Wednesday, January 26, 2011

Bernanke and Blinders: Making Distinctions Between Inflation and Relative Price Change

There were two articles in the Wall Street Journal on Monday about inflation. The articles raise many questions but central to them is the definition of inflation and what policymakers can do about it.
Most of us who are over 50 know what a colonoscopy is. Of course, we know it primarily from the user’s end – and by that you also know what I mean. But (and I do mean butt) most of us know very little about it from the doctor’s perspective. And while we might read the latest medical web sites, we really don’t have the training to understand all that is going on while we lay there on a cold bed with insufficient coverage of our precious parts.

Inflation is a word that most of us know. We feel the impact of inflation when our local grocer raises the price of bread and when a gallon of gas costs more than a double JD on the rocks. And we are constantly reminded about inflation since governments collect facts about price change and the press takes great glee in spreading the news each month. Then we hear that the Fed absolutely hates inflation almost as much as I hate anchovies and we feel somewhat relieved to know that Ben Bernanke and his colleagues are actively watching the numbers and are ready to attack like a head-butt in a Jets game.

Confusion may arise because inflation has two definitions. The first definition has to do with measurement. A price index is an average of prices. Some prices go up. Some prices go down. But the price index averages the ups and downs of all the items and calculates one number describing price change of all the items in the index. Food might be going up by 2% and horse shoes might be going down by 1%. The index doesn’t much care about individual changes because it averages them all together. Most price indexes are weighted – meaning they count some price changes more than others depending on how important the item is. We spend a lot more money on food than on horse shoes – so food prices are more heavily weighted or count more in the price index.

When we take into account all price changes in an index we get one number. For example, the consumer price index might be 202 this month. Perhaps it was 200 last month. So we would say that consumer prices rose by one percent (from 200 to 202). Or we would say that the inflation rate was 1% this month.
Okay – so the first definition of inflation is a measurement – it is the percentage change of a price index. This measure helps us to understand how far our income is going with respect to a particular basket or bundle of goods and services. Naturally when this measurement is high in a given time period, we don’t like it since it is telling us that our income is not stretching as far as it used to.

The big question is why this measurement of inflation matters for macro or for the Fed. So let’s wake up, do a few pushups, and move on to the second definition of inflation – macro inflation.

Recall that macro is about the national economy or the big picture. Macro is about aggregate supply and demand (If you don’t understand these concepts then I would suggest you go back and read all 60-something posts in my blog. Then you will be REALLY confused, give up, and go back to reading fun stuff.)
The Fed has no magic tool to impact the price of a specific single good or service. If food prices are misbehaving and causing the overall index to increase a lot, the Fed has no food price hammer to knock it back down. The Fed only has an aggregate demand hammer. Using traditional monetary policy to attack food prices would be notoriously inefficient since they would be using a macro tool that impacts ALL PRICES to whack away at food. The Fed’s tools are much better suited to times when the price index is rising because many or most of the items in the price index are rising (or falling) at excessive rates. This discussion gives us to ways to interpret a rise in the price index:

(1)   If it is being caused by only a small number of items, we call this RELATIVE PRICE CHANGE
(2)   If it is caused by many or most of the items rising, then we call that MACRO INFLATION

The hullabaloo in the papers recently is confusing because it is mostly screaming RELATIVE PRICE CHANGE and then wondering what the Fed is going to do about it. The Fed should, I believe, do nothing. Like a horse leading a carriage down a busy street, the Fed should be wearing blinders so it doesn’t get spooked by every little noise that signals a movement in prices.

So here is the fun part. While it is true that the Fed should not be tightening monetary policy because of recent changes in measured inflation – it should be tightening it because of other reasons. First, as the economy continues to improve banks will return to lending and spending and inflation will start to accelerate. Second, there is some risk that the Fed will wait too long to tighten the money supply and an inflation problem would be harder to douse once ingrained. Third, the combination of relative price change and a worry that the Fed will wait too long to address rising inflation can lead to a RISE IN INFLATIONARY EXPECTATIONS.  Fourth, a rise in inflationary expectations today causes behaviors that push up macro inflation today – as workers and other suppliers begin to press for their own wage and price increases. These behaviors are not only bad for inflation but they erode firm profits and could lead to a slowing of output and employment.

In summary – while current changes in the price index are not signaling higher macro inflation today there is, nevertheless, every reason to ask the Fed to immediately begin to lean against inflation. Without a quick return to a normal monetary policy we have the very real risk of a bout of stagflation similar to the kinds we experienced in the 1970s wherein both unemployment and inflation were rising. The only antidote was a virtual squashing of demand by the Fed late in the decade that sent interest rates above 20%. Let’s not go there again please. 

