The Fed, Persistence, and Global Imbalance

Has the world gone crazy? Congress decided to pass a continuing resolution for the budget without all the usual muss and fuss. Obama is being quietly applauded by many people in both parties for his stronger military stance in Syria. Soon we will read that Hillary Clinton and Rush Limbaugh are quietly dating.

I take all this personally as a slight against macroeconomics. Macro has clearly gone persona-non-grata. I can’t even find lonely shut-ins willing to talk about recessions or hyperinflations.  Apparently someone contacted the Fed and asked them to take up the slack and say some incomprehensible things. Have you read some of these stories? One line of thought is that the markets are ignoring the Fed. EVERYONE knows the Fed will soon start increasing interest rates so what is there to get excited about? Another line quotes experts who are absolutely sure that as soon as rates rise, the economy is going to return to a recession. The stock market mirrors these divergent views from day to day, 

What makes all this the more complicated and confusing is that the Fed has not announced when or if it will begin to raise rates. Forward guidance is tossed around as if it were a quarter-pounder with cheese. Honey, I am thinking of losing weight. Since you baked all those cookies I will have to eat them but be sure that if you do bake more cookies I will not eat one of them. You can count on that. 

Janet Yellen the head of the Fed recently said that while she does not see interest rates rising anytime soon she is definitely on to the possibility that once the overall economy returns to normalcy, rates will begin to rise and she will have to let them rise. Some people in the market today find that reassuring. If the economy is normal, then it seems silly to continue trying to keep interest rates near zero.  Bravo.

Of course there is more to it. The overall economy to you and me looks a lot like a huge elephant looks to a tiny ant crawling on the elephant. That ant cannot see the whole elephant and its idea of an elephant will be based on what particular part of the elephant it finds itself. Charles – be nice. Some of you guys are coming from a perspective wherein you think the economy is very fragile. You can point with vivid imagery and color to a lot of deficiencies in productivity, labor markets, and so on. 

You see bubbles about to burst. To you, any admission that interest rates are going to rise translates into weak seams turning into cracks and crack-ups.

So where are we really? As I said, no one knows the whole elephant and no one knows how much pressure the economy can withstand. But that doesn’t mean one cannot hold an opinion and mine is that rates will not spike upwards and the economy will withstand less pronounced increases.

Let me explain and support this forecast with a few ideas. First, the fifties were not good at forecasting the 60s nor were the 60s a good way to predict the 70s. Macroeconomics has grown and changed as history required. While much of the current models is valuable, there are key parts that will need changing before Macro leads to better predictions in the future. Models predicting that higher interest rates will doom us may be very wrong. Second, given the financial crisis and the following recession and slow growth period, I am betting on inertia or persistence to dominate the near future. Your spouse has persistence. Your spouse will remind you to push the toilet seat down every time you go to the toilet. 

Persistence in the economy means that a little healing from yesterday permits a little more healing today. The world economy got a huge smack in 2007/08 by way of a financial crisis. Such is NOT the kind of macro shock that can be fixed with a little tax here and some government spending there.  Durable behaviors guiding saving, investing, and other fundamentals got whacked. Financial hits take time to heal. When your savings have been depleted it takes time to return to financial health. For some the return has taken many years. For others there are still many years left to go. Then you add all the new regulations affecting a broad swatch of financial markets and you create even more impact and uncertainty with regard to timing. It is now late 2014 and we are well into that game. It should unfold on its present course.

Finally is the idea of relative strength. It is no secret that as we in the USA are lumbering along, some other major economic players are in much worse shape. Whether we look to Europe, Asia, or South America it is hard to see anything like US growth.  This means a lot of things. But one thing is sure – we are a long way from the kind of global synchronized economic expansion that raised prices and interest rates in the years before the financial crisis. New to our policymakers in 2014 is the idea that US economic growth will not be accompanied by growth elsewhere. Thus we can grow and have ample global sources for commodities, equipment, savings, labor and so on. We will and can continue to lumber ahead without the usual business cycle drag of significantly higher inflation and interest rates.

