Rising Mortgage Rates will not Kill the Housing Recovery

Cartoon by Jim Gibson



I do not know how many credit market columns I read last week that announced, lamented, and frantically worried about rising mortgage interest rates. It is as if a young couple fretted about the fact that their baby was reaching 22 pounds. For you people not from the US a pound is a unit if weight similar to a stone or a rock.  Most babies start at about 6 pounds and keep gaining weight until they become tackles for an NFL team. It is perfectly natural for the child to reach 22 pounds at some point.

According to the press, interest rates should not be allowed to grow up.  I will admit that US interest rates got very low. In fact a graph of the 30 year Conventional Mortgage Rate (let’s call this interest rate Mort) shows that Mort has not been lower since 1965.  http://research.stlouisfed.org/fred2/graph/?id=MORTG  Despite recent increases in Mort, he is still below every single data point since 1965 except the very recent time period starting from August 2010.

So rates are rising but they are rising only in comparison to about two years of historically low rates. Imagine living through a time period when the temperatures in Miami in July were 180 degrees F. You would have to admit that 185F in Miami in July is not normal. But then imagine when the temps went to 170F everyone started to worry about a coming freeze. People started cancelling vacations in Florida because they thought it would be too cold. Crazy right?

The graph of Mort is very clear. Starting in 1980 when interest rates rose to very high levels, the trend has been downward. That is right, for almost 35 years, Mort has been getting lower and lower. Of course there have been cycles around the trend and that means there have been times when Mort rose. But every upward phase was always followed by a downward one – one that left rates even lower than when the phase started. Consider these average Mort rates ---

          

            1985 to 89   10.7%

            1990 to 94   9.2%

            1995 to 99   7.6%

            2000 to 04   6.7%

            2005 to 09   5.9%

            2010 +        4.2%

As I write today Mort is about 4.5%. So it is higher than the 3.4% at the end of 2012 and the 4.2% average since 2010, but it is now considerably lower than any of the averages of the 5 year periods since 1965. It is also much lower than the average of recent years before the world recession.

Why are we so worried about Mort? The answer is that we are really worried about his cousin Heloise (Housing Starts). Heloise has not been well. Heloise is a shadow of her former self but has been improving of late. After coming in at a low ebb of 478,000 units in spring of 2009, Heloise has been rising hitting about a million starts in March of this year but settling in at a pace of over 850,000 starts since.

There is a worry that if Mort rises more that this will diminish Heloise. But this does not make any sense because it leaves out all those other variables that might impact the demand and supply for housing. Even at one million units per month, Heloise is more than a million starts below the previous annual peak and is probably only 60% of what might be considered a past normal result. Heloise remains weak despite super-record-low Mort. That means that there must be something else besides Mort that is bothering Heloise.

That something else is the same list of things that is keeping the general national recovery at a slow pace and restraining employment. Among the items in that list is an unfinished reform agenda that leaves banks and households uncertain about the future of housing, banking, energy, healthcare and more. Interest rates can and will increase.  But that should not be an alarming factor. It should be just the opposite. The rise in interest rates is signaling a stronger economy.  The risk of another major financial recession is slowly receding into the past. Output and incomes are rising. Employment is increasing, albeit slowly. This foundation means that the housing market will not vanish just because mortgage rates hit or exceed 5%. 

While we might not feel lucky the gradual US and world economic recovery will be a good thing for Mort and Heloise. As Europe, Japan, China, and emerging nations expand at a gradual rate, this puts less pressure on commodities and other markets and should keep inflation in check for a while. This will keep Mort in check as well. Note from the history cited above that trend Mort has come down for almost 35 years. Much of that can be explained by a secular decline in inflation and inflation expectations. So a key to Mort and Heloise happiness is keeping those inflation expectations damped.

In short the sky is not falling. Interest rates are going to keep rising as the economy gradually recovers. Housing will not be unduly troubled as housing demand marches back to more normal monthly starts. But a gradual recovery is not enough to guarantee success. Much would be improved by a return to sane monetary and fiscal policy. Removing stimulus means anchored inflation expectations. A sustained recovery is impossible without it. 

