Is Inflation like Cooking with Gas?

Cartoon by Jim Gibson

If you ever want to be really popular at a cocktail party or a high school swim meet, just drop the term “unit labor costs”. I jest but now I have your undivided attention at least until you get a text from your local pizza delivery service.

I would not say that unit labor costs (ULC) are the key to world peace or eternal personal salvation but I would claim that ULC is the least known and most helpful economic indicator for understanding the economy and especially what will come in the way of future inflation. Most of us are riveted now to stories about the Fed and I will not discount the fact that Fed policy is critically important to future economic growth and inflation. But let’s face facts, even if her majesty Hillary Clinton were to become the next Fed chair, we would still be stuck with ULC and she would have very little to do with that. What I show below is that sub-par inflation today is the result of two labor market factors – the rate of labor usage and wage increases. If these are temporary aberrations that disappear as we exit a very slow growth period, then we should be worried about inflation. But if longer term forces are at work in the US labor markets, then inflation could remain tame for some time despite massive monetary overhang.  

Most of us have learnt well that inflation is all about too many dollars chasing too few goods. Many of us have tattoos that say as much. Since the Fed is in charge of how many dollars rain down on the economy we usually associate inflation with Fed policy and how that policy affects our decisions to spend and/or save. The typical story is that the Fed injects money into the system, thereby reducing market interest rates, resulting in flash mobs at your local car and real estate companies.  All that new demand for goods and services, according to this tale, stimulates Charlie Sheen and others to buy stuff and this increases output, employment and prices.   It is a demand-side story and it is told over and over and over in our universities and art galleries.

I am not writing today to deny that story though if you will look at my thousands of past posts, you will find plenty of ammo that suggests some inconsistencies in that theory. But today is instead about why that story isn’t enough. It is a nice macro/market story but it doesn’t really get into the nitty gritty of price setting. Price setting is done by firms. Companies do not change their prices randomly and in the US most firms do not get a note from the government telling them what price to charge today. Clearly the demand for a company’s goods is important to the price setting decision but much also depends on internal production issues.

Economists believe that companies either seek profits or market share when it comes to pricing. When demand increases that will get their attention. But will meeting that extra demand mean a larger profit? To know if more production will generate larger profits the firm has to answer two questions – how productive is the labor input? and how much will the extra labor cost?

Unless a company has excess labor sitting around eating handfuls of chips loaded with onion dip, a sizable permanent increase in output usually entails more workers or more worker hours. Suppose there is a demand for 100 more units of chicken noodle soup. If in one company the workers are not very productive but they are expensive, that company might not make much money by meeting the extra demand. In another company the workers are highly productive but not as expensive then that company might expect higher profits from meeting the extra demand. Depending on the productivity and labor costs either company might want to raises prices to bring in even more profits – but that might come at the expense of market share.

The point is that a demand change is not sufficient to predict changes in employment, output, or price. We also need information on what is happening to productivity and compensation costs. Which gets me to today’s topic. Despite the Fed and despite record attempts at stimulating demand in this country, we have not seen much inflation. The table below helps us see why we have seen lackluster inflation and gives us some pointers when it comes to thinking about the future and what might happen to inflation once we distance ourselves from the world recession.

I compare the last five years (2007 to 2012) of recovery from the recession (first column of the table below) to a similar period in the previous five years (2002 to 2007, last column). Using two different measures of inflation (based on the GDP price deflator and the CPI) it is clear that the last five years has shown a marked decline in inflation. Inflation has been growing at a little more than half of the previous period. We see this behavior has a lot to do with ULC. ULC measures the cost-side. It tells you how much more it COSTS to produce an additional unit of output. Firms didn’t need to raise prices much in the second period because their costs per unit of output were barely rising. Whereas ULC grew at more than 8% before 2007, they grew at just a little over 1% since 2007. That  is a remarkable change in the cost of producing an additional unit of output.

The table helps us to understand why business costs have been rising so slowly. Notice that in the last five years, labor compensation rose by 11.2%. That is half the rate of the previous five years when compensation increased by 22.2% rate. Productivity, in contrast, could not keep up the former pace of almost 13% but did manage to grow by nearly 10%. The decline in productivity growth means added costs of production but this upward impact on costs was swamped by the rapid deceleration of labor compensation.

