to tidy up their portfolios in advance of the meeting. The lull before the storm, as it were.

Unfortunately, those words are ringing all too true in a literal sense. Tropical Storm Rita is bearing down on the Gulf coast. We did not need this right now.

Rita is expected to pass through the Florida Keys tomorrow, before heading into the Gulf's warm waters. It is forecast to reach Texas by Sept. 24, sweeping past the region devastated by Hurricane Katrina last month. The storm prompted New Orleans Mayor Ray Nagin to suspend plans for residents to renter the city and Galveston, Texas, to call for a voluntary evacuation.

``Our guidance points to a large, powerful hurricane in the Gulf of Mexico in the next few days,'' U.S. National Hurricane Center meteorologist Eric Blake said today in a telephone interview from Miami. ``We're forecasting a Category 3 hurricane, but Category 4 is not out of the question.''

The hurricane center's five-day projection has the center of the storm hitting Texas. Rita may, however, strike ``anywhere from the Texas through Louisiana coast,'' National Hurricane Center meteorologist Michelle Mainelli said.

``It's still developing and its path could change,'' Mainelli said.

New Orleans's levees are weak and can't handle more than 9 inches (23 centimeters) or a 3-foot storm surge, Nagin said at a televised press conference. He told residents of the Algiers neighborhood, who were allowed back for the first time today, to prepare to leave as early as Sept. 21.

I don't need to tell you that a direct hit from a category 4 or 5 on the weakened levees would be catastrophic. A 3 foot surge is nothing if they get a direct hit.

Of course, the financial markets are concerned about oil and gas. Also from Bloomberg:

Chevron Corp., Royal Dutch Shell Plc and BP Plc, three of the world's four largest oil companies, are among producers and drillers that are evacuating offshore workers as Rita approaches the Gulf. Crude-oil, natural-gas and gasoline futures surged in New York on concern over Rita. Katrina idled about 10 percent of U.S. refining capacity, sending gasoline prices to record highs.

Houston-based Diamond Offshore Drilling Inc. is idling two rigs for evacuation, and a third is being moved from Rita's projected path, company spokesman Les Van Dyke said today in a telephone interview. Transocean Inc. and Murphy Oil Corp. also plan to evacuate workers.

San Ramon, California-based Chevron, the second-largest U.S. oil company, is evacuating some workers essential to production and some who aren't, spokesman Mickey Driver said.

London-based BP is removing workers not needed for production from platforms in the eastern and central Gulf, spokeswoman Ayana McIntosh-Lee said. Shell pulled out 195 workers yesterday and will evacuate another 350 today.

CNN reports:

U.S. light crude oil for October delivery jumped $4.39 to settle at $67.39 a barrel on the New York Mercantile Exchange as Tropical Storm Rita headed toward the Gulf Coast. Also affecting the oil market are indications that OPEC ministers -- meeting Monday -- are unlikely to boost production quotas.

And James Hamilton comments:

...trading on NYMEX today pushed October oil up 7% and October natural gas and gasoline both up 14%. The latter figure amounts to 26 cents a gallon-- not bad for a day's work. Of the 40 cents a gallon decrease in retail gasoline prices that I promised here and here, we've seen 15 cents so far, but today's two bits could take a good bite out of what you've got left. Ah well, the NYMEX giveth, and the NYMEX taketh away.

Back to CNN (same article):

COMEX gold rose $7.10 to settle at $470.40 an ounce as investors poured money into the safe-haven commodity. Prices for Treasury bonds, another perceived haven for investors, also rose.

Bonds are not a refuge against inflation however. I haven't been reporting on gold until now because I generally don't buy into the hype about it that seems to come and go from time to time. But increases like this are hard to ignore.

Oh, and by now you've probably guessed that stocks are down today. You'd be right to the tune of 84.31 on the DJIA.

There is a lot on the table right now for the Fed to consider, and a lot to keep us occupied chatting away about it like we do. The present situation is quite out of the ordinary. It's going to take some time to sort it out.

Oh, and did I mention that data on housing starts comes out tomorrow too?

Sleep well if you can, we have very interesting day ahead of us tomorrow.

UPDATE: New Economist lists seven reasons the Fed will raise rates.

Via macroblog:

When weighted by their expenditure shares in the market basket used to construct the CPI, the majority of price increases were far less than the average increase. Over 50 percent of the weighted price gains were less than 3 percent (when annualized). Nearly twenty percent actually fell.

You might say that this is all fine and good, but you happen to actually purchase the average market basket, and the price of that went up by a full 1/2 percent in one month. In other words, your cost of living rose, and stripping out those prices that increased a lot does not make you feel one bit better.