The G20 Blame Game

As the world puts Syria under the microscope you might need a little change of topic to keep from going mad. So I decided to write about my gall bladder. People my age spend at least 74% of their time talking about their physical ailments and while I feel pretty good today I could share a lot of medical information with you. But as I was researching shingles and Dupuytren’s contracture I ran across an article about the G20.

Apparently the G20 is meeting in Russia and there were many photos of Mr. Obama and Mr. Putin playing darts with hand grenades. Since most of you think the G20 is the latest sports car made by Pontiac I thought it might be helpful to explain what was going in Russia with the G20 and why we should care.

The letter G in this context refers to the word Group and the word Group applies to countries that want to discuss politics and international relations. G2 is used when the US and China get together to chat about common issues. More popular is the G7 which includes the largest and most wealthy countries in the world when they do not want to include China in their meetings. This includes such stalwarts as the US, UK, Canada, France, Germany, Italy, and Japan.  The Canadians usually bring the beer. Eh. 

Anyway, the G7 has been meeting to solve global problems since 1975 and most people would agree that this group of overweight and sex addicted world leaders have solved almost no problems except for increasing Canadian beer exports. But they do meet regularly and have spectacular meals and the meetings are always followed by much back-slapping and a published summary of meeting accomplishments and common goals. For example hardly a meeting goes by when the G7 does not underscore their sincere interests in global harmony and world peace.

At one meeting it was pointed out by one G7 member that there are other countries that have gone beyond national potty training and ought to be included as formal members of the group. Since the name of the group was G7, they were met with an immediate mathematical challenge of how they could have more than 7 members and still be called the G7. I think it was France who suggested that they add Russia to the group and call it the G8. Problem solved!

As you can imagine, once Russia was added, the other members of BRIC – Brazil, India, and China -- felt lonely, rejected, and insulted and demanded that they be added to the G7 as well. Of course, this caused a stampede of other countries like South Africa, South Korea, and South Carolina who demanded they be included. So far we now have 19 countries in something we proudly refer to as the G20. Apparently the European countries didn’t get enough face time so they added the EU as the 20^th member. If your head is spinning at this point you may refer to the authority of all authorities – Wikipedia – for more information about the G20 at http://en.wikipedia.org/wiki/G-20_major_economies

The interesting thing about this most recent meeting in Russia is how the focus is on the US – and not just because of Syria, spying, and Miley Cyrus.  One issue has to do with US Federal Reserve policy. You know as a loyal reader of this blog that the Fed is talking about thinking about discussing and voting on the possibility that we might begin at some uncertain point in the future and in amounts not to be discussed in mixed company the idea of tapering. Tapering is now a four-letter word that brings out the worst fears in us. As a result of tapering discussions, the Eiffel Tower tilted and Al Gore admitted he did not in fact invent the whole Internet or fantasy football.

While I jest the truth is that the mere suggestion of reducing the rate at which we are dumping money into the US economy (think of water going over the Niagara Falls into a small cup) has already caused US interest rates to start rising upwards and hot money to flow away from many countries – and of course away from many G20 countries. The result is a chorus of countries singing in unison Amazing Grace. But I jest again. These countries sound like a chorus but the song is something more like the Everly Brothers’ Bye Bye Love or Hank Williams’ Your Cheatin’ Heart.

Despite triumphant announcements in 2008 that the emerging markets were finally de-linked from the US business cycle, we have seen how optimistic and wrong such pronouncements were. First they complained that the US was putting too much money into the world economic system. All that money was floating overseas and causing havoc in their financial systems and driving up their currency values. Now they complain of the opposite. Just the mention of tapering in the US and money is exiting these countries in waves. This is driving down their currency values. Apparently they are not as de-linked as they previously thought.

What are we to think about all this howling?  First, we are guilty as charged. One does not have to live in an emerging nation to dislike a very unstable US monetary policy. We in the US disliked how the Fed flooded the US economy with liquidity and then has gone well beyond the prudent point to begin withdrawing this stimulus. The Fed has generated a lot of uncertainty and unnecessary economic gyrations so that banks can sit around with mountains of excess reserves and the Fed serves as Obama’s lap dog dutifully running out into the street and collecting as many bonds as the government can sell.

