Tuesday, May 27, 2014

Misinformation and Monetary Policy

I wrote an article in the 1980s titled “Misinformation and Monetary Policy”. It was an academic-style paper published in the Review of the St. Louis Federal Reserve Bank. I would not suggest you read that unless you like having needles pushed into your eyeballs. The point of the article, however, is as true today as it was back then. The point is that inflation data can give you shingles. No, that’s not right. The point is that the actual behavior of inflation can sometimes be highly misleading.

The Fed is saying that inflation is not a problem. Fed officials know that too much money can cause too much inflation and the Fed stands ready to modify its current course of monetary ease once it sees the “whites of their eyes” – once they see inflation rising. This makes some sense. If the problem of money is too much inflation – you cannot say there is too much money if the inflation rate is low and stable. So the Fed has good reason to have a “watch and see” stance.

But here is the problem. There is a difference between inflation and the measure of inflation. For example, Casper the Friendly Ghost exists even if you can’t see him. Or maybe gravity is a better example. We are glued to the earth but no one can see gravity. Gravity is a force and it can be measured but only indirectly. It is known to be proportional to the mass of two objects and inversely proportional to the distance between them. Two small objects far from each other create little gravitational pull while two very large close objects would generate a lot of gravity. Okay so I am not an astro-physicist. Give me break.

The issue is that while gravity is never directly measured, we can use formulas to estimate its value. We do the same thing with inflation. Economists have models which tell us how much inflation is. Monetary models say inflation is high when money growth is high. But we don’t stop there. Governments spend a lot of money doing surveys and collecting data to try to measure inflation. But let’s be clear. These are two different things. We have inflation which cannot be measured – let’s call that Milton’s inflation. Then we have attempts to measure inflation – let’s call that Kardashian Inflation.

            Milton inflation usually does not equal Kardashian Inflation

This inequality is the source of policy disagreements since critics of Fed policy are looking at Milton Inflation while the Fed is focused on the Kardashian version.
To show why this all matters today, I use some traditional measurements. The first is theoretical Milton Inflation. We all know that the money supply increased a jillion percent and that means Milton inflation roughly equals a jillion percent. I exaggerate of course. But it is hardly worth care and precision since we know that the money supply has reached unprecedented proportions and if left at these values a return to some normalcy (especially in a thing called monetary velocity) the inflation rate could become very high. 

Now let’s turn to data on measured or Kardashian inflation. The place to begin is to note that we have a lot of measures of inflation. The one that is reported and circulated the most – the Consumer Price Index (CPI)– turns out not to be the preferred brand. It has some known defects like pimples and rashes in unmentioned places. A Similar index but with fewer distractions is something called the Price Index for Personal Consumption Expenditures (PPCE).  So I went to the Bureau of Economic Analysis (bea.gov ) and found that they had a ton of data going back to when I was in pig tails. I chose to examine measured inflation using the PPCE for the years from 2006 to 2014. The latest data point is the first quarter of 2014 or Q1 2014.  I look at annual percentage changes from the first quarter of each year to the first quarter the year before. There is much too much detail to put into a table so trust me when I report a few facts.

·        The PPCE increased by 1.1% from Q1 2013 to Q1 2014. PPCE was unchanged in 2009, bounced back to 2.1% in 2010 and averaged 2.1% per year from 2010 to 2013. So we can say that inflation is averaging around 2% per year but had a down year in 2013/104. Does that mean that inflation is low?

·        The PPCE has three major price components – prices of durable goods, nondurable goods, and consumer services. The reason that PPCE grew slowly in the past year is that the prices of durable goods fell by 2.2%. Within durable goods it was furnishings and durable household equipment that fell by 3.7%.  Because gasoline and other energy prices contracted by 2.8% in the past four quarters, we had flat nondurable goods prices. The prices of consumer services, in contrast, rose by 2% last year.