Hey -- that's a good point, and one that moves us in the direction of discussing what monetary policy ought to be trying to accomplish. Should we be content with managing the rate of inflation going forward? If so, the core measures seem exactly the thing to be focused on, as they likely provide a more accurate picture of the inflation trend. But there is no guarantee that such a let-bygones-be-bygones approach will undo the effects of large one-off increases in some price or subset of prices, even in the medium term. In other words, there is no guarantee that focusing on core inflation will stabilize the cost-of-living over horizons that people may care about.

Monetary policy is a very blunt instrument for dealing with changes in relative prices, especially in the short run. In the long run, if higher energy prices (which raise the cost of production) are passed through to all goods, that blunt instrument can be useful.

The question can be restated, at what point in the short-to-medium run do you bring down the hammer?

Read Tim Duy's remarks at Economist's View:

I'll quote from the conclusion because there's something worth your consideration. Pay particular attention to the last paragraph. The previous two provide the context.

But what about consumer confidence? The UMich Index saw a dizzying slide in September (WSJ subscription only) from 89.1 to 76. The question, however, is to what degree Katrina and gasoline impact consumers’ willingness to spend. This is different from the ability to spend. Consumers may be unhappy because the basket of goods they can purchase has shrunk (or is increasing more slowly), but that doesn’t mean they stop spending. Indeed, non-auto retail sales gained 1% in August – an annualized rate of over 12%! Even if a big chunk of that gain was gasoline, the will to spend remains intact.

A more concerning event would be for consumers to be scared into abruptly raising their savings rate. So far, we have seen little evidence that households want to hold onto a bit more of their paycheck. And even if they did, to what extent would that really change Fed policy? To be sure, many would be calling for the Fed to stop and even reverse course, but higher savings rates will be a necessary part of the rebalancing that (I believe) the Fed expects will happen at some point. Remember, the US is currently consuming roughly 6.4% (the current account deficit) more goods and services than it produces. I doubt anyone at the Fed believes such a situation can continue indefinitely.

In practice, I suspect that rebalancing will require slower demand growth to eliminate this gap – implying a risk that the Fed will raise rates higher in a deliberate attempt to hold growth lower than at any time in recent memory. I think this will come as a surprise to many, but in my opinion the Fed has been sending signals left and right that a change is coming. And, if estimates of potential growth are falling as well, as I read into San Francisco Fed President Janet Yellen’s speech last week, that change may be coming sooner than expected.

So I re-read Yellen's speech. Yes, she talks about the revisions to productivity growth. Here's a quote. You decide what it means.

Recent data revisions lowered estimates of productivity growth over 2001 to 2004 somewhat and reveal a deceleration in productivity growth over the past year or so. These revisions probably warrant a modest decrease in our estimates of structural productivity growth—the underlying noncyclical portion of productivity which is most relevant in assessing inflationary pressures. That said, it's very encouraging that even after a downward adjustment, structural productivity still appears to be growing somewhat faster than the robust rates achieved in the second half of the 1990s, and it remains quite strong by historical standards.

"Faster than the robust rates achieved in the second half of the 1990s" does not suggest enough of a revision to warrant a significant slowdown. If we are really talking about a quarter of a point drop in the growth of potential, do we believe we know enough about the effects of the increases already in the pipeline and those that are coming to be able to say with confidence that we should pick up the pace of rate increases? Consider also that capacity utilization is not yet at late 1990s levels (see Kash at Angry Bear)

So I'm curious as to whether Duy thinks the pace of increases will actually quicken, or the (as yet unstated and rather nebulous) target has shifted up, or both. I'll lay my cards on the table that I could very well see a shift up of the target--what the Fed would consider a "neutral" funds rate. But I'm nervous about quickening the pace just yet. As gas prices retreat from the post-Katrina spike, expectations should hopefully come back in line. It's clear were the interest rate trajectory was going before Katrina. The argument to shift to a higher trajectory is not compelling to me right now, whereas a shift to a higher target (at a "measured pace") is certainly reasonable. Such a view would not preclude a pause if growth slows suddenly, as long as we're clear that it is a pause and not a stop.

Duy also writes:

David Altig notes that the previous outlier in inflation expectations was a short-lived but sharp drop following 9/11. It is worth remembering that the Fed followed the attacks with aggressive rate cutting. Wouldn’t the appropriate strategy now be the opposite?