So we can all be critical of the US Fed. But wait – don’t the other guys have some responsibility? After all, it appeared that they were less reliant on the US economy when China became the Miss Piggy of global commodity demand… or when they diverted much of their international trade to a growing list of other countries as globalization created more international opportunities. Perhaps some emerging market ire should be aimed at China for its failure to continue 10% plus economic growth or to Europe for having almost no coordinated economic policy despite being called a “European Union”. In short, these emerging market countries might spread their dissatisfaction beyond US monetary policy.

But if we are going to play the blame game – let’s not forget that these emerging nations have some responsibilities when it comes to economic growth. Globalization makes possible huge gains as emerging nations exploit comparative advantage and compete for manufacturing locations and exports on a global scale. But as the last 20 or more years have shown, to benefit from those opportunities these emerging nations had to be competitive. This meant that they had to transform what were often highly centrally planned economies into more decentralized capitalistic systems. These countries deregulated prices and wages; they privatized many formerly state-owned enterprises; they changed laws so that property could be protected and they allowed foreigners to own domestic assets and companies.

Some countries have moved farther along the transformation curve than others. Depending on the politics, some have taken two steps backward after moving forward. And this lack of completion of transformation is very telling. When the US catches a cold many of these countries get pneumonia. Why? Because we all know that these countries do not have balanced economies. All their eggs – so to speak – are in one or a few baskets. It is great when you create a lot of employment and income by selling copper to China. But when China slows its purchases from you, it is not so great. You can’t love hot money inflows one day and then deplore them the next when funds flow out. Hot money is hot money. If you allow your economy to rely on hot money or on China then you have to take the good with the bad. Or somehow find more balance.

It is this balance that is so elusive to an emerging market. If exports to China or hot money flows create great benefits, it is tempting to want to keep the benefits flowing. But this growth strategy is unreliable and risky. Most countries strive for self-sufficiency while they enjoy the benefits of international trade and investment. But economic broadening comes slowly and often means slower growth as the economy adjusts from the very risky unbalanced model to one that is more stable. Broadening also means tough  new policies that essentially replace government edict and protectionism with capitalism and competition. It is easy to blame other for your misfortunes but these major emerging markets have no one to blame but themselves. Blame the Fed if you want to but get on with the transformation process.

Don't Stop Believein' by Guest blogger Jerry Lynch

Jerry Lynch has been an economics professor at Purdue for over 30 years.  He also served as Associate Dean and Interim Dean of the school in various past fits of insanity.  He has returned to teaching the core Macro Policy class in the MBA program and is pleased to have this blogging opportunity to spout off.

Don’t Stop Believin’

                Just a city boy

                Born and raised in South Detroit

                He took the midnight train goin’ anywhere

The headline news just one month ago, now usurped by the crisis in the Middle East, was that the City of Detroit had filed for bankruptcy claiming to be unable to meet the payments to its creditors.  One of the questions asked when it first filed was whether or not it was legal for a city to file for bankruptcy.  That question seemed to be answered on a federal level when the city of Stockton was allowed to file last April.  However, a state judge ruled that the Detroit bankruptcy petition violates the Michigan state constitution. 

The declaratory judgment came in lawsuits filed by Detroit pension funds, retirees and workers, which sought to prevent a bankruptcy filing that would ultimately impair retirement benefits in violation of constitutional protections for those benefits.

Legally Detroit is at an impasse now on its bankruptcy proceedings.  While the legal wrangling is of interest to many, of more interest to me as an economist is the role that pension funds played in getting Detroit to where it is.  Let’s start by exploring pensions in general, then look to the specific case of Detroit, and finish with a little speculation about how far this might go in terms of other municipalities meeting their pension obligations.