Wednesday, January 19, 2011

Angel Wings, three mumus, sweat pants, and Monetary Policy in 2011

When do you throw the angel wings away? My Dad threw me into Venetian Pool and told me to start swimming or I would sink to the bottom of the pool like a box of two week old Twinkies. Actually the water in the children’s pool at Coral Gables’ most unique swimming hole was only about two feet deep so my Dad wasn’t as callous as my sentence alluded.  Other parents purchased angel wings for their darlings. The angel wings hold the child on top of the water as they learn techniques of swimming – like moving your arms and legs in a manner that keep you on top of the water. They are a great idea. Once the kid masters the basic idea of swimming without fear of drowning, she can dispense with the wings and get on with trying to beat Mark Spitz’s records. The challenge comes with the more timid kids who are never quite sure their parents weren’t hiding in one of Venetian Pool’s dark and romantic caves making out. These kids were reluctant to give up the security of their angel wings and clearly jeopardized their ability to swim the English Channel. Their parents were faced with a dilemma. If we take the wings away our kid will NEVER learn to swim. If we don’t take the wings away our kid will NEVER learn to swim.

Martin Wolf and Ben Bernanke think that we are all reluctant kids who need our binkies or was that angel wings? Anyway M&B have been arguing of late that it is much too soon to start withdrawing monetary stimulus from the US and European economies. So I ask the question – will withdrawing stimulus now prevent us from ever swimming the English Channel? Or for you non-swimmers, will withdrawing monetary stimulus now mean that the economy will not recover? Or….tada…..will not withdrawing now imply the economy will not recover?

I think a clear and public plan to begin to withdraw the monetary stimulus is necessary right now. Waiting is foolish and will cost us. The reason is simple and relates to the angel wing example. Waiting creates self-defeating habits that are VERY difficult to reverse. Worse yet, reversing the policy too late creates unnecessary hardships. Okay – so let me dive into the deep end and splash around a bit. Sorry. I promise to not discuss angel wings one more time. But if you have never seen Venetian Pool in Coral Gables you REALLY have to see it.

M&B are like caring parents for more than 600 million people. They see an economy in the midst of a recovery, albeit one with less than hoped for employment increases. They see the risks surrounding another economic slowdown and do not want to contribute to an even longer and weaker recovery. Who can fault them for that? I guess I can or I wouldn’t be sitting here typing on a perfectly good day. It seems to me that postponing the inevitable puts central banks into a very bad position. Here is why. First, most of us know that the US economy will move closer to full capacity. At that time the Fed and ECB will need to generate more normal interest rates well above 0.25%.

Second, based on M&B’s unwillingness to raise the policy rate and tighten money after 6 quarters into a recovery, this raises the question as to when they will. Saying NO today means they are raising uncertainty for all of us. We know it is going to come but when? That matters to a lot of people.

Third, while we know it is prudent to raise rates at some point, how do we know they won’t raise them after inflation and inflation expectations have already firmed? Is it possible that we could be another 4-6 quarters down the road and still have a higher than desired unemployment rate yet inflation already starting to boil?  Will M&B continue to stall then? What exactly will it take to get them to remove the stimulus?  

Fourth, if inflation gets ingrained and rises above the Fed’s target this will surely cause longer-term interest rates to skyrocket. Even if the Fed stalls for a while longer – long-term rates will rise with or without a tighter Fed policy. This spike in interest rates without policy will be bad for the economy and the unemployment rate. If inflation jumps again and the Fed is finally impelled to reverse engines and raise interest rates—this could cause long-term rates to rise even higher. Remember 1979/80? Ugh.

But M&B promise to withdraw the stimulus right when it is needed. At the perfect moment when the economy is strong enough and inflation has not yet become ingrained in expectations, they will magically start the withdrawal. They want to do it this way to minimize the risk of hurting the economy with tight money. That is one risk. But what I am suggesting is that they are not considering the other side of the risk equation. History shows us that economic and political forces make it very difficult to identify the perfect time and that central banks often wait too late.  There is no such thing as just-in-time monetary policy and arriving too late has been shown to have disastrous effects.

 It is sort of like postponing a diet. You need to start right after Thanksgiving but you wait until after Christmas. Then you postpone to after New Year’s. But that would ruin your enjoyment of the bowl games. Okay – so you finally start the diet after the Super Bowl. At that point you need to lose a ton of weight plus you need to buy three mumus, four sets of sweat pants, and a small tent.  

