Tuesday, May 28, 2013

Pop-Up Inflation

Cartoon by Jim Gibson

In my last post I worried that inflation is coming back and likened Fed policy to – frying pan, fire, frying pan. In writing that I admit that trends showed there was some room for the inflation rate to fall further and I don’t have a good prediction for when inflation will rise again. The importance of this is that important people keep putting pressure on the Fed to keep the pedal to the metal. Any deviation from this monetary flooding is met with fear. Last week Bernanke happened to mention that the Fed was thinking about reversing policy – and the markets immediately went into the tank.

It is interesting that the markets are testing the Fed. The markets seem to love all that money. But that doesn’t mean it is good for Main Street or for employment. A recent article by Andy Kessler (Wall Street Journal, the Fed Squeezes the Shadow Banking System, May 23, 2013, page A17) explains that the Fed has robbed the private sectors of a lot of government bonds and mortgage-backed securities. All this stuff is sitting in the Fed’s vaults and is not being used as collateral for the private sector’s loans. I love Kessler’s line, “In other words the Fed’s policy – to stimulate lending and the economy by buying Treasurys…is creating a shortage of safe collateral, the very thing needed to create credit…”

James Bullard of the St. Louis Fed is worried that inflation is too low and he wants the Fed to keep stimulating the economy. As Kessler says, that is strangling the economy. Worse yet, the risk of a giant pop gets larger and larger the more money is out there. Bernanke is afraid to remove even a dime of it because of the market’s reactions. It is like promising to go on a diet tomorrow. Really, I have a headache today but I will start it tomorrow. Image how the financial markets are going to react when he finally has to remove some money from the system.

Back to this disinflation thing. It is easy to see why the US inflation rate is not going to increase in the next few months. The most obvious factor is slower expected growth in Europe, China, Japan, and most of the world outside of the US. World economic growth spills over into US markets for good reasons. First, when those countries stagnate they buy fewer of our goods. Thus US export sales decrease. Second, as money moves out of those countries and into ours, this has the effect of raising the value of the dollar. The higher value of the dollar dents exports further but it also makes imports cost less. Both factors push US inflation and inflationary expectations downward.  In my last posting I showed a strong medium-term downward trend in inflation. Clearly both medium- and short-term trends are pushing inflation expectations downward. That means less upward pressure on wages and the prices of various other inputs to the production process.

So long as world economic growth is restrained, it is hard to imagine the US inflation rate soaring back this summer. But damaging risk remains. Many people who worry about global warming admit that temperatures have not been rising in the last decade. But they look beyond all that and focus on what happens if you don’t combat warming immediately.  They are alarmed. Well I am alarmed about inflation coming back and putting us back into another deep recession. Europe will not be in a recession forever. China will find a way to grow faster. Japan may figure out its problems. The US is seeing wealth rise as stock and housing prices return to stable values. Many emerging nations are devaluing and restructuring.

No, these problems do not have to be solved soon or at one time. The way our financial markets work is through bits and pieces of information that begin to form a mosaic. When the image of a stronger world economy starts to emerge it won’t take long for inflationary expectations to rise. It is like the jack-in-the-box – you turn and turn and turn the crank but Jack stays in the box – at least until that critical moment. Jack-in-the-box is fun but not when the Fed is at the crank. If the Fed has not done a thing to impede rising inflationary expectations, we can expect a quick return trip from the frying pan to the fire. And it won’t be pleasant. They can take some of the sting out by starting the process now. 

Tuesday, May 21, 2013

Inflation History Lesson: From the frying pan to the fire and back again

Cartoon By Jim Gibson

Inflation is back in the news. While there are a few folks worried about rising inflation much of the energy has been focused on it falling (often called disinflation). The latest news on inflation in April showed it negative, -0.4% in April after -0.2% in March (a negative inflation rate means prices are falling and is often called deflation). Consumers generally like inflation to fall, so this is good news for them. It was also cheered by asset holders because lower inflation means the Fed has more room to pump up the economy. Of course, if disinflation or deflation continues, many will take this as a sign that the economy is once again going into a recession. And that is not good news.

