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August 31, 2006
Core inflation lower than expected--but how much does rounding matter?
After reading the FOMC minutes, I became convinced that it would take a spike in inflation (particularly the core measure) to get the Fed to resume the rate hikes in September. Well let me revise my priors upward once again. Today's inflation figures make it more likely that the Fed will keep rates where they are. But it does little to ease my concern that more increases are on the way in the months ahead. The year-on-year measure is still higher than many would like. The longer it stays that way, the harder it is to get it down (unless you get lucky like we did in the mid-'90s).
So the expectation was for the core to rise by 0.2% and it only rose by 0.1%. Reuters has the story.
WASHINGTON (Reuters) - Core U.S. inflation rose less than expected in July, but the year-over-year pace remained elevated, according to a government report on Thursday that the inflation-wary Federal Reserve will examine.
Core consumer prices rose a less-than-expected 0.1 percent in July, but the year-on-year rate of nonfood, nonenergy inflation remained at 2.4 percent, the highest since September 2002, a Commerce Department report showed.
Analysts polled by Reuters were expecting a 0.2 percent gain in core consumer prices, an indicator that will be a factor in the Fed's decision whether to hold interest rates steady.
For the Federal Reserve "this is another reason to not increase," said Robert MacIntosh, chief economist at Eaton Vance Management in Boston.
Or another reason to go to three decimals as the BLS is doing for the Consumer Price Index. Today's report is on the PCE which, presumably, will remain a one decimal series. (UPDATE: See comments.)
Not that it makes a whole lot of difference in the long run. If there is a lot of rounding down this month, it will just be more likely that it will round higher next month. But it does make one cautious about interpreting the difference between 0.2% and 0.1% in one month's change.
But even if it were a 0.2% in the PCE price index, it probably wouldn't be enough to move rates at this moment in time. The more incoming data we receive, the more it looks like the Fed will simply pause until the recession threat subsides, even if core inflation remains at current levels. They remain committed to preventing further increases in core inflation, but are not rushing towards "disinflation". If we get some relief on energy prices, we might just get lucky, just like in the '90s.
The march of data continues tomorrow with nonfarm payroll employment.
UPDATE: Macroblog links to the Dallas Fed's trimmed mean PCE inflation rate and is not ready to "declare victory" over inflation.
Posted by William Polley at 11:20 AM | Comments (2) | TrackBack
Midwest economy still expanding, but is the rest of the country slipping into recession?
Apropos of my last post which lauded the midwest economy, we have a new data point from the NAPM-Chicago business barometer. Via Reuters:
NEW YORK (Reuters) - Growth in business activity in the U.S. Midwest slowed slightly in August, a report showed on Thursday, but the data may signal the economy is in recession.
The National Association of Purchasing Management-Chicago business barometer slipped to 57.1 from 57.9 in July, for a 40th straight month of growth. Economists' median forecast had put the index at 57.0. A reading above 50 indicates expansion.
However, according to Kingsbury International, a partner of NAPM Chicago, which puts out The National Association of Purchasing Management-Chicago business barometer, "the U.S. economy could be in a recession at this time."
...
Although the NAPM Chicago index has shown expansion for 40 consecutive months, with an average reading of about 59, in the past three months the reading has been below that average.
"In four of the last five recessions, the slowing of the Chicago business barometer signaled a recession either one or two years later," Kingsbury International said in a report.
Let us first take note that 40 months of expansion with an average reading of 59 is a pretty good run. But I would hesitate to say that slipping to 57.1 might be an indication that we are already in a recession. In fact, if you look at the entire series, you will see several instances where the indicator his touched 50 without recession--most notably 1985, 1995-96, and 1998. Kingsbury International is saying that in four out of the last five recessions were preceded by decreases in the series. But there are at least 4 (depending on how long or large a decrease you want) cases where a decrease in the series produced no recession. The power of this test (probability of rejecting the null when it is false) is not good.
The economy is slowing, and we may be on the cusp of a recession--perhaps still with the opportunity for a soft landing. However, if a recession has already begun with the Chicago business barometer at 57 it would be the first time since 1973 that something like that has happened. I don't think that's likely.
Posted by William Polley at 10:50 AM | Comments (0) | TrackBack
Prosperity on the plains? Ya sure, you betcha!
[This started out being a single topic post, but it presented an opportunity to weave together a number of things that have come up in the news lately and have been on my mind. There is a common theme.]
Joel Kotkin looks toward my old stompin' grounds and likes what he sees. (Wall St. Journal)
Fargo-Moorhead, the pair of cities straddling the Red River (the boundary between North Dakota and Minnesota), is a thriving metropolis of slightly less than 200,000 that grew by over 20% between 1990 and 2000 and has added an additional 4,300 people over the past five years. One in five newcomers was an immigrant. Bismarck has seen a similar surge in population, growing by 3% over the past five years.
...
...According to the National Science Foundation, North Dakota ranks No. 2 in academic R&D dollars per $1,000 of gross state product, right behind Maryland and right ahead of Massachusetts. It ranks fourth in technology companies as a percentage of all business startups.
...
If the energy and technology booms bring more high-end workers to Bismarck, the broader labor shortages are driving up salaries, on average some 15% across the board between 2002 and 2005. This movement is even helping those workers who have historically had the lowest salaries. Bismark's McDonald's restaurants now start pay at upwards of $8 an hour, with some stores offering "signing bonuses" of between $100 and $150 to work under yellow arches.
Yes, opportunities abound, and the quality of life is good too. According to Bizjournals.com, the west and midwestern plains states are pretty good places to live and do business. In a survey of 577 "micropolitan" areas, the west and midwest were well represented. Bozeman, MT came in first. Minnesota has 7 in the top 50. Phil Miller will be pleased to know that Mankato came in 16th. David Tufte's home of Cedar City, UT was 48th. Here in Macomb, IL we made the top hundred (94th) which puts us in roughly the top 16%. Macomb narrowly misses the top 10 (11th) in percentage of residents with graduate degrees. Make no mistake--big university in a small town rockets a place to the top of a list like this. There is a lot to be said for living in a small town with a big (or medium sized) university. We have access to performing arts... a jazz festival that rivals those in much larger cities is coming up in a couple weeks. In October, the touring production of RENT comes to town. We have libraries, broadband access, and Division I athletics to entertain us. Not bad for a city of 20,000. By the way, micropolitan areas are defined as follows:
Micropolitan areas are smaller than metropolitan areas. Each micropolitan area consists of a county or cluster of counties that are economically dependent on a central city, town or village with 10,000 to 50,000 residents. The U.S. Office of Management and Budget has classified 577 micropolitan areas across America. Statistics in this study cover all portions of micropolitan areas, not just their central communities.
With such a good quality of life in places like Fargo, Iowa City, and Macomb a person can follow his or her vocatio and be very happy, very unlike the "Great Gatsby." As it happens, Robert Frank discusses happiness in today's NY Times,
Gatsby’s unhappiness may also be explained in part by the finding that those who focus most consciously and intensely on material success also tend to experience low levels of measured happiness. This is a singularly important finding for the many incoming freshmen whose only apparent goal is to become fabulously wealthy by age 25.