This is a lot of detail to throw at you. But one can come away with a story. Even Justin Bieber knows that housing has been slow to recover and that energy prices are high volatile. Looking at the last four quarters through Q1 2014, we see a lot of things that will probably not repeat in the coming year or years. The 3.7% decline in furnishings and household equipment was the worst performance of that category in the last 7 years. With a recovery, ever so gradual, in housing it is hard to believe that prices in this category will fall again. As for gasoline and energy – check out this stream of annual changes since 2008: +30.8%, -37.4%, +37.7%, +19.3%, +10.2%, -0.3%, and -2.8%. If this was your golf score you would be scheduling an appointment with your psychiatrist. Given the bouncing ball nature of energy prices it is hard to venture a guess for the coming year. But clearly, rising prices are not deniable after two years of declines.

The upshot is that consumer services have been growing steadily since the 1.5% rate of 2011. From this base a return to some normalcy in prices of consumer durables and nondurables would mean an inflation rate of above 2% and possibly well above 2%. And this is before we have much of a kick-in from well-anchored inflation expectations.

I am not ready to blame Casper the Friendly Ghost when I can’t find my car keys. The Fed doesn’t want to rely on Milton Inflation either. So we are stuck with interpreting measures like the PPCE.  Given the volatility of key PPCE components over time, interpreting these trends can be hazardous to one’s health and can lead to numerous interpretations. Since I am a card-carrying Miltonian I see inflation floating in my breakfast cereal. I also see it in the PPCE. Measured inflation in the last year was modest but may very well be misleading. The data suggests last year might be the eye of Hurricane Kardashian. 

Tuesday, May 20, 2014

Fed Policy: Chicken or Egg?

When it comes to chickens & eggs or climate change & Al Gore, we don’t know which came first. We take this to mean that we don’t know what is the ultimate cause of these things though I suspect Al Gore came from another planet. Regardless, the topic today is the Federal Reserve or as we lovingly call it – the Fed. The Fed says they will keep interest rates low. I doubt they can do it. 

There is a widely shared belief that the Fed controls interest rates. Thus we could say that the Fed causes interest rates and not vice versa. When Ms. Yellen proclaims that interest rates will remain low until Clint Eastwood stops making movies, that gives us the illusion that the Fed can and will keep rates low for a very long time. But this illusion, while technically correct, for most purposes can be highly misleading. This post suggests that interest rates will begin to rise soon, with or without the Fed’s permission.

To understand this point we have to go back and read several tons of text books or you can wake up and just read the next few paragraphs. Like there are many different kinds of Kentucky bourbons, there are many different interest rates. An interest rate tastes like chicken. No it doesn’t. An interest rate tells you how much you earn on a financial instrument. If you put money into a bank saving account your money would be earning about .02%. Invest your money in a government bond that matures in 30 years and you might get 3.5%. Corporate bonds might give you a little higher rate. These rates are market determined. That means that while a Fed policy might influence these rates, the Fed has no direct control over them. The buying and selling of these financial instruments by individuals and institutions change the prices and rates every day.

The one rate the Fed does have almost total control over is called the Federal Funds Rate (FFR). I say “almost” because even that rate is not dialed up or down in a mechanical fashion by the Fed. The FFR is mostly affected by banks borrowing money from each other. On a day when many banks want to borrow the rate goes up. When many banks don’t want to borrow from each other, the rate goes down. But unlike the other rates I mentioned above, the Fed considers the FFR as a target of monetary policy. When the Fed swears on a stack of Tim Geithner novels to keep interest rates at zero – we take this very seriously. We wait from Fed meeting to Fed meeting to learn of any real or imagined changes in the value of the Fed’s goal for the FFR.

It is easy for the Fed to control this rate. If bankers want to borrow a ton of money from each other on Tuesday then the FFR starts rising. The Fed watches and Yellen says – geez guys. I promised the FFR will stay at zero and today the rate is rising. So Janet knows what to do. She pumps money into the system so banks have plenty of money. They don’t need to borrow from other banks – the Fed intervenes and gives it to them. The FFR rate goes back down to zero. Like water on a fire, when the fire rares up just pour on more water.  The Fed apparently controls the FFR. 