So here we are. As usual we have a difference of opinion. Some experts are worried about the inflation rate rising while others are worried it is going to fall. While the past is never a perfect guide for tomorrow, it doesn’t hurt to review what the data shows us. And what the data shows is disconcerting. While inflation may well fall more in the near future there is every reason to bet it will come back with a vengeance. This data came from Fred at the St. Louis Fed. Fred is a handy-dandy free data and graph service. http://research.stlouisfed.org/fred2/

The graph below plots annual values of two measures of US inflation from 1959 to present. One measure is based on the well-known Consumer Price Index for All Urban Consumers. The second one is drawn from the less-well-known Personal Consumption Expenditures Deflator Excluding Food and Energy. Inflation rates are created by taking annual percentage changes in these indexes. Because these index names are long and ugly I am going to called them Steve (blue line in the chart) (like in Steve Martin who is wild and Crazy) and Angela (red line in the chart) (as in Angela Merkel who is not wild and crazy).

Steve inflation is published by the US Labor Department and is based on surveys of prices paid by the typical urban consumer. Steve inflation often swings wildly because food and energy are important parts of Steve and these prices can gyrate like Britney Spears after a night on the town. For example the graph shows Steve inflation rising to about 14% in 1979 only to fall back to about 3% within a few years. Much of that was attributed to food and energy. Not that food and energy prices don’t affect consumers – but they do distort what is happening to the prices of what most of the consumers buy. 

That is why I added Angela inflation – she is constructed and published by the US Commerce Department as a tool to deflate personal consumer spending. Angela is a little more boring because the Commerce Department has removed those pesky food and energy prices from this version of the PCE deflator. (This index also makes an attempt to remove some of the bias caused by Steve’s assumption that people do not economize on goods and services whose prices are rising the fastest.)

So that’s Steve inflation and Angela inflation. A quick look at the chart shows that Steve swings around like a young lady at a ho-down in Arkansas. Angela is more conservative and I must conclude – much more refined and reliable. Some might say that Angela is smoother! But notice too that Angela and Steve have the same general tendencies or trends. So while they might disagree on the extent of inflation during a particular year or two – they both agree on the general direction of inflation. Notice that from 1959 to 1979 they both were rising and thereafter falling. You might say that the most current trend of inflation was to flatten at a little less than 2.5% starting in about 1990.

Apparently what goes up must come down. As we think about where we are today and what will come tomorrow it is good to see these trends. But they are only part of the story. For example, you might want to extend the downward trend since 1979 into the future. That would argue against a quick return to higher inflation. Then again, you might think that 15 years of falling inflation is long enough for the trend and therefore you might want to predict a reversal of trend. In that case you are worried about rising inflation.

There is more to see in this graph. Notice the vertical shaded areas – they depict recessions. We have had eight recessions since 1959. After seven of those eight recessions the inflation rate fell. That makes economic sense. Recessions are times when buyers slow their purchases and firms find it more difficult to sell goods. They often discount their prices to get rid of excess inventories. These disinflation periods following recessions can be very shallow and short (e.g. after the 1970 recession) or they can be much longer and more pronounced (e.g. after the 1980 recession). After the 1990 recession the inflation rate fell for almost 10 years.

Now look at inflation behavior before each recession. In all the recessions except for 1982, the inflation rate was rising before the recession started. In all those cases you had sharp changes in Fed policy – increasing interest rates to try to cool off the inflationary economy. But as soon as the recession was evident, the Fed reversed engines and reduced interest rates. In one sense the policies worked – you can see that inflation did fall. But the unintended consequence of the tight money policy was a recession.

So what do we have? We have inflation rising followed by tight money followed by inflation falling followed by loose money followed by rising inflation. This cycle goes on and on. The prudent thing would be to bring monetary policy back to neutrality once the worst of the recession is over. Why? To answer that question we have to look into what caused the pesky inflation to begin with. The graph shows that food and energy prices must have had some impact driving overall inflation upwards – especially in the 1970s. But food and energy prices do not explain the upward thrust of inflation that occurred in in the late 1980s, late 1990s, and then again after the turn of the century.