The markets are correct to ignore the Fed’s multi-headed hydra. The Fed has a lot of mouths speaking these days saying a lot of different things. No matter what Janet Yellen says, rates will rise in the near future but they will not rise enough to cause major disruptions. The Fed has the luxury of a little time to get rid of excesses. It should use that global blessing to get its balance sheet in balance. Waiting too long to stop ISIS was a mistake. Waiting too long to let interest rates rise won't be the right decision either. 

Blogging Trivia

Since I am traveling and getting a bit lazy in my old age I thought I would give you a change of pace this week with some facts about this blog space.

I started blogging right after retiring from the Kelley School of Business in March of 2010. So the blog is about 4.5 years old.

The blog activity has accomplished what I had hoped. It gives me an excuse to hide in my home office and pretend to be working. It is also a way to keep up communications with friends, relatives, neighbors, former students, pole dancers, and other colleagues. 

During the last 4.5 years, with help from guest bloggers, we posted 267 articles that have received approximately 65,000 page views. We accomplished that without nudity or free drug distribution. 

People often respond to the blog with comments – we have posted approximately 2,100 comments. I have rejected very few comments – rejections come mostly because they feature advertisements.

Some people prefer to respond to my posts privately via email, threats of violence,  or gifts of JD. Either way is appreciated. 

While we can rightly support or not support various politicians, economists, ideas, policies, etc -- my blogging experience has taught me that nothing is simple in the real world and there is plenty of room for adults to hold on to their cherished beliefs. I am always amazed at how many ways there is to look at any fact or issue. Someone once said something like -- the more you  know the more you realize you don't know. That statement seems pretty true to me. Of course, there is always the problem of finding yourself in the garage and not knowing why you are there. That gets even trickier if you don't have a garage. 

None of that, however, keeps me from thinking that either side of the debate has to give up strong beliefs. Taking sides and arguing hard is the best way to learn. As such I enjoy my blogging and feel that I have benefited from our interactions. I hope you have too. 

Yes, I do enjoy Jack Daniels but will accept donations of any sort of brown liquor.

While the great majority of the viewers are from the USA, the remaining top destinations are South Korea, Ukraine, Russia, the UK, France, Germany, and China. 

I try to organize the blog posts by subject. On the right-hand-side of the blog is a list of those topics. I didn’t count them but I am guessing the number of topics is just under 100. For each blog post I usually assign two or three topics.

The top 6 posts in terms of number of page views are:

The G20 Blame Game, September 10, 2013

Negative Real Interest Rates Cannot Exist, June 3, 2012

Inflation History Lesson: From the Frying Pan to the Fire and Back Again, May 21, 2013

Why We are Lousy Investors by Guest Blogger Robert Klemkosky, April 23, 2013

Let the Money Weaning Begin, November 12, 2013

Don’t Stop Believein’ by Guest Blogger Jerry Lynch, September 3, 2013             

Interest Rate Hysteria

As I write today, the 30 Year Fixed Rate on Mortgages is about 4.2%. Though MORT30 averaged higher than that in 2010 and 2011, it was below that rate recently and there is much concern that it, like other rates is soon headed upward. When I say there is concern I could also say there is near hysteria.  As I often like to do I checked some historical data and find little reason for undo concern.

Don’t get me wrong. If mortgage rates climb some people will be hurt. Change in any economic indicator has a tendency to penalize some while helping others. Prices of weed in Seattle have gone up since legalization and many puffers would probably prefer to go back to the good old days when the government was not taking its “fair” share of the profits. Inasmuch, prices and interest rates always cut in at least two ways. As you know, however, I am a card-carrying macroeconomist and as such am less worried about distribution and more interested in how indicators impact the whole economy.

Luckily we have macro indicators like real GDP that represent the macro performance of an economy. My data analysis looks at how changes in MORT30 have impacted real GDP.  And while this might sound heretical, I am seeing little concern raised by more than 40 years of annual data (1971 to 2013). That is, while it sounds obvious that increases in MORT30 ought to be terribly bad for the growth of the national economy, there is really very little relevant evidence to back that up.  Today some of us are very worried that the Fed will change policy, jerk interest rates upward, and return us to a terrible recession. The data do not support such a worry.