But does it? Technically it does. It can do the actions of the last paragraph forever since the Fed has permission from the Koch brothers to increase money at will. No digging up gold is necessary. But the trick here is whether or not they can make their policy stick. You can pour water on a fire but if it a grease fire it might actually make the fire worse. In the case of the Fed policy, the focus is on the market factors responsible for driving up the FFR. Perhaps the FFR is just following other market-determined interest rates. Suppose the economy is stronger and inflation expectations are rising. These are factors that usually drive up market rates, including the FFR.

If markets are driving up interest rates then a one-time injection of money will take the FFR back down to zero. But will it stick? If the economy and its inflation rate are rising, then there will be continuous pressure on the FFR to rise. You might say that is no big deal because the Fed can just pump in more money. But here’s the challenge. If each time the Fed pumps in money this stimulates output, inflation, and credit demand, then there is EVEN MORE pressure on rates to rise…here is a very technical schematic:

      Rates rise – Fed pumps – rates fall – expectations rise – rates rise even more.

At this point the best way for the Fed to keep rates from rising is to stop pumping in more money. When people start to recognize that the Fed will stop stimulating the economy then they will reduce their expectations about economic strength and inflation. This reduced expectation brings rates back down.

So who controls interest rates in the economy? The answer is that it depends. If rates are being strongly driven by economic fundamentals it is not easy for the Fed to have much sway. They will have a very difficult time stopping rates from rising and attempts to do so may make matters even worse. Of course if the economy is not thrusting rates higher, this gives the Fed more room to maneuver. But if that is the case, it isn’t clear why the Fed would want to reduce rates. The market is already doing that trick. 

To modern progressives, this sounds strange and it should. Monetary activists think the Fed is all-powerful and should regularly employ countercyclical policy. But not everyone is a monetary activist. Milton Friedman and other monetarists have warned for decades about the unintended consequences of monetary activism. Today we have a very activist Fed under the guidance of Janet Yellen – a Fed that will promise lower future interest rates despite an inability to bring out that result. Bet on higher rates in the coming 6-12 months.

Monday, May 12, 2014

Income Distribution Policy: Dead End or Over the Cliff?

Writing about income distribution policy is a little like getting a lobotomy. You know the operation is necessary but you also know the end result is nothing one would wish for. But it is a rainy Saturday here in Bloomington and my self-imposed Tuesday deadline is looming.
I recently went to my 50th high school reunion in Miami and it reminded me of a lot of things. Life was simpler in the 1950s but the world was very cruel for a lot of people. Segregation ruled in Miami and women dealt with more than glass ceilings. Many Cuban immigrants found Miami more hospitable than Fidel, yet conditions often “forced” them into ghetto life along the Tamiami Trail. Most gays stayed in the closet. Today much has been improved for these and other minorities but we all know that there remains much to do. There is no question that we can improve results.

What gets me spouting today, however, is the related but important issue of income distribution. It is no secret that the current US presidential administration is highly motivated by polices to improve income equality. This is a noble goal but his ways of going about this seem wrong to me – and worse than wrong is that they are counter-productive. You wouldn’t throw an anchor to a drowning man. But current thinking about income distribution policy seems like doing just that. Of course, this post is not so much about President Obama as it is about a total dis-function of our elected representatives when it comes to making any progress with poverty or income distribution. 

Thus my title – Income distribution policy might be a dead end. Actually it could be worse than a dead end. Most dead ends have a turnaround place. Once you know you cannot get through, you can turn around and try again. There is hope you can get to your destination. My worry is that we have gone beyond the turnaround place and don’t know it. As a result we should aptly describe our situation as over the cliff. You heard the joke about the guy who falls off the top of a very tall building. At about the fifth floor a guy leans out the window and asks the man how it is going. He replies, “Okay so far.” That’s the definition of an optimist.

Already some of you are ready to remove my JD. You have branded me a big bad meany and you are ready to stop my subscription to the Wall Street Journal.
Let’s be honest. This issue of income distribution has become a war cry for extremes on the left and right and many of us get sucked into unthinking knee-jerk reactions that in and of themselves prevent us from making headway. We can’t even have a civil discussion about how to improve income distribution. Wouldn’t it be nice to know that when I go to my 100th high school reunion that we can say we made some progress? 
Or do we want to acknowledge in 2064 that we failed again to move the needle?

