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January 9, 2015

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Paul Krugman: Voodoo Time Machine

Posted: 09 Jan 2015 12:24 AM PST

Ideological rigidity causes blindness to the facts:

Voodoo Time Machine, by Paul Krugman, Commentary, NY Times: Many of us in the econ biz were wondering how the new leaders of Congress would respond to the sharp increase in American economic growth that ... began last spring. After years of insisting that President Obama is responsible for a weak economy, they couldn't say the truth — that short-run economic performance has very little to do with who holds the White House. So what would they say?
Well, I didn't see that one coming: They're claiming credit. Never mind the fact that all of the good data refer to a period before the midterm elections. Mitch McConnell, the new Senate majority leader, says ... that growth reflected "the expectation of a new Republican Congress."
The response of the Democratic National Committee — "Hahahahahahaha" — seems appropriate. I mean, talk about voodoo economics: Mr. McConnell is claiming not just that he can create prosperity without, you know, actually passing any legislation, but that he can reach back in time and create prosperity before even taking power. ...Mr. McConnell's self-aggrandizement is ... scary ... because it's a symptom of his party's epistemic closure. Republicans know many things that aren't so, and no amount of contrary evidence will get them to change their minds. ... Congress is now controlled by men who never acknowledge error, let alone learn from their mistakes.
In some cases, they may not even know that they were wrong. After all, conservative news media are not exactly known for their balanced coverage; if your picture of ... health reform is ... based on Fox News, you probably have a sense that it has been a vast disaster, even though the reality is one of success...
The main point, however, is that we're looking at a political subculture in which ideological tenets are simply not to be questioned... Supply-side economics is valid no matter what actually happens to the economy, guaranteed health insurance must be a failure even if it's working, and anyone who points out the troubling facts is ipso facto an enemy.
And we're not talking about marginal figures. You sometimes hear claims that the old-fashioned Republican establishment is making a comeback, that Tea Party extremists are on the run and we can get back to bipartisan cooperation. But that is a fantasy. We can't have meaningful cooperation when we can't agree on reality, when even establishment figures in the Republican Party essentially believe that facts have a liberal bias.

Links for 01-09-15

Posted: 09 Jan 2015 12:06 AM PST

Fed Watch: Volatile Week Ahead of Employment Report

Posted: 08 Jan 2015 12:00 PM PST

Tim Duy:

Volatile Week Ahead of Employment Report, by Tim Duy: At the moment, there are many different competing threads in the tapestry of monetary policy, with another thread entering the pattern with tomorrow's employment report. In short, the Fed is balancing clear evidence of accelerating US activity in the back half of 2014 against the implications of declining oil prices and a host of international weaknesses that are roiling financial markets. The reality of volatility in asset prices was on full display this week. The Fed desire to begin normalizing policy with a rate hike in the middle of this year certainly appears in jeopardy. They very much need continued solid data on the US side of the equation to push forward with their plans.
Early 2015 US data in the form of ISM reports provides little new guidance. While the measures slipped from recent high, I would be hard-pressed to say that the underlying trend has changed after considering the volatility of this data:

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Likewise, initial unemployment claims continue to hover below pre-recession lows, signaling solid labor demand:

CLAIMS010815

Plunging gasoline prices will almost certainly bolster consumer confidence:

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The Fed anticipates that declining energy prices will have a net positive impact on the economy. Via the minutes of the most recent FOMC meeting:
In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said that the effect on overseas employment and output as a whole was likely to be positive. While some participants had lowered their assessments of the prospects for global economic growth, several noted that the likelihood of further responses by policymakers abroad had increased. Several participants indicated that they expected slower economic growth abroad to negatively affect the U.S. economy, principally through lower net exports, but the net effect of lower oil prices on U.S. economic activity was anticipated to be positive.
I tend agree that the net impact will be positive, but note that the negative impacts will be fairly concentrated and easy for the media to sensationalize, while the positive impacts will be fairly dispersed. We all know what is going to happen to rig counts, high-yield energy debt, and the economies of North Dakota and at least parts of Texas. "Kablooey," I think, is the technical term. Easy media fodder. Much more difficult to see the positive impact spread across the real incomes of millions of households, with particularly solid gains at the lower ends of the income distribution. This will be most likely revealed in the aggregate data and be much less newsworthy.
The decline in energy prices, combined with the stronger dollar, confounds the Fed's inflation outlook, but for now they seem content to assume the impacts are transitory:
Participants generally anticipated that inflation was likely to decline further in the near term, reflecting the reduction in oil prices and the effects of the rise in the foreign exchange value of the dollar on import prices.Most participants saw these influences as temporary and thus continued to expect inflation to move back gradually to the Committee's 2 percent longer-run objective as the labor market improved further in an environment of well-anchored inflation expectations.
The Fed also, at least for now, is choosing to heavily discount market-based measures of inflation expectations:
Survey-based measures of longer-term inflation expectations remained stable, although market-based measures of inflation compensation over the next five years, as well as over the five-year period beginning five years ahead, moved down further over the intermeeting period.Participants discussed various explanations for the decline in market-based measures, including a fall in expected future inflation, reductions in inflation risk premiums, and higher liquidity and other premiums that might be influencing the prices of Treasury Inflation-Protected Securities and inflation derivatives.Model-based decompositions of inflation compensation seemed to support the message from surveys that longer-term inflation expectations had remained stable, although it was observed that these results were sensitive to the assumptions underlying the particular models used. It was noted that even if the declines in inflation compensation reflected lower inflation risk premiums rather than a reduction in expected inflation, policymakers might still want to take them into account because such changes could reflect increased concerns on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. In the end, participants generally agreed that it would take more time and analysis to draw definitive conclusions regarding the recent behavior of inflation compensation.
For example, the Cleveland Federal Reserve measure of inflation expectations over the next ten years was 1.83% in December, within spitting distance of the Fed's target. This kind of analysis, combined with survey-based measures, provides the Fed with a great deal of comfort regarding the inflation situation.
That said, inflation remains below target and, importantly, was decelerating before the impact of lower energy prices worked its way through the economy:

PCE33122314

Shouldn't this alone keep any talk of rate hikes at bay? You might think so, but the Fed already believed there was a good chance that they would raise interest rates while core-inflation was below target:
With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.
So what is the bar for "reasonably confident"? I believe that an acceleration of wage growth would do the trick, which is why this remains the data to watch in the employment report. If June rolls around with no inflation and no greater wage growth, the Fed will find it challenging to begin normalization. In that case, they would need to focus on the employment mandate or pivot to some financial stability story to justify a rate hike.
Jon Hilsenrath offers a potential interpretation of the implications of the rally at the long end of the Treasury yield curve:
If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned.
The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made at length in a speech in December. He argued the Fed had the wrong reaction to lower long rates in the 2000s, a mistake that might have contributed to the housing boom that ended disastrously.
I wrote about this last month, coming to the conclusion:
A second point is that Dudley is not taking seriously the possibility that the flattening yields curve suggests the Fed has less room to move than policymakers think they do. This is something I worry about - if the Fed leans on the short end too much, they risk taking an expansion that should last another fours years to one that has just two more years left. But that might be a story for next December.
I think the late-90's is a better comparator to the current envrionment, but that will take another post to deal with. For the moment, I will add that San Francisco Federal Reserve President John Williams hinted that current action in the bond market is in fact telling a less hawkish story. Via Greg Robb at MarketWatch:
Williams said he thinks a rate hike this year will be appropriate, but added he is in "no rush" to tighten. He said that mid-2015 is a reasonable guess of when the Fed will first ask "should we do it now or wait a little longer."
I have interpreted Williams remarks in the past as pointing at a June rate hike. Arguably, here he hedges and says June is when they should start considering the rate hike. Perhaps falling Treasury yields are having the traditional impact on Fed thinking after all.
Bottom Line: Fed wants to begin normalizing policy, but sees a murkier path compared to even just last month. They need hard US data to overwhelm the oil/international driven fears. An acceleration of wage growth would help put some light on the path they want to follow.

'Trying to Understand Current FedThink'

Posted: 08 Jan 2015 10:35 AM PST

Brad DeLong:

Today's Essay at Trying to Understand Current FedThink: Daily Focus, by Brad DeLong: The "more thoughts about this" I promised earlier below…

Jon Hilsenrath: Could Lower 10-Year Yields Spark A More Aggressive Fed?:
"Falling long-term interest rates pose a quandary for Federal Reserve officials….

…If falling yields are a reflection of diminishing inflation prospects… it ought to prompt the Fed to hold off on raising short-term interest rates…. If… lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner…. The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made….

The Fed's next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates. ...

Our current remarkably-low long-term interest rates has three possible interpretations:

  1. Ms. Market expects currently-planned near-term Fed policy to produce a very weak economy for a long time to come, and hence very low interest rates in the out years. Ms. Market is correct. In this case, low long-term interest rates are a signal that the Federal Reserve's current liftoff plans are a mistake and should be revisited.

  2. Ms. Market expects currently-planned near-term Fed policy to produce a very weak economy for a long time to come, and hence very low interest rates in the out years. Ms. Market is wrong. In this case, low long-term interest rates are not a signal that the Federal Reserve's current liftoff plans are a mistake and should be revisited. Rather, the Federal Reserve should act as in (3).