First I look at recession years. Did rising interest rates cause these recessions?  There have been 6 recessions encompassing parts of nine years since 1970. In three of those recessions -- 1973-74, 1980 and 1982, MORT30 increased and confirmed our worries. But it is important to point out that those years from 1973 to 1981 showed dramatic increases in inflation and MORT30 had reached over 16% by 1981. MORT30 increased from 7.5% in 1971 to 13.7% by 1980 and then 16.54% by 1981 (these rates are annual averages meaning that rates were even higher in some parts of those years). It is questionable how relevant those recessions are to today’s situation of low inflation expectations and interest rates.

In none of the three remaining recessions (1990, 2000, and 2007/2008) was there any interest rate increase during the recession. In most cases MORT30 was falling during or immediately before those recessions. It is seems unclear from this recession analysis that higher interest rates will cause another recession in today’s environment.

Second, I examine the time periods when real GDP growth declined. Did rising interest rates cause slower annual growth? There were 22 years between 1970 and 2013 when the growth rate of the economy declined. That is, the growth of real GDP in those 22 years was less than in the previous year. In nine of those 22 years interest rates rose in that year. Of those nine times when the interest rate rose during a slow growth period, in only five of those cases did MORT30 rise by more than 100 basis points in the year before and the year of the slowdown. In one case MORT30 fell by 222 basis points in those two years before and during the slowdown. There must have been something else contributing to the economic slowdowns in those 22 years. 

In the other 13 slower growth years MORT30 was falling.  If we combine the year of the slowdown with the year before, we find only one year in which there was a substantial rate rise of more than 50 basis points over those two years.

The great majority of recessions and one-year slowdowns are not associated with rising interest rates. Increases in interest rates did have large impacts on real GDP back when rates were historically high and rising but not so much when rates were more normal.

Finally, we turn to the times after 1980 when MORT30 rose more than a few points. What happened to real GDP in those years? 

1993-1994 MORT30 rose from 7.3% to 8.4%. In 1994 the rise of 110 basis points was associated with real GDP growth rising from 2.7% in 1993 to 4% in 1994. Growth did slow in 1995 to 2.7% as interest rates were declining in that year.

1998- 2000 MORT30 rose from 6.9% in 1998 to 8.1% in 2000. That was an increase of 111 basis points in two years. In each of those three years real GDP was increasing at rates above 4% (4.4, 4.7, 4.1). Real GDP grew at only 1% in 2001 but rates were declining in that year.

2005-2006   MORT30 rose from 5.9% to 6.4% for an increase of about 54 basis points that year. In those two years real GDP growth was 3.3% and then 2.7%. By 2007 economic growth fell to 1.8%  and by 2007 we were in a full blown recession.  That recession was attributed to a financial crisis emanating from a bubble in the real estate markets.

Rising mortgage rates do not bode ill for the economy. Often the rising rates are more a symptom of an expanding economy and less a precursor of a coming economic slowdown. Clearly the record is sketchy at best. Most clear is the danger of rising rates in a hyper-inflationary environment.  Lacking such a situation, the Fed can go ahead and let rates start to rise and not worry about economic fragility. The economy is growing and can take the hit. A bigger risk is that by waiting too long to let rates return to normality the Fed threatens a much bigger spike in rates and a return to some of the gloomier days of the 1970s.

I loved my 8-track player, disco music, and my Travolta-like dance moves but I am in no hurry to return to the 1970s.

The Strategy Hoax and ISIS

I am going to get a strategy soon. No you aren’t. My Mommy is bigger than your Mommy. Come on guys, you can do better than that.

The media is punch drunk on strategy. Republicans, of course, are giddy over the President’s admission that he has no strategy for ISIS in Syria.  The President is resolute that it takes time to design a strategy and as soon as he convenes important meetings with leaders on seventeen planets, he will announce exactly how he and they will both destroy and contain ISIS.

All of this manic depressive chatter gets us absolutely nowhere and therefore makes the problem worse. You say – Larry, how can you argue with strategy? Strategy is obvious. Strategy is like breakfast in the morning. Peyton Manning would not start a game without a strategy. Samsung Electronics has a clear and present strategy to destroy Apple. Jack Daniels plans to take over the world. No organization can exist without a strategy.