A far more promising strategy, according to the happiness literature, is to seek work you love. Those who find such a calling typically become deeply engaged in their professional lives. And engagement, in turn, leads to expertise, which in some fields, at least, leads to wealth. Finding work that you value for its own sake is thus not only a promising path to happiness, it may also increase your chances of becoming rich. But even if not, it will improve your odds of becoming an interesting person, someone who is attractive to both friends and potential mates alike.
One can follow that strategy anywhere if you really want to, even in places like Fargo, Iowa City, and Macomb. Furthermore, with the internet and modern supply chain management, we in the smaller metro areas (and micropolitan areas) can partake of the conveniences of modern life that make us wealthier just the same as folks from the coasts. That would not have been the case in the 1920s or even the 1960s. The fact that I can communicate these thoughts with you, my readers from New York to Australia, from the hamlet of Macomb, IL is itself an indication that we live in amazing times. It's difficult to measure it, but it makes me happy. And I count it as wealth.
Don't get me wrong. The picture is not entirely rosy. This is not a Panglossian "best of all possible worlds". But neither is the bottom falling out. When McDonalds is paying $8/hr (something that I last saw in Iowa City in about 1999 at the peak of the dot-com boom), that's something you can't ignore.
Posted by William Polley at 12:54 AM | Comments (0) | TrackBack
August 30, 2006
Fed's Lacker explains his dissenting vote
Via Reuters:
Lacker, explaining his decision at the Fed's Aug 8 meeting to break with the majority and vote for a rate increase, told Bloomberg Television: "I dissented because I thought we needed to bring inflation down more rapidly than would otherwise be the case without a move at that meeting."
"The risk of raising rates at that meeting for lower real growth was not appreciable and, moreover, I didn't think real growth moderating -- as it's likely to over the next couple of quarters -- was going, by itself, to bring inflation down," he said. "I think there is a danger of inflation becoming entrenched at the level it is now."
He said that since Fed officials last met, he had seen nothing in the data to change his assessment of the outlook.
In related news, James Hamilton has a different take on the recent data.
Posted by William Polley at 03:38 PM | Comments (0) | TrackBack
August 29, 2006
FOMC Minutes
The minutes of the August FOMC meeting are out. While they tell a story that we already know a great deal about, they do fill in a couple of gaps in what we know about what the Fed is thinking.
Some selected paragraphs that convey the message...
The staff forecast prepared for this meeting indicated that real GDP growth would slow in the second half of 2006 and 2007, and to a lower rate than had been anticipated in the prior forecast. The marking down of the outlook was largely attributable to the annual revision of the national income and product accounts, which involved downward revisions to actual GDP growth in prior years and prompted reductions in the staff’s estimate of potential output. The slowdown in the housing market, the effects of higher energy prices on household purchasing power, the waning impetus of household wealth effects on consumer spending, and the effects of past policy tightening were expected to hold economic growth below potential over the next six quarters. Core consumer price inflation was projected to drop back somewhat later this year and next, mainly as the effects of higher energy and import prices abated.
The fact that their forecast has been revised downward recently is significant. It was a close call anyway, and a downward revision could easily tip the scales for a lot of people. Further down the minutes...
Some participants noted that global demand remained strong, potentially adding to worldwide pressures on resources. Increased geopolitical risks, particularly related to developments in the Middle East, continued to put pressure on energy prices, and the prices of many other commodities also had firmed over the intermeeting period. Central banks had been raising interest rates globally, however, and this was viewed as a factor that should help to restrain global inflation pressures. But it was also noted that the recent decline in the foreign exchange value of the dollar could lead to a weakening of import competition in the form of increases in the prices of tradable goods in the United States.
See also: Dance of the bankers. One cannot ignore the fact that other central banks are raising rates. Global markets are integrated well enough that it could lead to exactly what they suggest in the last sentence. And that would mean... you guessed it.
As at the June meeting, all participants expressed concern about continued elevated readings on core inflation and inflation risks going forward. Several participants took note of the revisions to historical data that painted a more worrisome picture of cost trends; measures of unit labor costs had been marked up, reflecting upward revisions to labor compensation and downward revisions to labor productivity. Core PCE inflation now appeared to have been running at or above a 2 percent annual rate for more than two years, with prices accelerating over the first half of 2006. Many participants noted that the extent to which the increase in core inflation so far this year reflected transitory or persistent influences remained unclear. The recent pickup in price increases appeared to be broad-based, and a number of business contacts reported greater ability to pass through higher costs. However, some types of price pressures were not likely to continue to increase. The recent acceleration in shelter costs, which contributed substantially to the increase in core inflation this year, could prove short-lived. Moreover, while energy prices had risen further in the intermeeting period, energy prices could well level out in coming quarters. Also, the anticipated moderation in aggregate demand implied that pressures on resource utilization likely would not increase and could abate to a degree going forward. Finally, inflation expectations appeared to have remained contained despite adverse news about prices. In light of these factors, most participants expressed the view that core inflation was likely to decline gradually over the next several quarters, although appreciable upside risks remained.
In the Committee’s discussion of monetary policy for the intermeeting period, nearly all members favored keeping the target federal funds rate at 5-1/4 percent at this meeting. In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed. But with economic growth having moderated some, most members anticipated that inflation pressures quite possibly would ease gradually over coming quarters and the current stance of policy could well prove to be consistent with satisfactory economic performance. Under these circumstances, keeping policy unchanged at this meeting would allow the Committee to accumulate more information before judging whether additional firming would be necessary to foster the attainment of price stability over time. The full effect of previous increases in interest rates on activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much. Following seventeen consecutive policy firming actions, members generally saw limited risk in deferring further policy tightening that might prove necessary, as long as inflation expectations remained contained.
All members agreed that the statement to be released after the meeting should convey that inflation risks remained dominant and that consequently keeping policy unchanged at this meeting did not necessarily mark the end of the tightening cycle. They concurred that an indication that economic growth had moderated was appropriate, and a consensus favored citing the same reasons for that moderation as in the June statement. Members also agreed that the statement should both mention factors contributing to the likely moderation of inflation pressures over time and reiterate the forces that were seen as having the potential to sustain inflation pressures.
Though rather lengthy, I quote it all because each sentence has significance. Overall, I get the picture that despite the fact that inflation has been running high, and energy prices have not abated yet, the slowing of economic growth should be enough to take the pressure off. If they are correct that energy prices will level off and core inflation at least does not accelerate further, they will have timed everything about right. They recognize the policy lags that have been in alternating between the front and the back of my mind for the last year. To put it succintly, they are betting that they are not behind the curve and hoping that they are a little ahead of the curve if there is to be a coming disinflation (albeit a slight disinflation). But it seems to hinge a lot on the revised forecast and the impression that growth is slowing. Yet when talking about inflation, they use words like:
The recent acceleration in shelter costs, ... could prove short-lived.
...energy prices could well level out...
...could abate to a degree...
Finally, inflation expectations appeared to have remained contained despite adverse news about prices.
The last is really quite a statement about the confidence in the Fed's ability to fight inflation should things get even worse. No small feat. But note that when it comes to inflation, there is heavy use of words like "could" and "appeared" and the like. That is telling. Inflation is, right now, the real wild card in the game. We do not know what is going to happen next. It "could" turn out ok, but the risks are palpable. Slowing growth, on the other hand, is becoming more and more of a fact. Whatever our deep-down feelings are about Phillips curves might be, most of us do accept that, ceteris paribus, slowing growth on the demand side does temporarily take some pressure off of inflation.