The productivity part of the story is interesting. The decline in productivity had two major sources. First, total output of firms grew by only 3.9% in the past five years – much slower than the 18.4% in the previous five years. Equally dramatic was the reduction in labor hours – which showed a decline of 5.3% in five years. Firms were using fewer labor hours in 2012 than they did in 2007. Productivity has grown recently because firms have dramatically cut back on employment and hours worked.

We summarize all this as follows:

• Inflation is lower because costs per unit of production are growing more slowly.
• Costs per unit are growing more slowly because wage and non-wage compensation have slowed and because firms have cut back on employment.

The US economy is growing and output is rising albeit at a modest pace. The usual situation is that once the economy’s growth returns to something more normal, compensation growth will accelerate and employment will expand. This natural progression implies that productivity growth will decline, ULC changes will increase, and inflation will rise. It’s like microwave popcorn. Put the bag in the microwave, set the timer to 3 minutes, remove the bag when the popping stops, open the bag and add a little salt. Then eat. It’s like cooking with gas.

But is inflation like cooking with gas? Is it going to come back when economic growth resumes? Or will longer-term factors impede the usual employment, wage, and benefits progressions? What do you think?

                              Table: Percentage Changes

      2002-2007              2007-2012

Hours                            4.5                        -5.3

Output                         18.4                         3.9

Productivity                  12.7                         9.7

Compensation/Hour      22.2                       11.2

Unit Labor Costs            8.4                          1.4

Unit Non-Labor costs   17.3                        14.8

Inflation (GDP deflator) 11.9                          6.8

Inflation (CPI)               15.2                        10.8

Sources:  http://www.bls.gov/news.release/prod2.t06.htm

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

Doubling US Exports

Cartoon by Jim Gibson

While everyone is so focused on the beginning of fall sitcoms and American football it might be time to revisit the hopeful goal of the President to double US exports. He stated that goal in 2010 as he announced a five-pronged program to increase America’s focus on selling goods and services abroad. It sounded like a neat idea at the time because people who live outside the US just can’t get enough US produced goods like Kentucky bourbon and Mississippi River cruises. It sounded good to the President because when these foreign folks buy more of our stuff it should increase employment in the US. Of course the President never mentioned an import policy to go with the export policy because I guess when American’s buy Samsung ovens and phones that does not have a negative impact on jobs in the US. But I get ahead of myself.

The President is a clever guy. He knows that it is always much easier to reach a goal if you never exactly define it. Try as I might, I cannot find any clear cut definition of what the president was going to double in five years between 2010 and 2015. As it happens exports can be defined many ways. The balance of payments statistics (BOP) define exports in terms of current prices. The National Income Accounts (NIA) defines them two ways: in current prices and constant prices (Real, or chained).  As you might imagine these measures that include current price change can make a big difference. If we are interested in a version of exports, however that correlates to employment – then it is usually better to use the NIA constant price version. 

Another issue regards whether or not you want to focus on exports of goods and services or goods alone. The President never made it clear which one of these two variants was in his sights. This measurement issue implies that we can never be sure how to determine if the goal has been met. Maybe he was thinking of exports of Chevy Volts?

But semantic issues will not deter us. Let’s focus on NIA’s version of real US exports of goods and services. In the first quarter of 2010, US exports of goods and services reached $1.7 trillion. A doubling by 2015 would imply an increase of $1.7 trillion.  As of the second quarter of 2013 – much more than halfway through the five year period, real exports of G&S reached $1.986 trillion. That is an increase of $286 billion. In three and one half years we have managed to move 16% towards the target. To put that into some perspective, if we were well on target to meet the goal, exports of G&S should have increased by about $1.2 trillion.  Clearly we are way behind schedule if exports of G&S are going to double by 2015.

During this same time period imports of G&S into the US were not standing still. In the last 3.5 years imports of G&S rose from $2.1 trillion to $2.4 trillion – the increase was $324 billion. Exports rose by $286 billion while imports increased by $324 billion. Thus real net exports of goods and services decreased by $38 billion. If exports increase employment and imports decrease it – then in the last 3.5 years the President’s Export plan has worsened the employment situation in the US. We are moving away from the stated goal.

Perhaps you say, we should focus instead on goods. Perhaps the services numbers are not helpful. In that case exports of goods increased by $190 billion in those 3.5 years while imports increased by $277 billion. Net real exports of goods declined by $87 billion. Focusing on goods instead of the broader aggregate of goods and services makes the situation look even worse.