  3. Ms. Market expects currently-planned near-term Fed policy to produce a normal economy in the out-years, but the U.S. Treasury market has an unusually small or negative term premium because of the large number of foreign investors seeking U.S.-based political and economic risk insurance via holdings of U.S. Treasuries. In this case, low long-term interest rates are inappropriately stimulative and run the risk of generating an overheating economy, and the proper response by the Federal Reserve is to announce that it will raise interest rates sooner and faster in order to push long-term rates to where they need to be for a sustainable Goldilocks continued recovery.

The Federal Reserve strongly believes that Ms. Market has no information about the future course of the macroeconomy that the Federal Reserve does not have–that (1) is simply unthinkable. That leaves (2)–Ms. Market thinks the Federal Reserve's currently-planned near-term policy path is risking another lost decade, but Ms. Market is wrong–or (3)–long-term rates have an anomalously-low term premium because of foreign-investor demand.

A glance at the graph above would seem to rule out (3): 10-Yr breakeven inflation has fallen from 2.5%/year just before the taper tantrum to 1.6%/year today, while the TIPS has risen from -0.7%/year to +0.4%/year today. If it were (3), the surge of foreign demand ought to have put downward pressure on both nominal Treasuries and TIPS, leaving the breakeven largely unchanged. That is not what has happened. If the Federal Reserve wants to hold to (3), therefore, it needs to add to it:

3′. Something else weird and unrelated has happened in the market for TIPS.

While that is possible, it is disfavored by Occam's Razor.

Thus Dudley seems to be chasing down a red herring. The interpretation he wants to put forward ought to be this:

Today Ms. Market expects inflation over the next ten years to be 0.9%/year less than it expected it to be back in June 2013. But we know better: the economy is actually much stronger than Ms. Market thinks.

Coming from a Federal Reserve that has overestimated the future strength of the economy in every single quarter since the start of 2007, that is not a terribly reassuring posture for it to take.

'The Link between High Employment and Labor Market Fluidity'

Posted: 08 Jan 2015 10:03 AM PST

Laurent Belsie in the NBER Digest:

The Link between High Employment and Labor Market Fluidity: U.S. labor markets lost much of their fluidity well before the onset of the Great Recession, according to Labor Market Fluidity and Economic Performance (NBER Working Paper No. 20479). The economy's ability to move jobs quickly from shrinking firms to young, growing enterprises slowed after 1990. Job reallocation rates fell by more than a quarter. After 2000, the volume of hiring and firing - known as the worker reallocation rate - also dropped. The decline was broad-based, affecting multiple industries, states, and demographic groups. The groups that suffered the most were the less-educated and the young, particularly young men.
"The loss of labor market fluidity suggests the U.S. economy became less dynamic and responsive in recent decades," authors Steven J. Davis and John Haltiwanger conclude. "Direct evidence confirms that U.S. employers became less responsive to shocks in recent decades, not that employer-level shocks became less variable."

Many factors contributed to the decline in job and worker reallocation rates, among them a shift to older companies, an aging workforce, changing business models and supply chains, the effects of the information revolution on hiring, and government policies.
About a quarter of the decline in job reallocation can be explained by the decline in the formation of young firms in the U.S. From the early 1980s and until about 2000, retail and services accounted for most of the decline in job reallocation. This occurred even though jobs shifted away from manufacturing and toward retail, where job creation is normally more dynamic and worker turnover more pronounced. One reason for the slowdown in turnover was the growing importance of big box chains in the retail sector. The authors note that other studies find that jobs are more durable in larger retail firms, and their workers are more productive than workers at the smaller stores these retailers replaced.
Fewer layoffs and more employment stability are generally considered positive trends and natural outgrowths of an aging workforce. The flip side of this equation, however, is that slower job and worker reallocation mean slower creation of new jobs, putting the jobless, including young people, at a heightened risk of long-term unemployment. These developments also slow job advancement and career changes, which are associated with boosts in wages.
This is of particular significance since 2000, when the concentration of declines in job reallocation rates and the employment share of young firms shifted from the retail sector to high-tech industries.
"These developments raise concerns about productivity growth, which has close links to creative destruction and factor reallocation in prominent theories of innovation and growth and in many empirical studies," the authors write.
Government regulation also played a role in slowing job and worker reallocation rates. In 1950, under five percent of workers required a government license to hold their job; by 2008, the percentage had risen to 29 percent. Add in government certification and the share rises to 38 percent. Wrongful discharge laws make it harder to fire employees. Federal and state laws protect classes of workers based on race, religion, gender, and other attributes. Minimum-wage laws and the heightened importance of employer-provided health insurance also make job changes less frequent.
The authors study the effects of the decline in job and worker reallocation rates on employment rates by gender, education, and age, using state-level data. They find that states with especially large declines in labor market fluidity also experienced the largest declines in employment rates, with young and less-educated persons the most adversely affected.
"...if our assessment is correct," the authors conclude, "the United States is unlikely to return to sustained high employment rates without restoring labor market fluidity."

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