Fed policy had very much to do with driving inflation periods higher after those recessions. This belief is based on policy data. I used the level of the federal funds rate (ffr) as my measure of monetary policy. When the Fed wants to tighten policy they raise their goal for ffr; when they want to loosen money they reduce the ffr. So here is what I found:

·        The 1982 recession ended in November 1982. The ffr went from 15.1% in early 1981 to 6.6% in March of 1988. In other words – the Fed kept monetary policy very loose more than six years after the end of the recession.
·        The 1990/91 recession ended in March of 1991. The first quarter of 1989 had a ffr of 9.8%. It was reduced until February of 1994 to the point where it was 3.3%. Again the ffr was kept very low until three years after the end of the recession.
·        The 2001 recession ended in November of that year. The ffr was about 6.5% at the end of 2000 and continued down to 1.8% until November of 2004 – three years after the end of the recession.
·        Finally the 2008/2009 recession ended in June of 2009. The ffr started at 5.3% in mid-2007. It started down and has remained at 0.25% as of today. Today is now four years after the recession. It is unclear when the Fed will again begin the raise rates.

What is the history lesson? The Fed is an aggressive agent for monetary policy. It strikes hard at rising inflation and tries to offset recessions. But it also has a tendency to be very late when it comes to withdrawing monetary stimulus after recessions end. After the last four recessions, the Fed was late when it came to leaving the dance. They left four years late! They are still dancing some four years after the last recession.

Why not stay at the dance? The answer is in the data. Monetary policy eventually revs up the economic engine. Recessions do not last forever and the economy returns to strength. Always worried they didn’t do enough, the Fed keeps the stimulus going for too long and the result is – higher inflation and then a need to fight inflation again. And then another recession.

To my scientific friends – I know a graph or two does not constitute real scientific proof  of anything. Someone else might be able to manipulate data that shows a fuzzier result. But I have been reading the literature and watching the economy for decades. I don’t think you can deny the fact that the Fed can best be described by the old adage -- from the frying pan into the fire and back again. It is time for the fed to reduce monetary stimulus and forestall the usual recession-inflation-recession nightmare.

Wednesday, May 15, 2013

Error Correction: Wolf's Howl is Off-Tune

Tuesday I posted an article that had two main points -- (1) Germany's improvements in exports did not, as Wolf argued, have any strong negative impact on the exports of other EU countries. (2) The main slowdown in demand in Europe came from capital spending and not from overall domestic demand. I concluded that Wolf's continued emphasis on stimulus spending was wrong-headed since the main problem in Europe seems to come from one sector -- capital spending.

In looking at my spreadsheets again, I found errors in the part that measures changes in capital spending. These errors do not change the above conclusions -- but since technically I wrongly quoted some numbers. I decided I needed to come clean!

In the article I said that capital spending had decreased in all EU countries. The numbers were very strong -- for example I erroneously said that overall EU capital spending had decreased by 90%. My corrected numbers show that EU spending on capital declined by 4% and that 14 of these countries exhibited declines ranging from -66% for Ireland to -1% for Latvia.

While these errors are important, they do not detract significantly from my conclusions.Consumer spending and export sales were very strong among the EU countries between 2006 and 2012.  The main spending sector contributing to slower growth in the EU was capital spending. The problem is not overall aggregate demand -- the problem is no real solutions for financial and housing problems.

I feel better now. Thanks.

Tuesday, May 14, 2013

Wolf's Howl is Off-tune:Data Shows Why Macro Stimulus Can't Work

Martin Wolf continues his Keynesian tirade in the Financial Times, “The German model is not for export,” May 8, 2013, page 7. As in the US, a policy debate rages on in Europe as predictions call for impending slower economic growth.  Germany and a few other European countries push austerity.  So Wolf has to beat the Keynesian spending drum even louder to get a hearing for his stimulus advocacy. In this article Wolfe says that much of Europe is doomed to a protracted era of slow growth because Germany and the IMF are encouraging European countries to emulate Germany. Of course it would be difficult for most countries to mirror one of the world’s strongest export champions and so Wolf worries that Europe is in for big trouble.