There are essentially two kinds of pension plans, a defined benefit plan and a defined contribution plan.  In a defined benefit plan the benefit that a retiree receives is based on some formula that typically includes years of service times some multiplier per year times some final earned value.  For example, a pension may pay 2.5% per year worked times the last year’s earnings.  If someone worked thirty years then their benefit would be 30 (years) * 2.5% (per year) * last year’s earnings or 75% of their last year’s earnings.  There are many variations on this in terms of the multiplier or last year versus average of the last x number of years.  However, all defined benefit plans carry this in common -- Once you are retired, your employer/sponsor will pay you that benefit for as long as you live.  The complete liability for the program falls on the employer/sponsor.

In a defined contribution plan either you, your employer, or in combination make a defined contribution each month into a pension plan.  Typically your contribution is pre-tax.  Once you retire, you have that pot of money and can pretty much choose to draw it out any way you like.  Once you retire, your employer/sponsor has no liability for you.  You are on your own.

The defined benefit plan is going the way of the dinosaur in the private sector.  Employers do not want that liability. Shareholders in public corporations do not want it either as there is uncertainty about the present value of that future liability.  The defined benefit plan, however, is alive and well in the public sector as 88% of public employees are covered by a defined benefit plan.  The municipal employees of Detroit are “covered” under this type of program.  There are charges of abuse of the system in that employees will work a lot of overtime their last year of work so that the base for their pension is higher.  While that is no doubt of some concern, it is not the major reason why Detroit and other municipalities are in trouble.  A question you may ask yourself is, if I promise to pay you x number of dollars per year until you die, how much money will I need to set aside?  Good question, even if I had to prompt you to ask it.

Defined benefits programs can either be funded or unfunded.  In an unfunded program no assets are set aside and the employer pays out of current revenue as needed.  This is also known as PAYGO for pay as you go.  Up until the early 1970s about all defined benefit plans were unfunded.  Companies figured that revenue would keep growing and they would be able to pay pensioners out of those funds.  This is essentially how Social Security works but we’ll save that for another day.  As retirees started living longer the liability of the pension payments increased and the extent of underfunding grew.   Recognizing the impending storm the Employee Retirement Income Security Act (ERISA) was passed in 1974 that put restrictions on private pension funds and also required them to participate in the Pension Benefit Guaranty Corporation (PBGC) an independent agency of the government that insures pensions.  One of the restrictions imposed on private pension funds by ERISA was that an unfunded/PAYGO system would no longer be allowed.  Thus corporations, and probably also their employees, have to contribute to a pension fund even if it is a defined benefit program.  By the way, General Motors went from a defined benefit program to a 401(k) in the spring of 2012.  ERISA does not apply to public pension funds and they are not insured by the PBGC.

Back to Detroit.  Detroit has a defined benefit program that is neither unfunded nor funded.  It has what is the most common type of defined benefit fund today, an underfunded one.  Back to our question above, how much money needs to be set aside to fund the defined benefit obligation of Detroit and other municipalities?  The biggest uncertainty in all of this is the expected rate of return on the funds set aside to make future payments from.  If I expect to get, say, an 8% rate of return, I need to set aside a lot less than if I expect a 5% rate of return.   Detroit’s impending financial problems led Governor Rick Snyder to appoint Kevyn Orr as Emergency Manager of Detroit’s finances.  Mr. Orr, a former bankruptcy attorney for the Jones Day law firm in Washington DC, says the pension fund has underestimated the present value of its future liabilities by assuming a nearly  8% return on assets.  Not all of Detroit’s problems are related to its pension obligations.  The city’s population is half of what it was in the 1960s which has obviously reduced tax revenue.  It also has a history of corruption and overspending in awarding contracts, former Mayor Kwame Kilpatrick is awaiting sentencing in October 2013 for a pattern of extortion, bribery and fraud.   

Still, the pension fund is a large contributor to the problem.  Mr. Orr says Detroit has $18 billion in debt which includes $3.5 billion in unfunded retirement liabilities. The managers of the city pension fund said in a news release earlier this summer that they are no more than $700 million short.  Still not a comforting thought.  Their disagreement hinges on the expected return the pension fund will earn and thus what discount rate to use when bringing future liabilities back to their present value. A conclusion on how underfunded the pension funds are has more than academic implications as it will impact how much of a haircut both bondholders and the city’s pensioners are going to be asked to take.