We are now 14 quarters into the plan – 70% on our way to 2015 and only about 16% closer to the export goal. 

Perhaps the apparent failure is because the value of the dollar increased more than expected. A rising dollar would hurt US exports and raise imports. But the dollar has been on a downward trend for quite a while. It is true that the dollar has fluctuated but between 2009 and 2012 the dollar depreciated 8% against the euro, 15% against the yen, and 8% against the Chinese renminbi. In those same years the dollar depreciated by 5% against our major trading partners. It was down 31% against our main trading partners between 2002 and 2012. The dollar is not the problem.

The real problem is that the policy was mainly wishful thinking.  Despite being barely one year out of a world recession in 2010, the administration believed we would believe that it could wave a magic wand and make exports grow at a rate that was almost historically impossible. We would have to go back to about 1995 to get a doubling to today’s figure. That is it took 18 years for real exports of goods and services to double. President Obama thought we could double them again in the five years following a world economic recession. Really?

Exports are not the issue. Net exports makes a little more sense because it admits that trade is a two-way street both creating and destroying jobs. But even net exports are not the point. The US needs a vibrant competitive economy. Making up silly plans is not the way to make that happen. 

Stock Futures are Down Because of Good News?

Imagine the following conversation....Mom, the good news is that my temperature is down and my white cell count is back to normal. I feel much better. The doctor says I am definitely on the road to recovery. But I am really depressed. The doctor says he will have to reduce the amount of pain medicine I am taking.

I don't usually post short blurbs on Thursdays. But it is 9:20 am and the stock futures are falling like a rock. According to one Bloomberg article the markets do not like newly published indicators that show a stronger economy because it means the Fed may start tapering soon.

Does this make any sense to you?

How can good news be bad news?

Or maybe the so-called good news about the economy is really bad news about the economy? These snipets of news about last month's unemployment and inflation are simply heralding bad news about future inflation and unemployment?

Maybe the stock market was already over-valued and the sell-off this morning has nothing to do with monthly economic data.

Maybe journalists have to write about every little thing that happens.

Lots of maybes. My first reaction upon reading the news this morning was to try to understand a market that hadn't even opened yet. My better senses tell me to ignore all this noise and go back to playing darts.

It will be interesting to see how all this plays out in the coming months....

Can the Fed navigate the Next Hairpin Turn?

Cartoon by Jim Gibson

On May 21 of this year I posted “Inflation History Lesson: From the Frying Pan to the Fire and Back Again”. In that post I used data from the last four US recessions going back to the 1980s. The data supports the view that Fed policy is much too bumpy and it waits much too long after the end of each recession to turn off the monetary hoses. The result is that policy jerks us around between inflation and recession.

Our prime preoccupation today is when the Fed will ease off the accelerator pedal. Markets are edgy. Economic agents are uncertain about how to buy and sell and invest. In today’s post I focus on those same four recessions with particular interest in how interest rates behaved after the Fed started raising interest rates. It took the Fed a while each time, but once it declared the economy strong enough the Fed began reversing its stimulus and started raising rates. It is instructive to know following three of these recessions the result was a rise in policy rates, a subsequent rise in market interest rates, and the expected decline in the housing market. It is instructive because we have choices now following the end of the fourth recession. We can immediately begin to reverse policy and try for a gradual return to normalcy or we can wait until we are 100% sure about the economy and incur a sharp and painful reversal.

The housing sector is one of the glowing parts of our economic recovery today. It would not bode well if an abrupt change in policy threatened that. My look into three past recessions suggests that we need to get the policy reversal going soon because waiting may throw us back into the frying pan! I begin by discussing interest rate and housing spending for each of the past four recessions. A table at the bottom of this post summarizes all the data discussed.

In the recession that ended in November of 1982, the FFR (Federal Funds Rate) was kept low until March of 1988.  Low in those days was 6.6%. During those six years of economic recovery and expansion the FFR was not allowed to rise above 6.6%. But by spring of 1989, the FFR had increased to 9.4%. In one year the policy rate increased by 280 basis points. In that same year the Treas10 (rate on the 10 year Treasury Bond) rose by 99 basis points to 9.36% and the Mort30 (30 year mortgage rate) increased by 112 basis points to 11.1%. ResCon (Residential Construction Spending had been rising at 5.7% in the two years before March of 1988. In the next 8 eight quarters ResCon fell by -2.3%. In six of those eight quarters ResCon declined.