I have written about the counter-productive results of more stimulus when debts are huge and I won’t repeat all that here. Today I take Wolf to task over misinterpreting the current economic situation in Europe. Wolf says that Germany has been able to replace declining domestic demand by producing more external or foreign sales. He says this causes a big problem for the other European countries because Germany’s surpluses translate into trade deficits among the rest. He says a combination of weak domestic plus weak external spending is killing European countries. I show below that Wolf’s assessment is not the case. Worse, the data shows vividly why more macro stimulus cannot be the answer to our slow growth woes. 

I went to Eurostat – a great place to look at macroeconomic data for the EU countries. http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/  I look at GDP data as a way to see how EU countries have fared since the crisis hit. More specifically I examine key spending data. I looked at changes in the data between 2006 and 2012. In 2006 the EU economy was chugging along before the financial crisis hit and spread. Let’s call that the “before” photo. Sort of like the picture of Terry Bradshaw before he went on his diet. 2012 is the after shot – after the recession and after the economy had several years to recover. Terry says he lost 40 pounds. What happened to the EU?

I first looked at consumer spending. From reading Wolf you might think it had declined – or it was still struggling. If we look at all 27 EU countries together, the total growth of consumer spending increased by about 12%. Germany did a little better – about 14%.  But Germany was among the worst countries. 20 EU countries did better than the EU average. Slovakia led the group with an increase of 61% in consumer spending. Among this group of 20 countries having stronger than 20% increases in consumer spending were Switzerland, Bulgaria, Norway, Poland, and Lithuania. Of course, there were several countries with dismal domestic consumption spending and those included the usual suspects – Iceland, Ireland, Greece, UK, and Portugal. As a benchmark, US consumption grew by about 17% from 2006 to 2012.

What about Germany’s great trade splurge? Germany’s export sales increased by 29% from 2006 to 2012. That was stronger than its domestic consumer spending growth but clearly short of the US export growth of 45%. The overall EU’s export growth was about 24% but 21 EU countries had export sales growth faster than the EU average and 16 of those exceeded Germany’s rate. Slovakia managed an 82% increase in export sales. If most EU countries had bad trade deficit outcomes as Wolf alleged, it was because of their even stronger growth of imports. That means domestic spending must have been increasing – that is, Europeans were consuming more at home – some of the products were produced at home while others were brought in from abroad. That doesn’t sound like deficient domestic demand to me.

So why are these EU countries having such a bad time? The answer which Wolf never discusses is in what the EU calls fixed capital expenditures or what is sometimes called gross private domestic investment. Fixed capital includes domestic spending on plant, equipment, housing, etc. This spending category is interesting. Germany’s fixed capital was 91% lower in 2012 than it was in 2006. For the whole EU the number was -90%. For the USA it was -77%. EVERY EU country showed negative change in fixed capital spending from 2006 to 2012. The worst performance was from Greece (-115%) and the best from Sweden (-63%). If anything has not recovered in the world economy it is business spending on plant and equipment and national spending on housing.

Wolf is so wrapped up in Keynesian macroeconomic stabilization policy that he can’t even see that the main problem with slow growth and a return to stability in the EU and the US is mostly located in one single part of GDP. There is no real export issue and there is no consumer spending issue. The issue is that no country has sufficiently addressed the things that caused the crisis to begin – the housing and financial crises. People are not buying homes and firms are not borrowing to expand. It is pretty simple. The FED and ECB flooded the world with liquidity and drove interest rates to nothing. 

The US government introduced historical levels of fiscal stimulus. Yet we in the US are not growing much faster than our European counterparts.  More stimulus from monetary or fiscal policy means unsustainable debt and financial bubbles. Yet Wolf and other liberals continue to want more of the same. The data suggest that what we need is what we needed from the beginning – a satisfactory response to housing and financial problems. Yet most experts continue to admit after half a decade that they still have not brought forth anything to tackle excessive risk, too-big-to-fail, transparency, and various other elements of the housing/financial crises. I guess it is easier to cry Wolf (for more stimulus).


Dear friends,

I want to thank my college buddy Jim Gibson for adding a cartoon to this week’s blog post. Jim played defensive tackle for Bobby Dodd at Georgia Tech in the 1960s but was even more well known for the cartoons he posted on the football bulletin board. The coaches loved being lampooned by Jim. Jim also was recently given credit for the Georgia Tech logo he designed almost 50 years ago that is still in use today. Go Tech! Hopefully Jim will draw more cartoons for us in the future. 