But as they say, ceteris is not always paribus.
And further down we see a short explanation of Mr. Lacker's dissent.
Mr. Lacker dissented because he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged. The inflation outlook had deteriorated in the intermeeting period; the recent surge in core inflation had persisted and appeared to be broad-based, while the revision of the national income and product accounts indicated a recent upswing in compensation and unit labor costs. Although real growth was likely to be somewhat lower in coming quarters, in his view it was unlikely to moderate by enough to bring core inflation down. He noted, moreover, that real short-term interest rates had fallen in the intermeeting period and were still low relative to rates typically associated with sustained expansions.
Similar concerns were expressed by Martin Feldstein. I have noted my own concern over real interest rates here and here. This seems to be Mr. Lacker's concern as well. If you get behind the curve, nominal interest rates need to go even higher than they otherwise would because you need to get the real rates (pushed down by surging inflation) up. As just about all of us have said at one time or another, this is a really tough call. The entire episode reinforces the fact that the Fed is concerned enough about the slowdown (in all likelihood influenced by their revised forecast) that they are willing to take what any central banker knows is a risk. Not being privvy to the forecast and everything else that was said in the room, I'm prepared to give them the benefit of the doubt to a certain extent. But it is clear from the minutes that the market should not interpret this as the end of the hikes. Let's hope it doesn't put them behind the curve.
Finally...
The Committee then turned to a discussion of the goals and principles that should guide the review of its approaches to policy communications that it had recently undertaken. Participants agreed that communication was important for democratic accountability and could promote the effectiveness of policy. Although considerable strides had been made in FOMC communications over the past ten years or so, participants generally thought that further advances were possible. In that regard, consideration of how the Committee expressed both its economic objectives and its assessments of expected progress toward those objectives was likely to be particularly important. Conveying the degree of uncertainty and conditionality about Committee expectations of future developments was seen as a major challenge. It was recognized that communications should support appropriate decisionmaking, including respect for the diversity of views that contributed to good decisions. Participants agreed to continue the Committee’s review of communications issues at the FOMC meeting in October.
That is a nice note on which to end the minutes. I look forward to the transcript of this in five years. I'm sure they realize that calling it a "major challenge" is quite an understatement. While "impossible" might be too strong, they do have their work cut out for them. I am hopeful that they will learn from the "measured pace" episode and be more aware that certain catch phrases can take on a life of their own. Everyone needs to remember that transparency in the process does not imply certainty over the outcome.
UPDATE: CNNMoney reports:
Economists are mixed since it all depends on which portion of the minutes you find most important. You can clearly make a case for why the Fed will hold pat in September or why the central bank will once again raise rates.
"Clearly" might be a stretch. My read of the situation at present is that the default position for the next meeting is to keep rates unchanged and that it will take some unexpected spike in inflation data to move them off that position. While I share Lacker's concern that inflation and inflation expectations could become entrenched if they are not careful, I would not necessarily predict that the next data point in particular will cause them to reverse course. It depends on whether you are thinking 3 weeks or 3 months ahead. So for now I would look for no change at the next meeting unless something pretty drastic happens in the inflation data. But looking out over the next few months, more rate hikes could be on the way if inflation doesn't abate as it "could".
Posted by William Polley at 04:20 PM | Comments (0) | TrackBack
August 23, 2006
Beloit College's annual "Mindset List"
As you probably know, Beloit College has been publishing their annual "Mindset List" since 1998. The list is mostly a series of references to things that entering college freshmen would know nothing about. For example, from the very first list there was: "'The Tonight Show' has always been with Jay Leno."
Presumably the list is something of a public service to professors everywhere. Once I am reminded that today's freshmen have known nothing but Jay Leno, I am duly warned that reprising Johnny Carson's "Carnac" routine will probably fall flat on my students.
The first few lists were funny, but it is getting harder for them to come up with a lot of new items of great significance. Not only that, but the lists are getting longer which only adds to the obscurity of some of the references. I'm not sure that an item from this year's list like "Small white holiday lights have always been in style" would have made their first few lists.
While I think they are reaching on some of the items, and while it is starting to look like a list of things that happened in the year that these freshmen were born, it is still worth a couple minutes of your time. Chances are you'll find a couple that make you smile.
They have always known that "In the criminal justice system the people have been represented by two separate yet equally important groups."
Do college students watch "Law and Order"?
Diane Sawyer has always been live in Prime Time.
I will ask my students tomorrow if they know who Diane Sawyer is.
They are not aware that "flock of seagulls hair" has nothing to do with birds flying into it.
Ha ha.
They have never put their money in a "Savings & Loan."
Nor have they heard of the S & L crisis. This is relevant if you teach macroeconomics.
Posted by William Polley at 12:32 PM | Comments (1) | TrackBack
August 22, 2006
Fields medal given for proof of Poincaré Conjecture
Actually, four mathematicians received the coveted Fields Medal for work in a variety of areas. The NY Times carries a story today that lists all of them. However, the big news concerns Grigory Perelman, a Russian mathematician, who was one of the four named today, but refused the prize.
And while the Times article gives a little more background on the problem than the AP story carried by CNN and the Wall Street Journal, they all leave something out that is of interest to mathematicians. (But of course the mathematicians are not getting their news on this subject from the AP.)
Perelman may have actually succeeded in proving Thurston's Geometrization Conjecture which includes Poincaré's Conjecture as a special case. If the proof holds, it would be quite an achievement. However, according to the Mathematical Association of America's FOCUS newsletter this month, Perelman does not seem intent on publishing his result. In fact, the preprints are not complete to the standards of mathematical literature. Two other mathematicians, Bruce Kleiner and John Lott, have attempted to fill in some of the details Perelman left out.
The Clay Mathematics Institute is offering a million dollar prize for the solution to this and other famous math problems. (The link has an even better description of the conjecture.) However, the rules state that the work must be published and withstand two years of scrutiny. So Perelman receives (but turns down) the Fields Medal, but will he win the million dollar prize from the Clay Institute? That remains to be seen.
Posted by William Polley at 10:38 AM | Comments (0) | TrackBack
August 20, 2006
What market failure does a central bank address?
And does it succeed? Better then other (private, market-based) alternatives?
This post certainly cannot answer such momentous questions. I would, however, like to use these questions as a focal point for thinking about one of the hot topics on the economics blogs. I think a lesson that comes out of this (are you listening, grad students?) is that monetary policy questions can have very deep roots in fundamental questions about the nature of money and markets. Recently, Greg Mankiw posted a letter from Milton Friedman on his blog. The final thrust of the letter was as follows. Quoting Friedman:
Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.
Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level.
A wonderful round of comments ensued. Among them was Divison of Labour's Lawrence White. White actually wrote two posts. Quoting from the earlier of the two,
Do we need to keep the Fed around because the money multiplier might collapse again? Mankiw is right that the money multiplier declined sharply in the 1930s, but why did it? The proximate cause of the collapse in the 1930s was bank runs and fear of more bank runs. The underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs and no money-multiplier collapse in Canada in the 1930s, which had neither restriction. Fortunately we no longer have the geographic restrictions in the US. We still have note-issue restrictions. Friedman’s brief letter neglected to mention an important adjunct to his base-freeze proposal that he has elsewhere mentioned, which is that shifts in the public’s demand to hold currency could be accommodated by letting commercial banks freely issue currency redeemable for base money. With well-diversified note-issuing banks, a collapse of the money multiplier would not occur.