As one who taught for 169 years in a business school, I can hardly argue with the last paragraph. But the truth is that there are times when you can’t have a strategy – or at least you can’t meaningfully advocate one. You might think of other examples but I have one to press upon you today. When you wait too long to create a strategy and everything starts to fall apart – it is time to have either a Hail Mary or an escape route. College Joe doesn’t need an overall educational strategy when he gets his math test back with an F on it. What he needs to figure out is if he can find a way to bribe his math teacher. When the barn is burning, you don’t think about how to prepare your horse to win the Kentucky Derby. Get a hose and call the fire department.

See my point?  There is no strategy for ISIS in Syria or Ellettsville. There is no strategy because the horse is out of the barn. There is no strategy because we have let the problem get to where US leadership will not tolerate a solution.

The President seems to want a solution that involves political pressure either among Iraqis, regional players or perhaps NATO. But no such solution is possible – at least not for two hundred years or so. Whether you call it destruction or containment – that bunch of yahoos is not going to win a Parcheesi game.

More war-like approaches expounded by many hawkish Republicans are probably too late as well. Giving Kurds more modern equipment might help some but even with US air power to create cover, it is dubious to think that the Kurds, the Iraqis, and other partners will have the will to overcome a very motivated, entrenched, and determined ISIS. In the end, any such military solution will have to involve US troops and much more air cover. As in Vietnam many years ago, neither party in the US has the stomach to do the kind of bombing that might be effective in removing ISIS. There would be much too much collateral damage for either party to withstand.

So there you are. If there are no good tactical choices then it is hard to envision a strategy. I had one email interchange with a thoughtful friend and we started using words like bullies and worse bullies. Do we want help from Iran and Syria to topple ISIS? My friend says yes and he might be right. But we made friends with Russia as the Allies toppled Hitler.That seemed like the right choice since Hitler was a real menace. Like in our present dilemma the US waited too long to enter World War II – and for more than 60 years we had to deal with a Russian bear.  Maybe we could have stopped Hitler without selling our souls to Russia. Ask a Baltic friend how she enjoyed the Soviet experience. Then ask a Ukrainian.

What do we learn from all this? First, hesitation is often wrong. When something walks and quacks like a duck then it is a duck. ISIS is like kudzu*. Once it gets into your garden it will take over the whole neighborhood. If you wait to create an alliance with neighbors or you hope science will soon invent a new weed killer, then you will soon be choking in kudzu. Second, once you are forced to act quickly, don’t argue about strategy. That just slows the solution even more – and guarantees that no solution will be very effective. We may need to get help from dangerous places. We may need to harm civilians. We may need to live with dangerous consequences for decades. Quit arguing about strategy, make some tactical decisions, and get out a fire hose.

*From Wikipedia:Kudzu (/ˈkʊdzuː/, also called Japanese arrowroot^[1][2]) is a group of plants in the genus Pueraria, in the pea family Fabaceae, subfamily Faboideae. They are climbing, coiling, and trailing perennial vines native to much of eastern Asia, southeast Asia, and some Pacific Islands.^[2] The name comes from the Japanese name for the plants, kuzu (クズ or 葛^?), which was written "kudzu" in historical romanizations. Where these plants are naturalized, they can be invasive and are considered noxious weeds. The plant climbs over trees or shrubs and grows so rapidly that it kills them by heavy shading.^[3]

Inversions and Globalization

I learned how to invert a matrix in college and I have never been the same. Which is one reason that all this political talk about inversions brings back some pretty sweaty moments at Georgia Tech. Some people think corporate inversions show that some American companies are not good citizens. Others use this occasion as a means to discuss corporate taxes and to point out how and why US taxes are too high. Still others shrug their shoulders and admit that inversions are part of a larger process going on and will be with us with or without taxes or flag waving.

What a nice way to start. I now have everyone mad at me!  But the truth is that a larger process called globalization is going on. Globalization has been going on a long time but clearly it took a leap forward after the Cold War melted.  Distance matters when it comes to trading things. If you live here, you trade more with Bloomington's Big Red Liquors than with a similar store in Seattle. But it is also true that when you take a little trip to Indianapolis to visit Aunt Hillary, you might go to Costco – since you don’t have one yet in Bloomington. Why don’t Bloomingtonians drive to Indianapolis every day for their JD if Costco is so good? Answer: the cost of distance. Whether you value your time or gas or wear and tear on your car or the chance of getting into a wreck in Martinsville, the cost of distance makes you buy most things close to home.

