December 2005 Archives

I know, the blogosphere is a-buzz with predictions for 2006. Well, about the only thing that new year's predictions are usually good for is making fun of them next year. Instead, live by the forecaster's maxim of giving them a date or a number, but never both at the same time.

About a year ago, I made a few posts on the dollar. I wasn't 100% right on. Like nearly everyone, I thought the dollar would slide a bit more this year. The opposite happened. But I did get one aspect of it right. I was skeptical of some of the gloomier scenarios put forth by, for example, The Economist. And in a couple of posts, I made reference to similarities between 2005 and 1995. Well, that was actually a pretty good comparison--much better than I thought it would be--where the dollar was concerned. I will admit, however, that I didn't think it would happen so quickly. Had I been pressed, I probably would have looked for the dollar recovery to begin this fall or about now.

Anyway, here's the picture.

So, prediction #1--If things continue as they did in the last cycle, I'd look for modest gains in the dollar again this year. It goes without saying, of course, that predicting the value of the dollar is one of the most hazardous activities known to economists. Let's just say that if I were a long term speculator with a 10 to 20 year horizon, I'd be bullish. One economic reason for that belief is that the pension concerns and demographic pressures in the rest of the world are going to be even more of a problem than for us. In other words, it's not always going to be an easy road, but on balance, the dollar should weather it ok.

Prediction #2--Canada will once again cobble together a weak coalition led by the Liberals, but the Conservatives will gain a few seats.

Prediction #2a--One of our family vacations this year will be to Canada. (Ok, that's not a prediction so much as a shout out to my Canadian readers that I really enjoy visiting their country. During the Winter Olympics, I expect to be singing "Oh, Canada" a lot.)

That reminds me...Prediction #3--The order of the medal count in the Winter Olympics will be Germany, Norway, U.S., and Canada, but Canada will beat the U.S. in curling-- a sport with less of an adrenaline rush than luge, but just as fun to watch. Anyone know where I can get tickets for 2010 in Vancouver?

And finally, "measured pace" might be gone, but some other phrase will keep us talking. Greenspan will go out on a rate hike, but there WILL be a pause in the rate increases sometime this year!

Yeah, most of these are pretty safe predictions. Nothing on the housing bubble or on just where interest rates will end the year. Nothing even on real GDP or the probability of recession. Those questions are serious. (The dollar prediction is serious, but I'm also careful to put it in context.) Truth is, a lot of people might start thinking and talking recession this year, especially early in the year, especially if the yield curve stays flat. For me, the key right now is business investment. If firms remain confident and invest, we could be in for another good year of 3-4% GDP growth. If investment falters (always a possibility), we could get a lousy quarter that sets everyone on edge. I hope that doesn't happen, and that if it does that it is only one quarter.

One more sort of off the wall prediction based on a hunch. New rules on minimum payments for credit cards will have a noticeable effect on consumer credit data and maybe even savings. The effect on savings might be barely noticeable, but maybe enough to keep it from falling any more.

Happy New Year to the east coast already. 52 minutes to go here. It has been a good one. Thank you to all my readers--especially you regular (and semi-regular) commenters who make it fun.

From the beginning I've argued that China will at some point have to adopt a meaningful currency reform but that they should do it on their own timetable. It should also be pretty clear that a number of things will have to happen in a certain order. This isn't the sort of thing that you just go out and do haphazardly. For example, I posted this just a few short days before the small revaluation that happened back in July.

So what next? The answer came today via this WSJ article (subscription required).

SHANGHAI -- In another step toward more currency flexibility, China's foreign-exchange regulator approved the first batch of foreign and local banks to act as yuan market makers, bankers familiar with the matter said.

Here's what China Daily had to say:

Expectations for further appreciation of renminbi remain in the marketplace, as trading partners continued to push for a stronger yuan and complained about narrower-than-expected price fluctuations.

The introduction of market makers in transactions between renminbi and foreign currencies will likely broaden the fluctuations, but "it will only be seen after the system has worked for some time," the trader said.

China's four State-owned commercial banks, such as the Hong Kong-listed China Construction Bank, are still the biggest traders of yuan in the market after the People's Bank of China (PBOC), the central bank.