News about Detroit’s troubles have temporarily taken a backseat to the conflict in the middle east and A-Rod’s steroid use but it is not a problem that will go away by ignoring it.  And, it is not Detroit’s problem alone.  Cities across the country with defined benefit programs assume they are adequately funded because they are assuming relatively high returns.  An argument over the appropriate discount rate to arrive at the present value of the pension liability will determine in large part what the payout of pension funds will be.  The Government Accounting Standards Board last year called for underfunded pension plans to use a discount rate in the 3 to 4 percent range. That is well less than most pension funds expect to earn and, if followed, will likely lead to pensioners receiving less in benefits.  Don’t expect this issue to be resolved any time soon.  As unglamorous as a defined contribution fund may be, at this point, be happy if you have one.

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. 

Biases in Processing Information by Guest Blogger, Buck Klemkosky

The world is awash in data, so much so that a new field has evolved called “big data.” The explosion in data can be attributed to three factors: the increase in computer processing power at lower costs, the start of the World Wide Web in 1990, and the development of cellular technology. The explosion of digital data can only be compared with printed material in the Western world after Gutenberg invented the printing press in 1440.

How much digital data is available? No one knows precisely, but that doesn’t stop people from making estimates. In digital terms, everything starts with bits (short for binary digits, 0 or 1, computers use to store and process data) and bytes (8 bits, which is the basic unit of computing). It escalates from there:

kB kilobyte = 1,000 bytes                               PB petabyte = 1,000 TB

MB megabyte = 1,000 kB                               EB Exabyte = 1,000 PB

GB gigabyte = 1,000 MB                                ZB zetabyte = 1,000 EB

TB terabyte =1,000 GB                                  YB yottabyte = 1,000 ZB

Remember that the first personal computer had 56 kilobytes of memory and todays’ usually have a couple of gigabytes. But the total data in the world is estimated to be several zetabytes with more being produced every day.

As mentioned previously, most of the data in existence is noise and not useful for making decisions. But we try to decipher and glean from all of the data useful information. Our brains are surprisingly powerful processors of data and information, but selecting information to be used in decision making is hampered by several psychological biases.

It is only human nature that we get more pleasure from being right than wrong. So if we have beliefs or have made a decision, we become selective in collecting and using only confirming information. We filter out and reject information that is contrary to our beliefs and decisions. It’s much easier to support

than contradict. Sometimes we even use ambiguous and perhaps wrong information as supportive.

Investors are especially subject to confirmation bias. Once we buy a stock or bond, we are much more receptive to supporting information than contradiction. Some investors have strong opinions about the direction of the market in general, short term and long term. If you are a perma (long-term) bull or a perma bear, eventually you may be right, but it’s those intervening years that hurt.

What makes Warren Buffett such a successful investor is that he actually seeks out nonconfirming information. He has billions of dollars of his wealth, almost all, invested in Berkshire-Hathaway stock. At this year’s annual meeting, for example, he invited one of the most negative investors concerning Berkshire-Hathaway to address the 20,000 shareholders. This investor had taken a large short position in the stock, expecting it to decline in price.

In addition to confirmation bias, investors also have a tendency to use readily available information that can be easily recalled, which is called the availability bias. We also have a recency bias by giving more weight to more recent information and events and less to that more distant in time.

Investors also generalize with insufficient information, which means we use a small statistically insignificant sample or anecdotal evidence as information to make decisions. Most often it represents our own experience or something we are familiar with. The future looks like something we know or are familiar with based upon recent events or frequency of events. This is one of the reasons individual investors have been reluctant to invest in stocks again after the bear markets of 2000-2002 and 2007-2009, even though the market has appreciated 150 percent since the S&P 500 lows in March 2009.

It is easy to have opinions about almost everything. It is much more difficult to have informed opinions. But we never know if we are fully informed or not. Even though we may believe that we have correct information, it has a high probability of being biased. That is why uncertainty always prevails, especially in the financial markets.