Over at Marginal Revolution, Tyler Cowen enters the fray.
Greg counters that the lender of last resort function of the central bank may interfere with a fixed monetary rule. Fair enough (in fact I think the earlier Milton admitted this point, although the later Milton may agree with Larry White's comment on Greg), but my objection is more day-to-day. Hardly anyone is willing to live with the consequences of a strict rule for the monetary base.
In particular, the resulting short-term interest rate volatility would be much higher than, prior to experience, most people had expected. Liquidity is quite scarce. The demand for funds goes up and sometimes, in the absence of Fed smoothing, the supply just isn't there. Price has to adjust. No, interest rate volatility is not the end of the world but few people believe this makes for a better marketplace. That is why hardly anyone in the world of central banking defends monetary base targeting these days, even though the idea was fairly popular twenty-five or thirty years ago.
In a modestly growing economy, holding the money supply absolutely constant will approximate a "Friedman Rule". Students of macroeconomics will recognize the Friedman Rule as the well-known result that in a certain type of cash-in-advance model the optimal policy is to have deflation equal to the rate of time preference. This also results in a zero nominal interest rate.
In practice, with output varying around a long run trend, fixing the money supply would anchor the long-term interest rate only. Short term rates would vary depending on the shocks to output (and, importantly, changes in expectations of future output). For example, if output is expected to increase at a faster rate, borrowing will increase and the short-term rate will rise.
One of the successes of modern central banking is certainly the ability to smooth the short-term interest rate fluctuations. The directives of the FOMC, such as the most recent one that provoked so much debate, are instructions to carry out open market operations aimed at keeping the short-term interest rate at a certain level for the next six weeks. This aspect of the task is mechanical and is familiar to students in principles of macro. Without the Fed performing this function, long-term rates may be well achored, but short-term rate will fluctuate per Cowen's analysis.
Indeed one of the thorny puzzles for the Fed of late has concerned the short vs. long term rates. It was Greenspan's "conundrum"--how the long term rate could stay so low even as the short rate was rising so steadily and consistently. But this is a non-issue under a Friedman Rule. Even if we do not go quite that far, a credible commitment to low inflation should bring about increased stability at the long end of the yield curve. But to maintain that credibility in the long run, you might have to sacrifice a little bit of control at the short end. That is, you might have to let the short rate rise (or fall) in response to changes in expectations. The policymaker cannot have it both ways. You can't target both the money supply and (short-term) interest rates.
But what if, as White suggests, we allowed banks to issue private notes and traded those notes in financial markets. Suppose output is temporarily high. With a fixed supply of government supplied money, the price level would tend to fall as money becomes more precious. There is a need for more liquidity. As holders of highpowered money, banks could create the liquidity by issuing notes that would circulate until the need for liquidity subsides. These notes could be presented to settle debts between banks and between firms. If such notes were traded on an exchange, it would be immediately apparent whether there were too few or too many in circulation and adjustments could be made quickly.
Such an arrangement sounds like a 21st century version of 19th century free banking (the latter, not coincidentally being an area of interest for White). The thought of an institution or an exchange for clearing the notes reminds me (at least in a very general sort of way) of the Suffolk Banking System. I refer interested readers to a number of papers on the subject by Arthur Rolnick and Warren Weber (papers can be found at their websites). Along with the late Bruce Smith, they wrote a particularly concise and informative introduction to the subject in the Minneapolis Fed Quarterly Review. They conclude that the Suffolk Banking System, a clearinghouse for bank notes that existed in the early 19th century, was a natural monopoly. One piece of evidence in favor of this was that Suffolk's rival that eventually drove them out of business, the Bank of Mutual Redemption (BMR), may have engaged in predatory pricing. Clearninghouses such as Suffolk and BMR required participating banks to keep deposits with them (much like the Fed accomplishes clearing of payments by transferring reserves that banks have deposited with the Fed). BMR offered interest on their deposits when they entered the market, but after Suffolk exited, BMR stopped paying interest.
Stories like this are informative because they help illuminate some of the functions of the payment system that we often take for granted. So why do we have a central bank? Is it because clearing payments is a natural monopoly? But one can legitimately ask whether modern financial market technology could accomplish this function. Would this market function freely enough that short term interest rate fluctuations would be optimally smoothed? And if this market functioned well, would we need a lender of last resort?
These are very penetrating questions that cut to the heart of a monetary system. They are fundamental questions that walk the fine line between money and credit. The fact that there is still a demand for an asset bearing a zero nominal interest rate suggests that there is a market friction. Do central banks alleviate that friction or make it worse. My assessment is that they do both from time to time. But a completely private market solution would surely be a bit messy until all the problems were worked out. If we tried another Suffolk Bank today, it might work better, but there is no guarantee that it would work perfectly. Not to mention the fact that I would be slow to give up the Fed's role as lender of last resort (recognizing that this has potential problems for a fixed money supply rule).
But at the same time, if the Fed became truly serious about price stability as its only long-term goal (yes, I'm aware that would require an act of Congress), we should expect financial markets and institutions to take on some of the responsibility for maintaining a smooth functioning system--provided that the law allowed them to do so. After all, one of the functions of currency is to overcome frictions caused by the lack of information. In this, the age of information, we may have our best chance yet of seeing private markets for near money instruments assume at least some of the role for financial market stability that the Fed assumes today. However our experience with the Great Depression makes us cautious of ceding that responsibility--a fact which is at the same time understandable and unfortunate.
Posted by William Polley at 03:27 PM | Comments (0) | TrackBack
August 08, 2006
Department of Faint Praise
From the Wall St. Journal:
"The key is that they believe inflation expectations have stopped rising," Peter Frank, currency strategist at ABN Amro said. "They have not been more dovish than was expected, and that's why the dollar has not collapsed."
The as-expected statement from the Fed is therefore unlikely to change the market's general dollar-bearish tone, analysts said.
Ouch.
Posted by William Polley at 05:43 PM | Comments (1) | TrackBack
The long awaited pause
Today, the FOMC decided to leave rates unchanged for the first time since June 2004. We knew it was coming eventually. Beginning last summer many of us started to wonder if a temporary end to the rate hikes would come by year's end. By year's end, it looked like it would be this summer. Even up until a few weeks ago, one last rate increase today would have been seen as likely. That sentiment eroded and practically disappeared last Friday. Speeches by Fed officials, including Mr. Bernanke's congressional testimony cracked the door and the non-farm payroll data threw it wide open. And while the statement was not as hawkish as some might have hoped, the late afternoon interpretation seems to be that the market believes more rate hikes are possible. It is also possible that the thought of a slowing economy is starting to sink in on Wall Street as well.