But foreign banks will play a bigger role in the future. "It will enable us to fully participate in the development of the foreign exchange market, while providing more flexibility for our clients," Richard Stanley, Citigroup's China chief executive officer, said in a statement. "We believe this is another important step for the advancement of China's currency market."

The introduction of more market makers, which are expected to provide liquidity by quoting both selling and buying prices, will also help reduce the burden on the central bank to absorb excess dollars in the market.

The PBOC enforces the trading band of renminbi by buying the excess dollars in the market with local currency. Its purchases of dollars are added to a growing stockpile of foreign exchange reserves, while the local money it uses injects new liquidity into the banking system.

With China's foreign trade continuing to see huge surpluses and expectations for a renminbi appreciation remaining strong, heavy inflows of dollars have fuelled the growth of local money supply to unhelpfully fast rates.

There will probably be a year in the not so distant future when the economic story of the year is currency reform in China. I don't think 2006 will be that year. Maybe 2007, but even that might be pushing it (of course, the Olympics are in 2008). Until then, expect a story like this every few months confirming that progress is being made.

So what are we to make of the yield curve inversion that happened this week? (See Econbrowser and macroblog for many, many links.)

Crawling the web for observations on this rather rare event led me to this Marketwatch/NY Times article.

The flat and now, inverted, yield curve poses a challenge for banks, hedge funds and other companies. They can't borrow at cheaper short-term rates to fund longer-term loans and investments that in a normal interest-rate environment pay more than their borrowing costs.

The important thing to remember here is that the curve has been flat for some time and, even if the inversion goes away tomorrow, it will still be flat. We're talking about a few basis points in either direction. This week's inversion does little if anything to revise my priors concerning the probability of a recession.

I don't make my living in the bond pit, so I can't say precisely what drives the day-to-day fluctuations of a few basis points. Goodness knows that we've all seen day-to-day gyrations in the bond market that are beyond our powers to explain. I have to imagine that the overall health and strength of the economy both short and medium term as well as some technical rebalancing at the end of the year are all converging. Note that the inversion is at the 2 to 10 year spread. Certainly a valid inversion, but the 2 year is not a maturity that is followed like the 3 month or 1 year maturity. Just to cloud things even further, there was an auction in the 2 year market today. From the same article,

The Treasury Department sold $20 billion worth of new 2-year notes Thursday at a yield of 4.402%, slightly above expectations. Overall demand was the best in three months, with $2.42 in bids received for each $1 of securities sold. But indirect bidders, which includes foreign central banks, took a lean 30.6% of the auctioned notes, lower than the recent average.

It is, of course, too early to discern the significance of foreign central banks taking fewer notes than the recent average. If you read this as being the beginning of a trend, it should mean higher interest rates in the short to medium term and increased danger of a "hard landing". Or, it could be a one-off event. While I'm not ready to place my bets just yet, I do have to admit that out of all of the yield curve inversion commentary, that was the line that gave me the most pause.

And that brings me back to the central message from this episode. A yield curve inversion is not a sure-fire indicator of a recession. It is a warning of a situation where expectations are out of the norm. When that happens, it's always a good idea to pay attention and try to figure out why.

It's been a quiet week. GDP was revised downward just a bit, nothing to get excited about. Inflation numbers seem pretty tame. It will still be a while before we know how good the Christmas shopping season was and what it will mean for 4th quarter consumption and GDP.

And then, there's Greenspan's last FOMC meeting.

Lots to look forward to in 2006.

I've cleaned off my desk--shoveling away the debris of the semester just ended. Trying to finish a couple of projects and think about a couple of new ones. Despite the quiet of the last week, I won't be taking too much more time off from the blog. Not much blogging this weekend, however. But come back next week. I've been saving up some things.

And after the first of the year I hope to upgrade to the new version of Movable Type (happily continuing to avoid all of the problems fellow bloggers have had with Typepad). The new version allows multiple blogs on the same site. I'll be rolling out blogs for my courses over the break to coincide with the start of the semseter. I'll probably add a few links to this blog as well.

See you next week!

Bye-bye "measured pace". Bye-bye "accomodation". Hello "measured policy firming". Here's a link to the full FOMC statement, but I am going to quote the two important paragraphs in full. For the record, the FOMC did once again raise the funds rate by 25 basis points.

Despite elevated energy prices and hurricane-related disruptions, the expansion in economic activity appears solid. Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.