Not necessarily. The immediate and urgent response of the Fed to 9/11 is more attributable to the provision of liquidity to head off the potential for systemic risk in the financial markets. That they then held rates so low for so long after inflation expectations returned to normal is seen by many as fueling the housing bubble and perhaps the incipient rise in inflation now rearing its head. To be sure, the risk to the financial markets post-9/11 posed some unusual concerns and the immediate response was probably the correct one. But given the known difficulties in changing the course of policy, the risk of overcorrection is great. I would be very cautious about applying such a policy change with urgency in the present setting unless there is evidence that the change in inflation expectations is not a blip and not an over-reaction to the temporary gas price spike. If expectations stay this high for a month or two, all bets are off. If they come back in line, stay the course.

From Reuters:

Rate-setting members of the Federal Open Market Committee who gather in Washington on Tuesday, while mindful of Katrina's devastation, are expected to look past it to their goal of keeping prices stable and opt for an 11th straight quarter-percentage-point increase in the federal funds rate.

"The Federal Reserve cannot address directly supply disruptions and really the best support they can give in this situation is to keep the economy on a sound footing with low inflation," said Lynn Reaser, chief economist for Bank of America's Boston-based Investment Strategies Group.

The federal funds rate -- the U.S. central bank's key monetary policy tool for influencing borrowing costs throughout the economy -- now stands at 3.5 percent.

If this week's meeting had come in the immediate aftermath of Katrina, when calls were loudest for a compassionate act like a pause in rates and the economic fallout of the disaster was still evolving, the outcome might have been different.

Interesting thought. However I don't believe it is necessarily true. See below.

But Fed officials indicate they see the economy recovering from a slight dip in the second half when reconstruction kicks in fully early next year.

"Right now we're already starting to see that rebuilding is under way and energy prices are moving lower so that makes it easier for them to stick to their strategy," Reaser said. "They will likely conclude that the economy is showing a great deal of resilience and that it is able to withstand a higher level of oil prices."

Yes. Keep in mind that the current decline in energy prices (gasoline, especially) is just reversing the large spike that occurred after Katrina. Don't look for energy prices to trend lower for long. They will probably resume the same upward trend they were on before as we move into the fall and winter. (Much to the chagrin of those in colder climates.) In the long run, Katrina's impact will be minimal. The Fed should focus itself on the long run inflation picture (as it has been), ergo, it will probably be business as usual. Whatever trajectory they had in mind for interest rates into 2006 is probably the one they will stick with. To change course in response to Katrina's short run impact is the sort of fine tuning I wouldn't expect them to do.

A Reuters survey on Thursday of Wall Street's primary dealers found 16 of 21 expect a rate increase on Tuesday. On Friday, Goldman Sachs somewhat grudgingly joined those forecasting a rise, but noted that an energy-price shock worsened by Katrina and greater economic uncertainty had at least "created a rationale for a pause."

See above. If, before the hurricane, you thought that it was time to slow down the measured pace rather than keep it the same (or even pick up the pace), the hurricane might have added some weight to your argument. Perhaps Katrina strengthens an already existing rationale for a pause sometime by year's end, but I don't see it creating a rationale for a pause on Tuesday.

Skipping ahead...

Economist Dean Maki of Barclays Capital in New York had little doubt a rate rise was on the way.

"They will keep the measured pace and accommodative language in place," he predicted. "They still think that policy is accommodative, for one thing."

"Accommodative" is central banker talk for rates that are still adding stimulus to the economy.

Maki, a former Fed board economist, said he expected that the Fed will in its post-meeting statement "discuss Katrina ... but indicate they expect the impact to be transitory."

Quite likely. Such a statement could give them the opening to use language that would indicate either a change in the balance of risks (less likely in my mind) or simply that the the pace of rate hikes could slow (while still remaining "measured"). I am really looking forward to seeing how they word the statement because I'd be a little shocked if it remains the same as it has for the last few meetings. They have some inertia to overcome--any change will be seen as rather big news. And yet, change--sometime this year, early next year at the latest--is almost inevitable.

The legend gets cut off, and it really doesn't reduce well (I tried), so click the image to see all of the legend.

After some post-Katrina doubt, the Iowa Electronic Market appears to be favoring a Tuesday rate hike. Compared to the chart at macroblog, it appears that IEM participants were a little late in reacting. The dip in the price of the "up" contract is several days after the market started to react. It was also comparatively short-lived. Interesting.

From the NY Times

With few economic reports due this week, the Federal Reserve has the stage pretty much to itself. But even if the calendar were full, it would be hard to deflect traders' attention from the first formal opportunity to gauge the Fed's thinking on interest rates and the economy since Hurricane Katrina.