Around the web, Mark Thoma compares the language of the last two statements. Several things do stand out. First, they report that economic growth has moderated as opposed to "is moderating". They removed the statement about productivity gains, likely this was in light of this morning's news revising productivity downward for the last couple years and lackluster gains in the 2nd quarter. They also removed the sentence, "In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives." I would like to know about the discussion that led to the removal of that sentence. Personally, I don't think that sentence provided any particularly useful information. If there is doubt on that issue, the rest of it doesn't matter. Perhaps they were trying to cut down the excess verbiage.
Barry Ritholtz does not approve of the decision or the statement.
From the NY TImes,
The Fed appears less concerned about a recession. In its statement today, it described economic growth as moderating, not stalling or slumping.
And that does add credibility to the notion that more rate hikes are possible. If they were really worried that a recession was immenent, this would be the end, not just a pause.
Greg Ip does his usual fine work in the Wall St. Journal. Read the whole thing.
Also from the Wall St. Journal On-line, in their "Economists React" page, there are a number of good entries. This one caught my eye,
Richmond Fed President Lacker dissented in favor of an increase, so the vote was 9-1. That should not, however, be taken as a signal that the discussion was not contentious… I would imagine that there may have been other who could have gone either way and perhaps even some non-voters who would have dissented if they had a vote. So, now the Fed, economists, and market participants will sit back and watch the incoming data to figure out whether the economy continues to cool and whether there is any sign of a moderation in core inflation. RBSGC believes that activity may pick up a bit and that core inflation will remain too fast, so we look for one more rate hike on Sept. 20. -- Stephen Stanley, RBS Greenwich Capital
It is indeed possible that this was very contentious. The dissent of one member speaks volumes. Generally only one member dissents, even if there is deep division. This may be one of those times. It is also interesting to see some of the television commentary on the decision. Former San Francisco Fed President Robert Parry was on Bloomberg shortly after the decision and while he was not overly critical, he did not think that the present policy stance was too restrictive.
This decision is going to be critiqued for some time to come. There are plenty of commentators out there who wanted one more hike. Of course, I would be remiss if I didn't point out that there are plenty who think the Fed has already gone too far. My opinion remains that the real interest rate is low enough (barely cracking 1%) that it is not terribly restrictive and has room to move upward. Also, the Taylor rule indicates that current policy is still accomodative. There is a good possibility that rates will indeed be pushed higher down the road, and I'd rather see it sooner than later. While I would stop short of calling this a mistake, I think it is risky. I'm more worried about the inflation risk than the recession risk at the moment, and I don't think that monetary easing is going to suddenly reverse the labor market weakness that has lasted throughout this recovery. Nor do I think that another 25 basis points would capsize the labor market.
But for now, the decision is made. The Fed is taking the chance that moderating growth and the lagged effect of past rate increases will keep inflation at bay. They have confidence in their forecasts. If core PCE inflation holds steady in the next couple months, this could be the breathing room that they have been seeking. But the big question on many people's minds is what if core PCE inflation continues to tick upward? How long will the Fed wait to address the issue? Would they act in September or hold out until October? Until the next round of speeches by FOMC members, it will be hard to say. I will be particularly interested in the release of the minutes of this meeting to see what kind of concerns were expressed regarding inflation and the level of restrictiveness that members perceived in the current policy stance.
Just for kicks, I looked at what I wrote on June 29.
I can envision scenarios in which there is a pause in August, and that is something that I could not say about the June meeting.
And so it goes. If anyone asks me right now what I think about September, my response would be, "What part of data dependent don't you understand!" We really are in a mode of waiting to see if the Fed's forecast of moderating inflation turns out to be true. Depending on that data, the next two meetings could go either way.
Posted by William Polley at 04:44 PM | Comments (1) | TrackBack
August 07, 2006
And then the markets realized that a pause may not be great news after all...
The stock market likes low interest rates because they stimulate investment and because a lower interest rate means less discounting of future profits. Of course, a slowing economy is not good for investment or profits. Hence, all the jubilation over the possibility of a pause in the rate hikes might be a little premature. (CNN Money)
Yippee! Stocks rallied; bonds surged; bets for a rate hike Tuesday dwindled down to 16 percent from 41 percent the previous day, according to Chicago futures trading.
And within an hour the rally was gone.
"The market seemed to realize almost immediately that the Fed pausing now because it is worried about economic growth is not a good thing for stocks," said Ken Tower, chief market strategist at CyberTrader. "Weaker economic growth means weaker profits."
...
[MKM Chief Economist Michael] Darda said that he thinks the economy will show greater strength in the fall, which could lead to a need for more rate hikes. Additionally, all the analysts said that they were worried that rising inflation would force more rate hikes going forward, a scenario even more troubling for stocks.
Not sure about Darda's comment. I'd expect somewhere in the 2.5% to 3% range for GDP growth, which is not necessarily enough to trigger more increases. It is, of course, the inflation part that worries me. If they let real rates fall and expected inflation rise as a result of pausing too soon, then you could have a much more difficult situation to deal with.
So... bottom line: what will they do? The IEM is putting it at about 70-30 for a pause. That's up from 60-40 on Friday. It will probably inch higher by tomorrow. At this point I'd regard a pause as at least that likely. I still think there is a possibility of an increase but the more the market's expectations get entrenched, the further the Fed would have to go out on a limb to go against them. So it's not a sure thing, but it's tough to bring yourself to bet against it. I would prefer one more increase, but you knew that already.
Will there be dissent? Who knows. That's not something I'm going to try to predict. Remember that in Fed culture dissenting sends a strong message. Generally no more than one person dissents even if there is significant opposition. Early in the term of a new chair, I would expect that members would want to maintain a unified front. The bar for dissenting might subjectively be set a little higher, even for hawkish members. If the vote is unanimous, I would not interpret that as meaning that there is no sentiment that rates need to go higher. We will need to see the minutes in 3 weeks to know more. I know that some of my more hawkish readers may want or expect someone to dissent. There may be, but I'm just saying not to expect it or read too much into the lack of it. A unanimous decision now does not preclude rate hikes in September or October, if necessary.
UPDATE: Barry Ritholtz puts a higher probability on an increase than I do.
I think the odds of a 1/4 point hike is much higher than people think; I place it at 49%, versus the 18% or so the Fed Fund Futures have on it
I'd split the difference at around 30%, maybe a little less.
Meanwhile, King Banaian returns to SCSU Scholars and would bet on an increase.
I know what the numbers say. I also think I have a handle on Bernanke; he is sufficiently stung by previous perceptions of being an inflation dove that he probably needs one good 'sting' of the markets to get them to pay attention to what he says rather than what they think he's going to do. I won't be surprised if the string of increases ends tomorrow, but I'm betting on the momentum instead.
...
This is a cautious bet, so I'm only putting down $10 -- i.e., half the beer money -- on a rise tomorrow. But still, at about 4-1 odds it's a nice opportunity. Besides which, if the Fed starts saying the economy has slowed... If I'm right, want to bet on the market's reaction? I say 'up'.
Sounds like King and I are on the same page. No one is talking about betting the farm here, but I certainly think the market's 18% probability is underestimating the potential for a surprise. How will the market react? Well, given how often I talk about the stock and bond markets overreacting to Fed statements, I'm not even going to guess. The market may need some time to digest it before it figures out where it is going.