Wouldn’t it be nice if we could apply logic or common sense to this challenge? For example, we noticed a few days ago that no matter how low we set our AC’s thermostat, the temperature in our house was rising. That is what I call detection of a problem. So we called an expert who looked over the situation and found that a part had been installed incorrectly. We didn’t notice this in the winter but as soon as we had some hot days, it became obvious that a problem existed. The expert fixed it and now we are back to being cool.

To summarize – we detected a problem, we searched for the source of the problem, and then we applied a solution to fix that problem. We do that all the time. We do this at home, at work, and we sometimes do that in the public arena.

It is possible that two experts might have different opinions at each stage of the process. They might disagree that a problem exists, about the source of the problem, and then about the remedy. The sad thing is that politics is very different from home electronics. Two electricians might disagree but with a little more investigation, they can search for the correct approach. Politicians, on the other hand, will search out their base political support and continue saying things for years if not decades to keep getting elected.  

But surely we can do better than that. Economic and social success is not a partisan issue. Presidents Kennedy and Johnson are often given credit for starting the War on Poverty. They had the right idea. They wanted to eradicate if not minimize poverty. Their presumption was that people wanted to take care of themselves and not be permanently dependent on government assistance. Yet we find ourselves today after more than a half century of social programs far removed from that goal. Too often government programs lead to long-term dependency if not inter-generational reliance on fiscal support. Social programs have not wiped out poverty.  It is as much or more evident than it was in the early 1960s.

What is the problem?
            Racism has worsened?
            Reverse racism has worsened?
            Rich people are better able to take advantage of the poor?
            Rich people do not pay enough in taxes?
            Social programs are too skimpy with benefits?
            Social programs do not address the root causes of poverty?
            Social programs themselves engender dependence?
            The minimum wage is too low?
            The minimum wage is too high?
            Globalization reduces domestic wages and job opportunities?  
            Companies replace US workers with machines?
            Too many young people do not finish high school?
            Too many children are raised by single parents?
            Too many young people have children before they finish high school?
            Too many people are hooked on drugs?

Most of you might agree with some of the above possible causes but not all of them. But let’s face it – these and other issues deserve to be looked at objectively. After such a real inquiry then perhaps we can prioritize this list. Some items will go to the head of the list. Some will be dropped entirely.

But let’s face it – while the average guy might think this is a logical approach can you imagine some of the leaders of our two parties digging in examining these issues dispassionately? I can’t. If you agree then the problem is pretty obvious. Poverty can be addressed and reduced – but the people we pay in Washington to accomplish this are simply not up to the task. We should vote for people who are. 

Tuesday, May 6, 2014

At Last A Better Measure of Economic Growth

Pete recently got a new motorcycle – a real hum-dinger. He also got a new espresso machine. I asked him which one was better. He looked at me dumbfounded and told me I was an idiot. You can’t compare a motorcycle to an espresso machine.  Yet, the Wall Street Journal decided to publish an article on their Opinion Page (A15) on April 23 by Mark Skousen that essentially amounts to the same thing. Skousen compares apples and oranges and leaves us in a state of bewilderment wherein we now neither know what an apple or an orange is. Specially he says, “It (Global Output) is a better, more comprehensive measure of the nation’s economic activity than GDP, and a better indication of the economy’s growth prospects.” So my spout today is to explain why Skousen is both wrong and confusing.

The article is about an old economic concept that will now be published more regularly. The concept is called Gross Output (GO). There is nothing wrong with this concept. Just like an apple, it is a nice thing to have around. Actually, it is misnamed. It should be called Gross Sales. Why? Because it is a sales figure. GO is the sum of the sales of most companies in the country – those that produce raw materials, assemble units, manufacture goods, render services including those of retail and wholesale companies. GO is essentially the sum  of the sales of all those companies. It will now be published quarterly. I like that. 