In the recession that ended in March of 1991, a similar pattern emerged. It took three years after the end of the recession for the Fed to allow its policy rate to rise. The FFR was at 3.3% in Spring of 1994 but almost doubled to 6.1% by Spring of 1995.  The Treas10 increased by 150 basis points to 7.5% and the Mort30 rose by 170 points to 8.8%. ResCon which had been growing by 10% for the past eight quarters slowed to growth of only 2% in the next two years. During those two years. ResCon fell in three of those eight quarters.

In the recession that ended in November of 2001 rates again took three years to rise. In November of 2004 the FFR was 1.9%. By summer of 2006 the FFR had risen to 5.3% -- an almost tripling of value in about 1.5 years. Market rates followed. The Treas10 rate rose by 90 points to 5.1% and the Mort30 rose by 103 basis points to 6.8%. ResCon which had grown by about 10% in the two years before grew by 0% in the two years after rates began rising. In three of those eight quarters ResCon fell.

Our last US recession ended in June of 2009 – just a little over four years ago. The FFR has remained at 0.25%. Market rates are about as low as they have ever been with Treas10 at 2.6% and Mort30 at 4.4%. Housing is booming in the last eight quarters at a rate of about 9%. The big question is what will happen next.

What we hope is that the Fed can navigate this next hairpin turn better than history suggests. The Fed cannot go much longer than four years before it reverses policy. We all know the policy change is coming. Optimistically, the Fed could taper and then reverse policy over the coming months with gradual increases in interest rates without damaging the growth in housing. If this policy change is warranted by a strengthening economy, then the sources of this strength might keep spending growing despite rises in interest rates. Less optimistically, once policy is reversed expectations will drive interest rates much higher and this will severely crimp housing and other forms of interest-sensitive spending and an overall economic slowdown will ensue. It seems to me that the longer the Fed waits to adjust for the coming turn, the more likely the economy will go into another spin. Getting on with the taper seems the least risky course of action.

Table: Interest Rates and Housing after

The Last Four US Recessions

Recession Ended			Nov-82
FFR floor			Mar-88		6.6
FFR Peak			Spring 89		9.8
Treas10 Peak			Spring 89		9.4
Mort30 Peak			Spring 89		11.1
ResCon Avg/Neg			2 years  before		6/3
ResCon Avg/Neg			2 years after		-2.3/6
Recession Ended			Mar-91
FFR floor			Feb-94		3.3
FFR Peak			Spring  95		6.1
Treas10 Peak			Spring  95		7.5
Mort30 Peak			Spring  95		8.8
ResCon Avg/Neg			2 years before		10/0
ResCon Avg/Neg			2 years after		2/3
Recession Ended			Nov-2001
FFR floor			4-Nov		1.9
FFR Peak			Summer 06		5.3
Treas10 Peak			Summer 07		5.1
Mort30 Peak			Summer 08		6.8
ResCon Avg/Neg			2 years before		10/0
ResCon Avg/Neg			2 years after		0/3
Recession Ended			June 2009
FFR floor			Now		0.25
FFR Peak			???		???
Treas10			Now		2.6
Mort30			Now		4.4
ResCon Avg/Neg			2 years before		9/0
ResCon Avg/Neg			2 years after		???

The Fed, Quantum Physics, and Leeches

I have never read so much about the Fed as last week. It is as if I was an astrophysicist and everyone wanted to debate the probability of an atom decaying. Until recently the average guy in the street didn’t know anything about the Fed and now school children have opinions about tapering and professional basketball players are recommending their best friends to be the next Fed chairman.

I should be happy. Most of my life few people cared about the Fed and about macroeconomics and I had fewer visits than the famed Maytag Repairman. So now everyone wants to talk about the Fed. The problem is that the Fed has gone beyond its capabilities and most of the debates and discussions are so wrong-headed that it makes me want to spout. So here we are.

Wrongheaded is a pretty nasty thing to say about Ben Bernanke and his gang of misfits. But it is true. Let’s suppose you decided to go for a jog in the neighborhood. You were about to put on your favorite running shoes when your son suggested that you try wearing your winter boots to run in August. Your daughter then countered it would be much better to wear your flip flops. A discussion then followed about whether to wear flip flops or winter hiking boots for your run around the neighborhood in August. No I am not drinking JD at 10 am in the morning. This example makes a simple point – it is possible to have a debate whose answer will not be helpful. It has been posed in such a way as to deliver only a bad solution…and possibly a blister or two.