Posted by William Polley at 02:55 PM | Comments (1) | TrackBack
Inflation and the labor market revisited
One of the nice things about blogging is that you can go back and revisit ideas from the past because the blog archives all of those old words and pictures as if you wrote them yesterday. For a professor, this is nice because invariably you want to bring up things that you discussed in the past, but a new set of students needs to get up to speed. In economics, it is essential to have access to that background. This post is in that spirit--just in time for classes to start in a couple weeks. Just about exactly one year ago I wrote this post that looked at the core CPI inflation rate and payroll employment starting from the trough of the last two recessions. Go back and take a look.
Here are the corresponding charts updated to the lastest data (including the labor market data from Friday).
The payroll charts tell us what we already know, but put it into context with the previous recovery. With the exception of the last few months, job growth has hovered around the 150,000 per month widely recognized as necessary to keep up with the growth of the population. There has not been the kind of robust recovery of jobs that came along after the 1990-91 recession.
Note also that the point in the recovery from the 1990-91 recession that corresponds best to today is early 1995. The labor market did experience a bit of a slowdown in 1995, and the possibility of recession was openly discussed. At the same time, inflation, which had been high at the start of the recovery, was starting to come down. This was the beginning of one of the most successful non-recessionary disinflations that this country has seen in the modern era. And in Feburary 1995, the Fed raised rates one last time by 50 basis points to 6.0% where it would stay until July when rates began to fall slowly for the next couple years.
Remember, the 1994-95 episode was a success in terms of a soft landing--a cooling of GDP to a sustainable pace, fall in inflation, and no recession.
Is it any easier to predict what is coming on the basis of this information than it was last year? Not really. I do have to say one thing, however. The totality of the picture is less encouraging than it was a year ago. Martin Feldstein shows his concern in Monday's Wall St. Journal opinion pages.
The Fed governors and Reserve Bank presidents appear to believe this [soft landing] will happen. Their "central tendency" economic projections, summarized in the July Monetary Policy Report, state that the Fed's favored measure of inflation, the PCE price index excluding food and energy, will decline from the 2.9% rate in the most recent quarter to between 2% and 2.25% in 2007, presumably on its way to Ben Bernanke's "comfort zone" of 1% to 2% in 2008. They project this to occur with real GDP growing above 3% and the unemployment rate remaining under 5%. Indeed, not a single one of the 19 FOMC members projected growth of less than 2.5% in 2007 or an unemployment rate above 5.25%.
Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.
The last recovery being an significant exception to that rule, but as we have discussed, that requires everything to go right, especially productivity. Feldstein continues...
The official estimates of productivity growth showed a gradual decline of productivity growth in the nonfarm business sector from 3.9% in 2003 to 3.4% in 2004 and 2.7% in 2005. The result of the slower productivity growth and rising compensation per hour (from a 4% rate in 2003 to 5.1% in 2005) caused the increase in unit labor costs to accelerate from 1.3% in 2003 to 2.1% in 2004 and 2.8% in 2005. Taking the new GDP estimates into account is likely to lower the calculated productivity growth rates and cause estimated unit labor costs to have risen faster than 3% in the most recent quarter. There is no reason to anticipate a favorable productivity surprise of the type that contained inflation in the 1990s.
...
While this risk provides a rationale for a pause at tomorrow's meeting, it would be wrong to focus just on this downside risk. The probability that inflation will rise above the FOMC forecast is at least as great. The unemployment rate of 4.8% still represents a tight labor market. Waiting for more data before deciding to raise rates is not costless. If the Fed does not act and core inflation continues to rise, expected inflation may rise further. Higher expected inflation would cause faster increases in wages and prices. If the core PCE inflation rate rises above 3% in 2007, it would take a very substantial slowdown and a large loss of GDP and employment to bring it back under 2%.
In assessing the current interest rate decision, the FOMC members should recall that during the Volcker and Greenspan years the Fed pushed the fed funds rate to 8% above the concurrent rate of CPI inflation in the early 1980s, to 4% in 1989 and to almost 3% in 2000. That measure of the real fed funds rate is now less than 1%.
The Federal Reserve has a difficult task ahead. It is understandable that it would like to achieve the soft landing of low inflation with continued solid growth. But that may not be possible. And if the Fed wants to convince the markets that inflation will be contained in the future, it must show that it is willing to take the risk of tightening too much.
Feldstein is entirely correct to point out the real fed funds rate is still a bit low. This is what I have railed about time and again. If it is not possible to have the soft landing as we did in the '90s, then this meeting is a test of inflation fighting resolve. One long term lesson this episode may provide future generations of policy makers is just how important productivity growth is for cushioning the economy in situations like this. Without productivity growth, and worse yet with further increases in oil prices, it forces the Fed to go further than it would have ideally wanted in order to get the real rate where it needs to be. I am sympathetic to the argument that they should have raised rates faster in the early going (2004) to head off the rise in inflation. But in light of the weak labor market data--a labor market that the above charts show just never got off the ground the way it did in the mid-'90s--I can't say that I would have done anything differently. To raise rates too quickly while productivity growth rates were falling might have choked off the recovery even sooner.
On that note, I conclude with this little blurb from the NY Times.
DO WE HEAR A PAUSE? The central economic news of the week will emerge from the meeting of the Federal Open Market Committee, which will decide whether to raise the benchmark short-term interest rate — now at 5.25 percent — yet another time. On the one hand, many economists predict that the Fed will leave things unchanged, which would be welcome news for investors, but then again, who knows? The dearth of one-handed economists is legendary. (Tuesday.)
Try as I might to be single-handed, I can't say for sure what the Fed will do. I can come up with a lot of reasons to raise them one more time. I do worry a bit about the 6 to 18 month picture for inflation if they pause now. I'd like the increase to be now and the pause to be for the remainder of the year. But the markets have made up their mind, and Bernanke may not want to stir them up too much. They could very well send a strongly worded statement that though they pause now an increase in October is the default option unless new data changes that stance. If such a statement comes off as credible, it would be an acceptable compromise. We shall see.
UPDATE: The September meeting escaped my mind. Change the above to read September or October.
UPDATE 2: It gets worse. Michael Mandel reports that productivity figures for 2004 and 2005 are likely to be revised downward.
UPDATE 3: Mandel was correct. Productivity was revised downward for the last couple years and the 2nd quarter of 2006 came in at 1.1 percent growth. The trend is downward. While Mandel tries to tell a positive story of the 10 year productivity growth rates, his chart shows exactly what is troubling in this situation. In the mid-'90s, the trend was reversing and going up making it easier to contain inflation. Today, the growth rate of productivity is falling.
Posted by William Polley at 02:30 AM | Comments (0) | TrackBack
Bad news on the oil front
Eight percent of U.S. oil production just got shut down. It is already affecting European markets. We'll see how this plays out. (Bloomberg)
Aug. 7 (Bloomberg) -- Crude oil surged 1.7 percent to $76 a barrel after BP Plc shut Alaska's Prudhoe Bay field, the largest in the U.S., because of corrosion in a pipeline.
An inspection completed in July found a leak in a pipeline, London-based BP said in a statement today. The shutdown will take ``days'' to complete, a company spokesman said. The BP- operated Prudhoe Bay field produces 400,000 barrels a day, about 8 percent of U.S. production.