Calling GO output, however is misleading.  Sales and output are not the same thing. This is easy to understand. Crotch Rocket Bicycles produced 100 bicycles this quarter. Unfortunately they forgot to hire a salesman and they sold no bicycles.  As a result, they produced 100, sold 0 and had inventory accumulation of 100. Or take the case of the whiskey producer Jim Daniels who had 1000 bottles in inventory. Jim Daniels then produced 700 bottles this quarter. Sales were 800.  So sales were 800, production was 700, and inventories declined by 100. Sales and Output are the not the same thing. If GO is sales then it should not go around calling itself output.

I know a guy who called himself Rocky for many years even though his name was Mike. No big deal. But in this case GO calling itself output is a problem because that word is reserved for GDP. GDP is output. GDP is not sales. So can I possibly be more obnoxious?

                          GO              GDP 
         Sales          Yes               No
        Output         NO              Yes

Why does any of this matter? It matters because apples are apples and they are not oranges. It helps to keep these things straight when you want to make apple juice or orange pie. GO is going to be published every quarter. It will tell us zip about output.
My above examples explain that the difference between sales and output has to do with changes in inventories:  (1) stuff produced this quarter that doesn’t get sold or (2) stuff produced in a previous quarter then sold this quarter.

GDP can rise in a given quarter only if we produce more. And by “we” I mean all the firms in the country whether they extract minerals, assemble cars, or sell insurance policies. Notice that GO, being a sales figure, can rise this quarter even if we didn’t produce more. GO rises because we sold more of current product or we sold more of past production.

Is GO better than GDP? Is sales better than output? The answer is no. Is a left brain better than a right brain? Is a car better than a blood transfusion? These things are mostly not comparable. GO and GDP are both products of measurement of a national economic system. They measure similar but different things. Having both of them published quarterly will be useful but clearly GO will not replace GDP. There is no sense comparing them.

Skousen says that GO is the better indication of a country’s growth prospects. He says it downplays the role of consumer spending in favor of business-to-business sales. Not true. Think of a value chain wherein
            Firm 1 digs up materials and sells them to Firm 2 for $50
            Firm 2 assembles the materials into a product and sells it to Firm 3 for $60
            Firm 3 paints the product and sells it to Firm 4 for $70
            Firm 4 sells the product to me for $80

Cool eh. Anyway, the value of the sales equals $50 +$60 + $70 + $80 = $260. This is the value of GO. What is the value of the total output? It is $80. You can calculate that as the value of the final product sold or you can sum the values of production added at each stage ($50 + $10 + $10 + $10). GDP is $80.

Even without any inventory complication, you can see that GO is much larger than GDP – it took $260 of sales to generate output of $80. You can see that they are both very different concepts or dimensions of a nation’s performance.

Why would GO be a better indicator than GDP? Because GO includes more lines of activity? I don’t think so. Think of bowling pins. The bowler aims at the front pin. If he hits it just right, he knocks over all 10 pins. The bowler doesn’t go to the bar and brag how each of the other 9 pins performed. He puffs up his chest and explains how he smacked that head pin just right!

The economy is the same. If you want to understand economic growth, you focus on cause and effect. All those intermediate sales are like those 9 pins – they just go along with something that started the chain reaction. The key to understanding the economy is not determined by how these intermediate sales react. The key to growth is how you get the chain reactions started. You don’t improve your game by finding ways to avoid the head pin and hit one of the others. 

Most macro policies aim at well-known driving variables. These usually focus on the end consumer or the firms that serve the end consumer. Macro policies rarely try to get Firm 2 to sell more to Firm 3 or to help Firm 3 to buy more paint. It makes no sense to focus on intermediate sales instead of sales to the final customer. Thus GDP and output are what we focus on if we want more growth, knowing full well that once we do the right thing a lot of things will be happening including a lot of intermediate sales.

So I say welcome to GO. Welcome to the quarterly macro indicators club. Having GO along side GDP may help us understand GDP even better. But let’s not waste our time wondering which one is better. GDP will remain the key gauge with or without GO.