For reference, here is the last statement from Nov. 1.

Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs has the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.

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.

Unlike past statements where the change of a word or two could be highlighted, this is a substantial rewording.

In particular, the 2nd paragraph puts the focus less on price stability per se. I suppose that will rattle a few chains. The 2nd paragraph sounds more like it is paving the way for a temporary pause in the action with words like "...some further measured policy firming is likely to be needed..." (emphasis mine). Keeping a "measured pace" for so long heightened the possibility of the committee painting themselves into a corner. This language gives them a way out while still maintaining the ability to press on with higher rates if inflation continues to pose a threat. It may take the market a couple days to sort it out, but at first glance, this language could work. I would still like to see it evolve, however.

The first paragraph now contains an inflation warning, "Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures." Hawkish? Maybe, but that sentence has some qualifiers in it. Again, the tone throughout the statement seems to be one of paving the way for an eventual pause in the rate hikes while maintaining vigilance against inflation.

Enough of what I think. What does the bond market think? At the moment, the bond market is satisfied. They seem to be taking the news well. The 10 year price is up 7/32 as I write. They don't seem to think that the Fed suddenly turned into a dove with this statement. With that as an objective measure of the success of the new language, I'd have to give it a passing grade, perhaps a B+ (lest I be accused of grade inflation.)

UPDATE: For more see: Economist's View, The Big Picture, and possibly more to be added later.

Here's a Reuters story concerning the Fed meeting tomorrow. Not much we haven't already discussed. But in all the talk about "measured," we sometimes forget about the other word that will probably have to go--perhaps tomorrow.

A Reuters survey of Wall Street economists found just over half expect some changes in Tuesday's statement, such as dropping or watering down the reference to "accommodative" policy because rates are no longer clearly boosting growth.

The other critical piece of guidance about future policy -- that rate rises will be "measured" -- is likely to be preserved this month, since at least one more rate rise after December is expected universally by economists and financial markets.

UPDATE: Meanwhile, Tim Iacono, notes that the Bank of New Zealand is raising rates with vigor ("in a way that really hurts" as Governor Alan Bollard put it) and openly discussing the inflationary pressures caused by a booming housing market. Macroblog is planning on a special installment of his fed funds futures probabilities tomorrow.

Western Illinois University has the most sensible final exam schedule I've ever seen. Finals are at or near the regular class time and almost always on the same day as the class regularly meets. No complicated schedule matrix that changes from one semester to the next.

Happily, I'm the first one in my department to be all done. By 9:50am on Tuesday it's all over but the grading.

Now, to write some exams. Have a good weekend, everyone!

Greg Ip writes in the Wall Street Journal (full story here)

Since August 2003, the Fed's statement released after each meeting has signaled its next move. Since it began to raise rates from a 46-year low of 1% in June 2004, that statement has described Fed policy as one of "monetary accommodation," meaning rates were below a "neutral" level that neither stimulates nor restrains growth. The statement has also said more "measured" increases were likely, which markets have interpreted as at least one or two more quarter-percentage-point increases.

Given the uncertainty, Fed officials expect to drop or water down their previous language soon. Minutes of the Fed's Nov. 1 meeting, released two weeks ago, showed that "the statement is currently a subject of discussion," Federal Reserve Bank of San Francisco President Janet Yellen said last week. "At issue" are the references to "accommodation" and "measured," she said. "While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate."

The lingering word "measured" reminds me of the old story of the paradox of the unexpected hanging. As the story goes, a condemned criminal is given an unusual sentence by an eccentric judge. He is told that he will be executed sometime next week, but the exact day of the execution will be a surprise. Some versions of the story say that if the prisoner can predict the day of his execution, his sentence will be commuted.

The prisoner reasons that the execution cannot be on Friday becuase if he was still alive on Friday the day would be known with certainty. He reasons that it cannot be on Thursday either since if he were alive on Thursday the execution must be on that day (since Friday is ruled out). Repeating this reasoning (this is called backward induction) the prisoner concludes that the execution cannot happen at all. Satisfied with his reasoning, imagine his surprise when he's led to the gallows at high noon on Wednesday. The judge's sentence was right after all.

It's a paradox.