UPDATE: Expect about a 3 to 5 cent increase in gas prices in the short term, according to this CNN article. James Hamilton has more.
Posted by William Polley at 02:18 AM | Comments (0) | TrackBack
August 04, 2006
The plot thickens
By now you've probably heard that payroll employment only increased by 113,000. And what did I just say?
Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.
Indeed, I am willing to listen. James Hamilton just posted his latest analysis showing that a pause is coming based on futures data, which he shows is a very good predictor. Hamilton writes,
In any case, the BLS release seems to have settled the argument, as least as far as the CBOT Fed watchers are concerned.
He's not alone. Here's a quote from the NY Times:
“This evidence should seal the case for a pause in rate hikes,” Nigel Gault, an economist with Global Insight, wrote in a research report today. “Given the slowing growth picture, the Fed is likely to decide that the prudent course is to await more evidence rather than risk overdoing the tightening” when it meets on Tuesday.
From the Wall St. Journal:
U.S. payrolls posted their fourth-straight tepid gain last month and the jobless rate spiked higher, likely giving Federal Reserve officials all the evidence they need to pause their two-year tightening campaign at next week's meeting of the Federal Open Market Committee.
"All the evidence they need"? "Seal the case"? Those might be a bit strong. Let's get one thing clear. The market does expect a pause. If you're predicting it based on what the markets (futures, bonds, and stocks) are saying, you've got to say pause. But that's not the end of the story. Will the Fed surprise the markets?
While my subjective probabilities may have changed, my basic analysis has not. Recent data has shown both a slowing economy and rising inflation. Given that the Fed knows how important it is to keep inflation and inflation expectations under control, they are paying very close attention to the inflation data. Until this morning's labor report, I would have (as I expect many at the Fed would have) put more priority on the inflation problem. The GDP report was not enough for me at the time.
But viewed together, the GDP report, the labor report, and other recent evidence all seem to point in the same direction. The economy is slowing. Not crashing. Not yet on the brink of recession. Slowing. Is that a reason to put the pause sooner rather than later? Perhaps. But I have a Ritholtz-esque concern. My concern is that if the Fed pauses on Tuesday the market interprets them as being done. If inflation does keep rising in the second half of the year, the accompanying rate hikes later could wreak havoc with the markets. How can the Fed prevent such misunderstanding? They'll need a very craftily worded statement. Something like, "...the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives" is not quite strong enough, I believe. Not exactly sure how I would word it, but if the Fed pauses now they need to clearly state that they will raise rates in October if inflation continues to rise.
With a well-worded statement, I could support a pause at this meeting. I still think that when they sit around the table on Tuesday they'll have enough ammo to support either decision. I've been anticipating a pause for a long time but for the last several months have been concerned that a pause too soon could allow real interest rates to fall too much and make things difficult later. And while I have been reluctant to bring it up because the Fed is somewhat independent of the political process (but then again, they don't operate in a vacuum either), it would be nice to pause in October before the election. Then comes December and the Christmas season. There is something to be said for firing one more shot now and hoping that you can ride out the rest of the year. (Just please don't characterize that as being "one and done".)
I want to believe that inflation will be kept under control by the lagged effect of previous rate increases, but I am not 100% convinced. I guess that makes me a "hawk" in the current circumstance. Overall, this is one of the toughest races I've ever had to handicap. I'd probably say 60-40 in favor of a pause in light of the labor data, which is in line with the IEM prediction at the moment. All I can say for sure is that whatever the outcome I will not be terribly surprised. The same cannot be said for the broader markets. They've made up their mind. I wouldn't underestimate the Fed's willingness to surprise them, but I wouldn't bet the farm on it either.
Working on a data oriented post (lest the blog be overrun with policy oriented handwaving)... should have it up this weekend. Have a good one.
Posted by William Polley at 01:54 PM | Comments (3) | TrackBack
August 03, 2006
Why do economists blog?
The Economist asks the question, but doesn't hit on any very satisfactory answers. New Economist links to the article and points us back to Brad DeLong's idea of the Invisible College--which I think does a much better job of explaining the value of academic blogging, of which economic blogs are a healthy subset.
I did find one bit from the article worth mentioning, however.
With professors spending so much time blogging for no payment, universities might wonder whether this detracts from their value. Although there is no evidence of a direct link between blogging and publishing productivity, a new study* by E. Han Kim and Adair Morse, of the University of Michigan, and Luigi Zingales, of the University of Chicago, shows that the internet's ability to spread knowledge beyond university classrooms has diminished the competitive edge that elite schools once held.
...
* “Are Elite Universities Losing Their Competitive Edge?” by E. Han Kim, Adair Morse and Luigi Zingales. NBER working paper 12245, May 2006.
I think that is true. A person can have access to the insight of a Brad DeLong or a Greg Mankiw anywhere in the world for the price of an internet connection. That means that my students at Western Illinois University can discuss what DeLong and Mankiw happen to be talking about that day. That didn't happen when I was in college. For a professor, the internet is a professional lifeline. Being a blogger connects you to the larger world in a way that is hard to define. My site statistics show hits coming in from all over the world. I may not have as many active commenters as the major sites, but comments are of generally high quality. There is a demand for what we do, and we get something in return, even if it is not measured in dollars and cents (or pounds or euros). As a professor, blogging about economics allows you to participate in conversations about policy and theory that used to happen only occasionally at conferences or in the faculty lounges of the "elite" schools. That is not to diminish the "elites". Any place where you can have a couple of Nobel laureates and someone like DeLong or Mankiw congregate in a hallway is still going to retain a prominent standing. But it is not in their interest to keep that hallway conversation to themselves. They want to influence the public debate. They want the immediacy that blogging provides. The ideas flow more freely. The invisible college grows.
Furthermore, blogging forces one to sit down and write. It disciplines a person to think about voice, audience, clarity, style, etc. It keeps you sharp intellecutally by reading everything that comes your way in your fields of interest. My publication record has not suffered as a result of blogging. If anything, I write more and think more clearly. It is also a good source of ideas for teaching and research. As the medium matures and as I mature as a practitioner, I expect that things will get even better. The economist as blogger is a phenomenon that is here to stay.
Posted by William Polley at 04:22 PM | Comments (1) | TrackBack
August 01, 2006
Inflation continues to creep upward... what next for Fed?
From the Wall St. Journal:
A price index for personal consumption expenditures -- or PCE -- that excludes food and energy increased by 0.2% in June, the third straight month it has risen that much. Compared with a year earlier, the core PCE price index grew 2.4% in June, the fastest growth since September 2002. The June rate was up from the 2.2% pace in May and April of this year.
Barclays Capital bond market strategist Michael Pond said the year-to-year increase is consistent with the Fed's forecast for the end of this year, but the "upward trajectory" seen already will concern policy makers.
And also...
Last month the Fed raised its forecast for core PCE inflation this year to 2.25%-2.5% from a previous projection of about 2%, while expecting 2%-2.25% inflation next year. The forecast suggested the Fed can tolerate inflation above its preferred 1%-2% zone for some time because it expects slowing economic growth and stabilizing energy prices to ease price pressures eventually.
Bank of America Treasury strategist George Goncalves said Tuesday's inflation data suggest the Fed will have to raise its short-term interest rate target again at its Aug. 8 meeting.