Much of the discussion these days about the Fed and about monetary policy revolves around a so-called choice of the Fed – should the Fed focus on inflation or should it emphasize unemployment. Bernanke has stated clearly that the Fed will continue to pour money into the economy at a very fast pace until the unemployment rate reaches 6.5%. That’s pretty clear language. Implicit in this goal is that so long as inflation does not come unglued and inflation expectations seem well anchored, it is okay to focus on the unemployment goal. I have already written a lot about inflation and inflation expectations so I won’t get into that part of this false debate.

What I want to address is the idea that the Fed can or should determine the nation’s money supply and interest rates based on something as specific as the unemployment rate. You might think that Bernanke has a magical megaphone that lets him speak to human resource directors or workers or labor unions or someone who might have some control over the unemployment rate.

Bernanke has none of that. He pretty much has one shovel that he uses to spew money into banks. Sometimes he requires short-term government bonds in exchange – sometimes he trades money for mortgage securities. But he really only has this one trowel. It is sort of like saying that if Florida was at war with Michigan, it should send troops into Georgia and before too long they would find their way to Detroit for the fighting. If you have ever been to Georgia or Tennessee you know that a lot of things could happen to divert these warriors – not to mention lard-soaked fried chicken and hot buttery hominy grits – as they trudged northward. It might make more sense to drop these fighters in Ohio and hope they could make their way to Michigan from there.

It is the same thing with monetary policy. Bernanke’s shovel cannot create one single 

job. In fact, notice that the Fed’s goal is not spelled out as JOBS OR EMPLOYMENT. He did NOT promise to stop the monetary flood gates when 300,000 jobs were created per month. He had to make it even more impossible! He wants to get the unemployment rate down to 6.5%.

For those of you who forgot to memorize the definition of the unemployment rate, you will now have to do 20 push-ups. It is a simple division of the number of people counted as unemployed divided by the number of people in the labor force.  These numbers come from the now-famous Gangnam-style dancing. No not really – these two critical pieces of information come from something called the Bureau of Labor Statistics Household Survey. There is one and only one “official" unemployment rate for the country. It is calculated and reported each month.

Sure the unemployment rate in California is different from the one in Kentucky, but Bernanke doesn’t care about those differences. He wants the national number to get itself below 6.5%. So if you are in a state with a high unemployment rate when the national rate improves – then Bernanke apparently does not care about you.

But that is small potatoes. Notice what happened last Friday when the unemployment rate was announced. It fell from 7.6% to 7.4% -- edging closer to the magical 6.5%. 

You would have thought that Bernanke would have been driven through the national capital in the pope mobile with teenage girls shrieking and trying to shred his clothes. The reaction to the news of the unemployment rate falling was muted because the improvement was not the main result of a lot of new good jobs – but instead was the result of a few more low-paid part-time jobs coupled with another hunk of people deciding they could not find jobs so they left the labor force. The more people leave the labor force (for you math jocks – the more the denominator of the unemployment equation declines) the better is the measured official unemployment rate.

So here’s the point. Bernanke has his eye on the wrong ball. He might as well be sending soldiers into Cuba to win a war in Luxembourg. 

But here is a bigger point. There is no single macroeconomic indicator that will unambiguously communicate that the US patient is well again. There will always be strengths and weaknesses in the national economy. A simple rule that focuses on any single variable is bound to fail when the nation’s welfare is jointly determined by employment, unemployment, wages, consumer spending, the share earned by the middle class, the housing market, and much more. And of course, with one shovel, the Fed just doesn’t have the equipment to get the job done.

Unemployment can be improved. A nation has a lot of tax rates and government regulations that fall under what is often called fiscal policy. I am not going to oversimplify the myriad short- and long-term factors that are causing unemployment to rise in the USA. What I am going to say is that unemployment is like many issues that can be objectively analyzed. What is causing people to drop out of the labor force? Why aren’t firms hiring more workers? Why are wages not keeping up with inflation?

Rather than have a real debate about how to reduce the unemployment rate with effective and intuitive tools, we would rather cling to old-fashioned, inappropriate yet popular approaches. It is as if modern doctors kept advocating blood sucking leeches despite advances in medical technology and pharmacology. Current monetary policy is like a leech, it is not only harming the patient but is preventing effective remedies from being discussed.