The word "measured" will not stay in the press statement forever. It has a finite life. For that matter, the interest rate increases will come to an end eventually as well. But when? As it becomes ever clearer that a shift is coming it becomes tricky for the Fed to manage those expectations. They want the flexibility of choosing when to change the policy (or the wording) on their own timetable in response to incoming data without being too hamstrung by market expectations. If they get too predictable, they lose that flexibility. They end up painting themselves into a corner, making the change at the last possible minute (leaving in the word "measured" all the way up to the end of the rate hikes, for example). On the other hand, you don't want to totally surprise the market. It's an even tougher problem than the hangman's paradox.

So how do you maintain your flexibility without introducing too much uncertainty into the bond market? Very carefully. A review of St. Louis Fed president Poole's remarks from this spring are in order. What should the new "stock phrase" be? It needs to have a clear interpretation without being too confining given that we seem to be approaching a shift in policy stance. Comments are open.

UPDATE: Mark Thoma read the same WSJ article and responds,

For now, the problem is how to change or remove the current language without having the market lock into a particular view of future policy. If the market anticipates a particular path as a result of changing or removing the language, say a pause in rate hikes, that would undermine the flexibility altering the language attempts to achieve.

From the NY Times:

WASHINGTON, Dec. 7 (Bloomberg News) - Alan Greenspan, the Federal Reserve's longtime chairman, said Wednesday that it was "unwise" to focus the bank's interest rate policy only on reaching a "neutral" level that neither spurred nor restrained economic growth.

The complications associated with inflation "suggest that reliance on a single summary measure such as a neutral real interest rate would be unwise as a strategy for formulating monetary policy," Mr. Greenspan said in a written response on Nov. 28 to questions submitted by Representative Jim Saxton, chairman of the Joint Economic Committee of Congress, after Mr. Greenspan's testimony on Nov. 3. The panel released the responses on Wednesday.

Further down in the article, it looks like Mr. Greenspan is of the opinion that the solution to the "conundrum" is part savings glut and investment dearth.

Asked why long-term bond and mortgage rates had declined even as the Fed raised short-term rates, Mr. Greenspan said that lower inflation, high global savings and "low levels of intended investment" had pushed down long-term rates worldwide in the last 10 years.

Greg Ip adds a bit concerning the yield curve in the WSJ (subscription required):

In his letter, Mr. Greenspan, as he has in the past, questioned the usefulness of the gap between short- and long-term interest rates, or "yield curve," in forecasting economic growth. Historically, a narrowing of that gap, called a "flattening" yield curve, has foreshadowed slower growth. When short-term rates rise above long-term rates, a recession often follows. The yield curve has flattened significantly in the past year, which some analysts say portends a sharp slowdown.

The full text of the letter is available at the WSJ website.

Term papers must be coming due from sea to shining sea. My site statistics are showing all kinds of interesting search terms that brought people here from (fill in the blank).edu. Sounds like Cold Spring Shops is seeing something similar.

Word of advice: Blogs themselves are not the greatest scholarly sources for term papers. However, they can be useful for your research. Most bloggers provide references (lots and lots o'links) with their posts. So if Google brought you here, I hope that you find a link to a paper, news item, government source or something else that can add that extra touch to your term paper. I can envision cases where citing a blog would be acceptable (even desirable), but you're taking your chances.

For next semester, I would like to make an assignment for my principles course that gets students reading the economics blogs and seeing what they are, what they aren't, and how they can benefit from them. I'll keep you posted.

Also in the category of "'Tis the season", my finals are done on Tuesday. Posting will be somewhat sporadic until then. Fortunately, I'll be done in time to comment on the FOMC meeting.

From ABC News:

Michael Viscardi, a senior from San Diego, won a $100,000 college scholarship, the top individual prize in the Siemens Westinghouse Competition in Math, Science and Technology.

Viscardi said he's been homeschooled since fifth grade, although he does take math classes at the University of California at San Diego three days a week. His father is a software engineer and his mother, who stays at home, has a Ph.D. in neuroscience, he said.

...

Viscardi tackled a 19th century math problem known as the Dirichlet problem, formulated by the mathematician Lejeune Dirichlet. The theorem Viscardi created to solve it has potential applications in the fields of engineering and physics, including airplane wing design. He said he worked on it for about six months with a professor at UCSD.

"He is a super-duper mathematics student," said lead judge Constance Atwell, a consultant and former research director at the National Institutes of Health. "It was almost impossible for our judges to figure out the limits of his understanding during our questioning. And he's only 16 years old," she said.