That's not the only news today. Manufacturing remains strong, and pressure on raw materials prices show signs of easing. (NY Times article).
The National Association of Purchasing Management-Chicago said yesterday that its regional index rose to 57.9 this month, from 56.5 in June. A reading greater than 50 signals growth. A separate index of prices paid for raw materials fell from its highest level in 18 years.
On days like this, I always look forward to Barry Ritholtz's take. I was not disappointed.
Once again, the portfolio wrecking crew know as "Team One & Done" have suckered investors for the umpteenth time (we have lost count) into believing that there is little inflation, the economy is slowing, and therefore the Fed is done.
Astonishing.
Indeed. If you have been following my blog for very long, you are aware that I try to avoid going back and forth on whether or not there will be a pause. My opinion has not changed much from what I wrote after the last Fed meeting.
If economic conditions remain status quo, the default option is to continue rather than pause. There is some evidence that higher energy prices are being passed through to the rest of the economy. Interest rates may have to go a little higher to make sure that this pass through is minimized.... Figuring out what the appropriate level is--in real time--is not a trivial matter.... Fortunately, ... we are not starting out quite so far behind the curve, but if we are behind the curve at all, it means that it will take more effort from the Fed to get real rates where they need to be. That is a risk that cannot be ignored.
As long as we're digging in the archives, let's go back almost a year. Last summer, recognizing that a pause was neither imminent nor necessarily advisable, I argued for a pause as early as December. By November, as inflation data came in and economic growth continued unabated, I could see that the rate hikes could continue for a while and that it wouldn't necessarily be a bad thing. In an Econoblog with Tim Duy, I wrote,
If incoming data forces us to redefine "neutral" as something higher, then (all other things being equal) I am slightly less worried than I was this summer about policy error. What concerns me more is, as you suggest, the need to communicate the transition to a new policy, especially if the economy begins to slow and the Fed is forced into some tough choices. If GDP growth slows at the same time that the recent increases in energy prices finally feed through and increase core inflation, the Fed must decide which objective is the most critical. If you advocate inflation targeting ..., your choice is clear. I sense that some of the more vocal opposition to Mr. Bernanke is coming from ardent proponents of price-level targeting who fear that he may not be tough enough.
It's been about 9 months since that Econoblog, and a year since the summer of my concern over policy error. "Neutral" has been defined upward, and the effort to communicate the Fed's new policy stance is, shall we say, "in progress." Concerns over Bernanke's inflation fighting credentials are still evident. As a result, I think there is a sentement developing that if the Fed did pause now in the face of today's inflation data it would paint Bernanke as extremely dove-ish.
I think it is a little more nuanced than that. The real issue is how you see the balance of risks to the economy shaping up in the 6 to 18 month time frame. James Hamilton does a nice job of laying out situation (prior to today's inflation numbers). It's the classic slow growth vs. inflation risk trade-off that any beginning student learns. More specifically to our current dilemma,
A. Energy prices may stay elevated, but they are not going to increase as they have in the last couple of years. Further, most of the pass through has already occurred. Thus inflationary pressures will start to ease gradually over the next year. As that happens, the real interest rate will rise, even if nominal rates are constant. This could threaten business investment in 2007. Coupled with a housing slowdown, this makes a recession likely.
B. Energy prices could go higher, and it is possible that some of the pass through has yet to occur. Rising inflation is keeping real interest rates too low to have the desired effect. Some might even say that this is the price we are paying for the "measured pace". Stopping too soon could turn what should have been a transitory inflation episode into something more serious. Inflation will remain at this elevated level until the next recession (a mini-repeat of the late '70s, though much less severe).
So which camp are you in? Today's data tells me I can't quite dismiss possibility "B" yet. If I'm advocating for a policy, I still say one more hike, then pause, then re-evaluate in December. Predicting what the Fed will do is another question. Do they lean towards "A" or "B"? Reuters tries to figure it out, but they don't see a clear answer either.
[SF Fed President Janet] Yellen said she believes the Fed needs to be "modestly restrictive" given the tightness of labor and product markets, but she concluded rates were in the "vicinity that is roughly appropriate" to keep inflation contained.
...
Some officials, however, may want to err on the side of higher rates out of concern that doing too little now may make their job that much harder should inflation risks morph into inflation.
"A slowdown is coming, but there are other factors sustaining hearty growth for now, and inflation risks are still rising," Richard Berner, chief U.S. economist at Morgan Stanley, said in a note to clients. "Consequently, it's premature to think that the Fed is finished tightening, much less that officials will soon ease."
But for every hawk on Wall Street, there seems to be at least one dove and markets see a better-than-even chance of the U.S. central bank holding its fire on August 8, although that could shift when key employment data is issued on Friday.
"Recession odds right now, according to our model, are around 40 percent, which is exactly where they were when the Fed went on hold in the summer of 2000," David Rosenberg, chief North American economist at Merrill Lynch, said in a note.
Yellen's entire speech can be read here. It is worth your time, especially the part on inflation, of which I reprint one paragraph.
Next, there is the issue of the role of energy prices in the recent disappointing data on core inflation. As I said, core inflation excludes energy prices. But there may have been some passthrough of higher energy prices into the prices of core goods that use energy as an input to production—airfares are a good example. If this is the case, and if energy prices level out as expected by futures markets, this pressure is likely to dissipate at some point. However, the whole question of passthrough is actually the subject of some debate. For example, recent evidence suggests that there has been much less passthrough in the past twenty-five years than there was back in the 1970s, when inflation got out of control in the face of soaring energy prices. If it's true that there's only a very small passthrough of higher energy prices to inflation currently, then that raises the concern that something more fundamental is pushing up inflation. Unfortunately, at this point, it's too soon to untangle these alternative interpretations.
Viewed in light of my description of scenarios "A" and "B" above, it's easy to see that this issue is far from settled and that intelligent people can differ. For my part, I think that Yellen gets it about right in describing the issue. I think there is probably more concensus about the risk of a slowdown than there is about the passthrough of energy prices and the risk that this temporary inflation episode is not so temporary. So while I lean towards advocating (and expecting--though it is a close call) one more hike, I would not cringe mightily at a pause. A pause simply means that the FOMC is tilting towards scenario "A" and that they see passthrough as becoming less of a problem as time goes on. Sooner or later, they will pause. The only question is what another quarter point would do to the expected, and ultimately the actual, path of the real interest rate over the next 6 to 18 months. That is perhaps the most critical, and most difficult question on the table.
UPDATE: Tim Duy weighs in. He wants to believe that a pause is coming next week--quite frankly, so do I--but he can't quite bring himself to believe. Nor can I. The financial markets also want to believe, and are having an easier time convincing themselves. Duy concludes,
Perhaps tomorrow’s employment report will help lift the cloud…
Well, the consensus forecast according to the WSJ is for 150,000 new jobs. I'll tell you right now that if the actual comes in close to that, it won't lift the cloud that much. Anything between 125,000 and 150,000 would cause me to raise my subjective odds of a rate hike slightly. Anything over 150,000 would raise those odds a bit more. If it does come in at less than 125,000 I'd be willing to listen to the argument for a pause again, but I'm not sure I'd flip.
Posted by William Polley at 04:30 PM | Comments (0) | TrackBack