What happens if the cost of distance dramatically decreases?? Answer: you widen the size of your market.  The end of the cold war reduced the cost of distance. After the cold war it was safer to travel to more places. As formerly non-capitalist countries entered into global competition and offered lower priced goods it was as if someone had “shortened the road” there. Innovations and technological progress in shipping, communications, and travel also lowered the costs of doing business across continents and countries. Of course reductions in regulations, taxes, and corruption added a recognition of the improved ease and cost of transactions at distance.

Globalization is a word that describes how International trades have mushroomed since around 1990. It isn’t just greedy business people who trade more. Lower distance costs have promoted more tourism. Imagine in 1985 the Chinese being the largest groups of worldwide travelers. Churches cooperate more. International organizations meet and work together more. Governments find it easier to use Skype or Korean Air – to facilitate more frequent meetings.

That’s the backdrop. Globalization has slowed but it continues today.  In macroeconomics we often measure globalization through what are called the Balance of Payments Accounts (BOPA). These accounts measure legal cross-border transactions of an economic nature. If you are awake you noticed the word legal – so we are already admitting these measures are not perfect. But based on a lot of different information sources, nations routinely measure trade in goods, services, dividends, interest, charitable giving, bonds, stocks, bank accounts, real estate, corporate ownership positions, derivatives, and more. This information comes out quarterly. And yes, it often gets revised over time.

Pertinent to the question of inversions is the part of the BOPA called the Financial and Capital Accounts (FCA). FCA measure changes in international transactions that relate to cross-border trades in financial instruments and capital, including acquiring and merging with foreign companies. These trades are summarized in the International Investment Position (IIP). It is the IIP that is relevant to put today’s concern about inversions into perspective. You can find the kind of information I quote below at the Bureau of Economic Analysis (  http://www.bea.gov/international/index.htm#iip ).

Let’s start with one fact. At the end of the first quarter of 2014 foreigners owned US assets worth $29.1 trillion. That’s a lot of Taco Bells. Of course it wasn’t all Taco Bells. Foreigners owned approximately $16 trillion of US bonds and stocks. Add to that $5.7 trillion for enough ownership in US companies to give foreign owners some managerial control. While we are worried about money flowing out of the US please note that between 2012 and 2013, foreigners increased their ownership of US assets by about $2 trillion.

And we reciprocated the interest. By Q1 2014 we owned $23.6 trillion assets abroad, up from $22.5 trillion the year before. You own me. I own you. That’s part of globalization. Furthermore – in the last year you owned even more of us and we owned even more of you.

Some of you accountants are saying, hold on a minute. Who owns more of whom? We calculate the Net IIP by subtracting what foreigners own of us from what we own of them. The result in Q1 2014 was -$5.5 trillion. Foreigners owned $5.5 trillion more of us than we owned of them. Some people interpret this as a bad thing. Note the negative sign. Negative signs are usually interpreted negatively. J  But it sounds pretty cool to me. Foreigners like our US assets. Would you rather be in Argentina where people wouldn’t buy your assets with a ten foot pole?

Anyway, this -$5.5 trillion suggests an imbalance in which we have future financial obligations or debts to pay internationally. That could be viewed negatively but won’t be a problem so long as people believe we can pay those foreign debts. But there is more to it. All this buying of our assets leads to needs for dollars which leads to a robust demand for dollars that makes the value of the dollar higher than it might be otherwise. So this Net IIP isn’t all good. If American companies invested more abroad, it would reduce this imbalance – making us less of an international debtor and perhaps improving our competitiveness.

I know this is getting complicated. And it is. Politicians who call our companies traitors for inversions are doing what politicians always do – making up simple stories to please some of the voters. Don’t be fooled. Companies will continue to react to the cost of distance. Taxes may impact the cost of distance but taxes are only one of many factors. Let companies do what they think is right for their stakeholders and in the end they will do what is right for America. Let's not call them nasty names until they actually break laws.