Some news stories described his project. This article goes into even more detail. This is an outstanding achievement and Viscardi sounds like a prodigy in more than one area.

The NY Times, on the other hand, had this to say about Viscardi.

Michael Viscardi, a senior from San Diego, also won a $100,000 grand prize for his entry, a project that tackled a centuries-old puzzle in mathematical physics.

If you haven't checked out his blog, do so. Vote for him by clicking over to this site.

John Palmer is on the economics faculty at the University of Western Ontario.

BLS News Release:

Nonfarm payroll employment grew by 215,000 in November, and the unemployment rate was unchanged at 5.0 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Over the month, job growth was widespread, with large gains in construction and food services.

Barry Ritholtz took the "under" and was just barely right.

Earlier this week, I said that if it didn't hit 200,000 we'd all be scratching our heads over the weekend. Now, if only we could string three or four of these in a row.

Off to class. More later.

UPDATE: Here's what the BLS had to say about Hurricane Katrina:

Beginning in October, questions were added to the household survey to identify persons who evacuated from their homes, even temporarily, due to Hurricane Katrina. Data collected through these questions do not represent all evacuees; persons living outside the scope of the survey—such as those living in hotels or shelters—are not included. The questions were asked of persons in the household survey sample throughout the country, since some evacuees relocated far from the storm-affected areas. The questions also determined whether evacuees had returned to their homes by the time of the survey. This additional information enabled analysis of the employment status of this subgroup of evacuees. (The total number of evacuees estimated from the household survey may change from month to month as people move in and out of the scope of the survey.)

Information gathered in November showed that about 900,000 persons age 16 and over had evacuated from where they were living in August due to Hurricane Katrina. These evacuees either had returned to their homes or were living in other residential units covered in the survey in November. Half of the evacuees had returned to their August 2005 residences. Of all evacuees identified, 55.2 percent were in the labor force in November. The employment-population ratio for these evacuees was 43.9 percent. The unemployment rate for persons identified as evacuees was 20.5 percent; it was much higher for those who had not returned home (27.8 percent) than for those who had returned (12.5 percent).

PGL notes that the household survey showed a drop in employment and that the employment/population ratio (e/p) fell from 62.9 to 62.8.

Drilling down a little further into the household data we see that e/p increased slightly for white women and white teens while e/p for African-Americans fell from 58.5 to 57.3.

So then we read the BLS's statement on page one of the report:

In November, the state population controls used for the household survey were adjusted to account for displacements due to Hurricane Katrina. These adjustments had a minimal impact on the national household survey estimates.

Perhaps minimal on the total number, but if the displaced residents are disproportionately African-American, it may affect those numbers. To be honest, I'm not sure if their population controls take race into account or how reliable those adjustments might be for this sample. I think it might be too early to say just how much of it is a statistical quirk and how much is truly the impact of Katrina on African-American unemployment. But it does suggest a sizeable impact on African-American unemployment that stands out in today's data.

African-American teenage unemployment jumped from 32.9% to 38.8% this month. It is now at the highest level since August 1995. For those who want the longer view, here is the chart I generated from the BLS website (which has one of the best web facilities for getting the data just the way you want it).

Most other aspects of the labor data appear to be holding their own or slowly improving. This picture is not, and not just because of the hurricanes either. That is a little disconcerting.

UPDATE 2: Andrew Samwick also weighs in.

From the Wall Street Journal:

Though Ford's plan, dubbed the "Way Forward," is still being formulated and is subject to change, the nation's second-largest auto maker is likely to shutter assembly plants in St. Louis, Atlanta and St. Paul, Minn., according to two people familiar with its product plans. Also slated for closure are an engine-parts plant in Windsor, Ontario, and a truck-assembly plant in Cuautitlan, Mexico, said these people.

...

"Gone are the days when we are going to sell 400,000 Explorers [a year] without incentives," said Ford sales analyst George Pipas, commenting on November's results. "It's sayonara."

Sayonara, indeed. And konnichiwa, Toyota and Honda.

UPDATE: James Hamilton has more.

For the first time in five years, rates are on the rise in Europe. Read the Reuters story.

Macroblog had a good post about it yesterday (UPDATE: and another today).