Wednesday, January 12, 2011

Why I Want to Turn my Digital TV into a Hat Rack

Here’s a spout. Rose and Merlin were brother and sister. Rose played soccer and generally liked math. Merlin played in the orchestra and loved to photograph orchids. They hardly agreed on anything. Their arguments often got heated.  Rose would say – “you are mean and you called Daddy a monster.” Merlin would retort – “you are a pig and Mommy loves me more than you.” One day they were confronted by an evil visitor from outer space who threatened their very existence.  They were both worried but instead of working together to overwhelm the predator they took the occasion to yell at each other one more time. Rose started –“ if you had washed the dishes last night as required, none of this would have ever happened. “Merlin quipped, yes, but you are fat and ugly.” Rose and Merlin were never seen again.

So you are saying – Larry has clearly gone off the deep end. People have been saying that a long time so there must be another reason for me writing the above paragraph.

I am writing this paragraph after reading and re-reading my own words below and realizing it is possible for people to get the wrong idea – the opposite of what I am trying to say. The bottom line is that we have VERY challenging issues to deal with in the USA.  These are made even harder by a divided government. It is tempting to up the rhetoric but that might make it even harder to find solutions for security, defense, employment, health care and other pressing issues. The below spout is not meant to single out any one side or person.  As most parents find themselves saying – “I don’t care which one of you did it – you both can go to your rooms and right now!”  I am not taking sides here. Both sides can hate me equally!

I am REALLY irritated by the political fighting concerning the Tucson massacre of this past weekend. Some people are being somewhat careful with their words. Some are not. Let’s face it – some people on the left are using this shooting as a way to point a mean finger at their adversaries. They associate what is so far being called a crime by a deranged shooter with statements made by politicians on the right. In private people are saying what they really feel and they are even more ugly and vindictive about their political enemies. I don’t like to use the term political enemy but when I hear the adjectives some people use I cannot help but classify their categorizations of those with differences in political opinions as enemies. Of course, some of those on the right are not exactly making things better as they defend themselves and counter attack.

This is crazy. How many days will we spend listening to talking heads discuss whether or not the deranged killer was motivated by right-wing politicians? How much time will we waste hearing our right-wing friends defend themselves and counter attack and name-call their detractors?
Not all of the discussion is wrong headed if it seeks to protect better politicians and the rest of us from crazies and others who seek to hurt us individually or collectively.

But come on – most of what I am seeing and hearing is not directed that way. Here is what I don’t understand and what I am spouting about.

First, what religion or spiritual body of thought supports this mean-spirited talk?  

Second, why are they wasting our time with useless diatribes? Do we not have real and urgent problems to deal with?

Third, are our politicians so tired of battling the real and tough issues that they find it easier to lob stupid bombs at each other?  

Fourth, do these talking heads have some real data or information that has uncovered a plot by right-wingers to use weapons and other means of violence to take over America?

Fifth, have left wingers never advocated violence against the rich, big corporations, or the powerful?

Sixth, are there not always fringe persons in our free society who seek to incite fear, hurt, and kill the rest of us?

Seventh, would we not all be better off if we worked together to protect us from these crazies?

Rose and Merlin are fictitious people and the story about them is silly. But why do we act like them? The USA allows freedom of speech and we have a right to say intelligent and stupid things. Neither the left nor the right has a corner on the stupid statements. I just wish the rest of us weren’t so often brought into it. What irony. Now that I finally purchased a digital TV I find myself wanting to use it as a hat rack. 

Wednesday, January 5, 2011

2011 Kickoff

If you are like me you have probably already seen enough college football to last you until next Fall. But then, not many people would admit to being like me so let’s switch our attention to Brett Favre’s sexual exploits. That’s not what I meant. I meant Roethlisberger’s sex habits. No that’s not what I meant.

At this point you have either gone bowling or you are actually reading in excitement. So let me take advantage and switch to the economy and its performance in 2011. I am writing this on January 4th so not much of 2011 is in evidence but I have noticed that the stock market has been very happy. That makes us retirees and hopeful retirees very happy. But will the fun continue?