Tuesday, May 7, 2013

Global Economic Growth: the Pause that Refreshes?

Any athlete knows there are times in a contest when you rest. A marathoner can’t sprint the last mile if she tries to sprint all the miles. The sprint takes it out of you. The world economy was on a sprint before the last crisis hit. The downturn didn’t hit all places at the same time – but a look at world growth in 2005 and 2006 looks like a global economic sprint. Some policymakers long for a return to those heady days. I try to explain below why a fast return may not be the best approach to sustainable gains and lower unemployment.

The average annual growth rate of the world's advanced economies (35 countries labeled so by the IMF) from 1995 to 2004 was a modest 2.8 percent. The median growth rate of the real GDP of these economies  was 3.9 percent in 2006. In 2006 the top 17 countries had real GDP growth rates ranging from 3.9 percent to 10.1 percent. IMF projections for 2014 have the top 17 countries growing anywhere from 1.6 percent to 5.5 percent. (The data and the list of countries can be found in table A2. Advanced Economies: Real GDP and Total Domestic Spending  http://www.imf.org/external/pubs/ft/weo/2013/01/pdf/tables.pdf )

Clearly 2006 was a very strong period of world economic growth. The strong growth was shared across most countries. The recession stopped all that with no change in world growth  in 2008 and a contraction of 3.5 percent in 2009. World growth returned to positive but averaged only 1.4 percent per year between 2011 and 2012.  We are clearly still far off the torrid growth pace of 2006. With respect to these 35 countries the great majority will be nowhere near their 2006 paces even by 2018. The IMF forecasts the following real GDP growth relative to the strong growth of 2005 and 2006:
  •   4 countries will return to past high growth by or before 2014: US, Australia, Japan, Norway
  •   6 countries will return to strong growth by 2018: Germany, France, Greece, Portugal, UK, Taiwan
  •   25 countries will not return to strong growth rates by 2018.
  •   Some 12 years beyond 2006, only 10 countries are predicted to return to strong economic growth. Some of the 25 countries on the list that will not repeat past strong growth include Italy, the Netherlands, Canada, South Korea, Iceland, Estonia, Singapore, Czech Republic, and Hong Kong.

For people in many of these countries, this slow growth is not desirable. Unemployment is too high and many business firms are having trouble staying afloat. Interest rates are low preventing savers from reaching their investment goals. Houses remain empty or unsold and excess capacity deteriorates. Countries have large debts that limit their use of traditional fiscal policies. The negatives are stark and frustrating.

But there may be a silver lining. Like a pause in the runner’s pace, this growth respite is not all bad. To understand this we look back at the 2005/2006 period’s strong growth. With so many countries growing so quickly at the same time, we placed impossible demands on world commodities markets. To produce so much economic output for the world takes inputs. Output requires energy, steel, aluminum, copper, rubber, and many more commodities. Demand for food commodities also spiked. Bringing all this together we saw commodities prices ebb by 2002 and then increase dramatically thereafter until falling sharply in the middle of the global recession.

The prices of many commodities doubled (or more than doubled) in the run-up after 2002. While the global recession caused a temporary hiatus in inflation the subsequent economic recovery witnessed a return to strong commodity price growth. Recent pessimism about economic growth in Europe and China has taken some steam out of commodities but with the US, China, and many other emerging countries showing resilience, commodity demand and commodity prices are ready to resume a rapid upward clip. The only real thing that will forestall them is a more gradual return to stronger growth among the leading countries.

A quicker turnaround in world growth sounds good on the surface but if it brings with it another bout of extreme commodity price inflation, it is doubtful that firms will be able sustain a stronger pace of output in the face of rapidly increasing business costs. We see now how uncertainty about rising medical costs and taxes puts a lid on hiring – another bout of rising commodity prices would just add to that.

It seems perverse but right now good economic news is not necessarily unqualified good news. We want to finish the race in first place. Running too hard right now is not the way to do it. It might be frustrating watching some runners catch up, but we need to have some patience and some trust that the tortoise might again beat that pesky hare.