Stocks have rallied since the hurricane, at least partly in the hope that the Fed's rate-setting panel will end its streak of 10 consecutive quarter-point rate increases when it meets on Tuesday. That is the expectation of Henry J. Herrmann, chief executive of Waddell & Reed, the asset management firm, but he does not think that the Fed will stand pat for long.

"They'll find some reason to go on hold and signal at the same time that the economy is continuing to do well and that just because they are passing this time doesn't mean they won't raise rates again," he said.

Ultimately, he said, repairing the damage caused by Katrina is likely to result in a new growth spurt.

"Based on everything I'm hearing about the government programs that are going to be put in place to restart New Orleans, you could make the argument that the economy is going to be hurt in the short term," Mr. Herrmann said, "but a reasonable person would conclude that there is then going to be an acceleration" in growth.

The number I'm hearing is $200 billion in anticipated federal spending. But is that meant to be disbursed all in one year? It looks like about $51 billion has been appropriated already. Certainly there will be more in the next 12 months, but how much more? It's an important question. Remember that the first appropriation for the Iraq war was around $80 billion. By now spending on Iraq is certainly in the hundreds of billions, but has been spread out over the 2 1/2 years since the beginning. Estimates of the cost of the Iraq war vary, but for sake of argument, let's call it $100 billion per year. It would seem reasonable, given the figures quoted above, that the spending appropriated for the clean up of Katrina will be at about that level as well. At least it is reasonable to expect them to be on the same order of magnitude. And yet, the spending on rebuilding after Katrina will come after a period of hurricane-induced slack in the Gulf region. This would tend to mitigate any national inflationary effect. One could reasonably argue that Katrina will be less inflationary in the long run than the Iraq war.

Yet it seems to me from what I've been hearing that the spending on Katrina is being regarded by the media and the pundits as much more inflationary than spending on Iraq. Yes, there were (and are) some who point out that the spending on Iraq could be an engine of growth and dangerous to price stability. But those voices are scarcely being heard in the din over Katrina's effect.

Now I wouldn't characterize the Iraq war as an economic growth engine, per se. It's impact on growth and inflation is small but positive. As a driver of GDP growth lately, it pales in comparison to consumer spending driven by the housing boom (or bubble, if you prefer). Why is Katrina expected to be so different?

More evidence that Katrina is expected to be different can be found at macroblog. Altig shows that in the last few years there have been two major spikes in consumer expectations of inflation. After September 11, people expected a big drop in inflation. After Katrina there was a big jump. (There was some volatility around the start of the Iraq war, but nothing as big as the other two spikes.) Furthermore, the aftermath of Katrina is causing a jump in 5 to 10 year inflation expectations that the Iraq war did not! To me, this seems a little backwards. In 5 to 10 years, Katrina will be a painful memory with the requisite spending tapering off, but the Iraq war may very well still be with us.

I will grant that it is possible that in the aftermath of Katrina a lot of economic chickens are coming home to roost. People are recognizing that Iraq and Katrina together make a powerful one-two punch to the budget. No argument there.

Even so, the reaction is hard to explain. Even harder to explain are statments like this, again from the Times article.

As is often the case when the Fed's policy makers announce their rate decisions, the accompanying statement is likely to carry more weight than the decision itself. If the Fed holds steady and hints that further increases are not necessarily in store, stock prices could benefit, Mr. Herrmann said.

Well, yes, the stock market would party like it was 1999 on that news. But if you believe what Herrmann was saying earlier about the "acceleration in growth," what others are saying about Katrina's inflationary impact, and the consumer inflation expectations both long term and short term, how do you regard it as even possible that the Fed will stop now and hint that further increases are not necessarily in store? Admittedly, Herrmann may not believe that will happen, but even mentioning it seemed like a non sequitur.

Both views (hike rates relentlessly because Katrina was a catalyst for more inflation or stop altogether becauase Katrina was a catalyst for slower growth) are clearly present out there. At least one of them is wrong. Perhaps both are wrong. In any case, we will soon get a better idea of what the FOMC thinks, and it causes me to make the only prediction that is almost 100% certain to come to pass.

On Tuesday, we will have a lot to talk about.

(My prediction that is admittedly less than 100% certain to come true still stands about the same as before--another increase, possibly with language indicating the measured pace may slow. But that last part is no sure thing.)

Read the BLS press release here.

The two numbers everyone is looking for are the headline inflation rate (all urban consumers) and the core rate (excluding food and energy). The headline rate was the same as in July, up 0.5% for the month of August. Excluding food and energy, the CPI was up 0.1% in August, also the same increase as in July. In the previous 12 months, the headline rate is up 3.6%. Excluding food and energy takes it down to 2.1%.