That’s the $64,000 question and if that doesn’t date me then holy cow, what else could Edith? Those of you with short-term memories will remember that last year around this time we were very optimistic about the US economy but by spring and the unfolding of too much negative information about gyros and other Grecian statistics, we were wondering if we were in for a double dip – meaning that the US economy would fall from Grace and re-enter purgatory or even worse, you would receive a four-day visit from your closest relatives.
It took a while to climb out of that worrisome economic hole but here were again waiting for another Super Bowl and wondering if the economy will resume a clip fast enough to make a dent in the unemployment rate.   Macro is a great tool but being a practitioner of it doesn’t mean that I can forecast the economy for the rest of 2011. It is too bad that professional talking heads and journalists don’t have some humility because they get us all revved up for nothing but their own fame and wealth. They don’t know any more than we do but they sure look solemn and professional when they tell us about the future.

So if you have nothing better to do let me spend a little time explaining why I am generally optimistic but why I am not betting Betty’s Genesis on any particular outcome. What I do below is to explain why I think we might continue to recover but why there remain challenges that will impact the path of recovery. First, it seems to me that time has helped to heal the economy. While the stimulus policies helped to prevent a more severe downturn the main benefit is that the economy has mostly run its downward course. You don’t spend 10 years in rehab every time you get sick. The economy was not permanently injured by the factors that came together in 2007and thereafter to generate the recession.  The economy got punched and we adjusted to the punch. It was a hard punch so it took a while to digest. The good news is that we are on the mend.  The worst is over. The patient is on an upswing. But let’s not get too crazy.

Second, we still have some lingering problems. For example, housing experts believe that the foreclosure issue is still with us in 2011 (and beyond) and that means that housing prices may have to adjust downward another time or two. Most reports, I believe, see this as an orderly process. I interpret this to mean that housing news is 2011 won’t be good but it won’t interrupt too much the faster growth coming from other sectors of the economy.  I would expand this line of reasoning to include the broader financial system. While regulations have not addressed our problems adequately (too big to fail is one) I think time has helped to resolve the worst problems and debts are being worked off in the private sector.  As long as we don’t learn really bad unexpected news from housing or the financial sector, these sectors will only provide a small drag as we go forward.  Of course, that is one risk factor. If there are new unpleasant discoveries in the financial and housing sectors, then anything could happen.

Third, the big news item right now concerns US government debt and what our leaders in the government are going to do about it. There is the political silliness about extended the debt ceiling. Ignore that. We will not reneg on our national debt and everyone knows that. You guys have really fat wallets and the government has the ability to create infinite amounts of tax revenue at any time. So stop with that nonsense. What does matter is how we deal with reducing the debt. We REALLY need to have a plan and we have one brought forth by a commission at the end of 2010. The plan does not have to create extreme austerity forever and it does not need to create any real austerity until several years hence. But it does need to have an explicit and impossible to wiggle out of plan that reaches into the future. It must have credibility to bring government debt-to-GDP ratios back down to long-term averages.  Should our leaders legislate such a plan in the next few weeks that event will help the economy grow stronger now. Without it, we will lumber forward on the edge of a knife blade until the bond vigilantes get tired of harassing others.

Fourth – whether you call them bond vigilantes or simply grandma and grandpa – any hint of a significant resumption of the disastrous spending and saving performances of either our private or government sectors is going to lead to a economic calamity. Just like your child, presently a freshman  at Spendthrift U who cannot be given your credit card in his second semester,  our nation will not be able to find anyone willing to take the risk of lending us money – that is, buying our stocks and bonds . This eventuality will have the effect of raising interest rates, reducing the values on the stock market, depreciating the dollar and generating very slow growth – if not another recession.

So there we are.  We could have a nice reasonable story for the continuation of the recovery. But there are critical factors which include, at minimum, continued improvements in national saving and no unexpected or severe deterioration in housing or financial markets. With luck we might even see the unemployment rate begin to fall.  There is no magic to getting the unemployment rate back to 5%. In fact, I am guessing that what we call the “natural rate of unemployment” has significantly increased since firms have now found ways to reduce the employment factor in production for three years. Even with a spurt of sales I doubt they will go back to employment levels of 2007.

With households and governments taking years restoring saving balances, economic growth should not be spectacular. That is, do not expect a typical fast-paced recovery now nor in the near future.  Reality suggests that once firms become even more confident and optimistic about the future both output and employment will grow – the GDP gap will shrink and the unemployment rate will fall. This confidence will result from more time passing and the absence of negative surprises. So a gradually improving economy is possible. But those negative surprises with respect to housing, finance, and government debt policies suggest the possibility of something worse.  Time is on our side. Let’s hope our new government in Washington has the sense to minimize and not aggravate those things which will put us in reverse.