Transportation was up 2.2% in August, due to higher fuel costs. Energy was up 5.0% in August and 20.2% in the last 12 months.

Reuters is reporting "Treasuries tick up on tamer-than expected core CPI"

NEW YORK, Sept 15 (Reuters) - U.S. Treasury debt prices ticked higher on Thursday on tamer-than-expected core consumer inflation data in August, suggesting that, at least before Hurricane Katrina, the Federal Reserve could still raise rates at a moderate pace.

But post-Katrina data showing a bigger-than-expected jump in weekly first-time jobless claims, also added to buying in the bond market.

The U.S. government said the core consumer price index, which excludes food and energy prices, ticked up 0.1 percent in August, compared with economists' expectations of a 0.2 percent increase and a July's 0.1 percent rise.

The government also said jobless claims rose to 398,000 in the week ended Sept. 10 -- above the 350,000 economists expected and the upwardly revised 327,000 in the prior week.

Tamer than expected, perhaps. But energy price increases are starting to be passed through. Transportation is hit first and most obviously. It will be interesting to see how the media reports on this. Just glancing around some news sites it appears that most are accentuating the "tamer than expected" story.

UPDATE: Econbrowser, macroblog, and The Big Picture continue the discussion.

...A club that counts United and US Airways among its members. 4 of the 7 largest U.S. airlines are in bankrupcy protection.

Read more here.

UPDATE: expedia.com just sent me an e-mail advertising a low price tickets on, among other airlines, Northwest and Delta. Kind of makes you wonder. These folks aren't buying, but at least in the short term it's not likely to be a major hassle. It's not like when a small carrier goes bankrupt and all of a sudden shuts down. Like I said, United and US Airways are part of the club, and they're still going. They will restructure, but the airline industry has undergone what might be almost an irreversible change. We will be dealing with this for a long time to come.

From Reuters:

CHICAGO (Reuters) - The Port of New Orleans resumed commercial operations Wednesday, with the first vessel loaded with general merchandise heading out since it was closed by Hurricane Katrina more than two weeks ago.

"The ship is leaving as we speak," Paul Zimmermann, the port's director of operations, told Reuters by telephone.

He said the vessel, Lykes Flyer, was heading to Brazil, Argentina and Mexico with an assortment of products after unloading a cargo of coffee from Brazil.

Last night on the news, I heard the coffee prices are heading up due to supply disruptions with the Port of New Orleans being closed. As it happened, today (not even one hour ago) I was using one of my favorite supply and demand examples in class. I use some variation of it every semester, but this time it seemed particularly relevant.

If the price of coffee increases, what happens to supply and/or demand in the market for tea? If coffee and tea are substitutes, an increase in the price of coffee will cause people to switch over to tea, thus pushing up the demand for tea and raising its price.

Of course, in class I discuss how this reasoning depends on the assertion that coffee and tea are substitutes. For some people they may not be. But if there exist some people who choose their beverage on the basis of price, then the effect will be as described.

Every principles book seems to have different examples. Coffee and tea is not in all of them, but it does make an appearance in some. This might be a chance to see if it really is true. I intend to check on the price of tea (most tea probably comes from the Far East through the Port of Long Beach and will be relatively unaffected by Katrina). Comments are open for your observations on the price of coffee and tea and your thoughts on the substitutability between them.

Here are some actual ones...

US Aug producer prices up 0.6 pct pre-Katrina (Reuters)

Producer prices tame, trade gap shrinks (Reuters)

Doves Win a Round as PPI Arrives Light (TheStreet)

Hmmm... can't resist quoting from this one:

Solely on the basis of Tuesday's wholesale price inflation data, the way is cleared for the Federal Reserve to take a break from its rate-tightening campaign at its Sept. 20 meeting

Uh, yeah. Not sure I'd go that far. Even though I've been looking for a pause sometime in the next few months, I don't think it will be next week, nor do I think this data clears the way for it.

"It's another month of contained inflation at the wholesale level, and pipeline pressures are decelerating. There is so far little evidence of high energy prices getting down to core inflation," says Michael Gregory, fixed-income strategist at BMO Nesbit Burns.

...

"This is telling the bond market that first, the Fed has a little more wiggle room when dealing with core inflation. Second, it may not have to raise rates as aggressively in the long run; it may even be able to pause in the short-term," Gregory says.

If you are willing to stick with this article to page 2, however, you'll find...

As noted by Wachovia chief economist Jason Schenker, the report did not capture the industrial price shocks resulting from Katrina, including soaring gasoline and natural gas prices. The September report will see a predictably huge jump across the board in producer prices.