Archive for July 2013


The Fed should target inflation (as it is wrongly conceived by the public)

It’s a pretty well-established fact that the public thinks inflation is higher than the official statistics show.  I believe that’s because the public thinks of the “cost of living” in a slightly different way from how economists think of the term.  If the average phone bill was $30/month in 1970 and its $60/month today, then people think the cost of phone service has doubled, even if the price of a long distance call has fallen by 99%.  If popular models of color TVs now cost the same $400 as in 1960, then the price is unchanged in the public’s mind, even if the BLS says TV prices are down by 90%.  Only for items like gasoline do the public and BLS agree.

To the public, the “cost of living” is the amount of income you need to have a normal lifestyle.  What’s a normal lifestyle?  Roughly the lifestyle of your neighbors. And since both income and consumption tends to rise a bit faster than the CPI, the public’s estimates of the rate of inflation are slightly higher than the BLS’s estimate.  (I’m cheating a bit here; I actually think the public is composed of a mixture of people who understand what the BLS is measuring, and those who don’t.)

Let’s say the public does think of the cost of living in terms of the amount of money needed for an average lifestyle.  In that case, what variable should the Fed stabilize?  Obviously growth in average incomes.  And if population growth is fairly steady at 1% per year, then one way of stabilizing average per capita income growth at 4% per year, would be to set a 5% NGDP target.

So the public actually favors NGDP targeting, they just don’t know it.

BTW, if my theory were correct then the Chinese people should believe that the cost of living in China is rising really, really fast, even though the inflation data shows a very slow rise in prices.  That’s because nominal incomes are rising very fast in China.

And they do!  It may be hard to believe, but the Chinese people were complaining bitterly about inflation back in 2010, when the Chinese CPI was rising by 2.7% and their nominal incomes were soaring at double digit rates.

It’s all about “keeping up with the Zhangs.”

PS.  In addition to the article I linked to, I’d like to cite my wife as a source.  She tells me that the Chinese people feel that prices in China have risen very rapidly in recent years.

PPS.  Some people claim that NGDP targeting is a bad idea because the public doesn’t understand NGDP, but they do understand inflation.  OK, the Fed should tell the public they plan to target the “real price level.”  To the public that phrase will sound like the “actual price level,” not the phony numbers that the BLS puts out, which (according to Peter Schiff) make inflation look lower than it really is.  The Fed’s reputation will rise.  The public will think; “Aha, I knew all along inflation was more than 2%.”  The “real price level” is also a dog whistle to economists that the variable being targeting is real output times the price level.

All hail Mark Sadowski

Here’s Mark from yesterday’s comment section:

I’ve developed my own relatively simple nowcast model based on the subcomponents of GDP using currently available monthly FRED data. (For example the last available new data was the Value of Manufacturers’ Shipments for Capital Goods: Nondefense Capital Goods Excluding Aircraft Industries for June on 7/25, which I used to project private fixed nonresidential investment.) My estimates for 2013Q2 have been consistently more optimistic than those of the major modelers. My current estimate is actually a frightenly high 2.0% RGDP growth for 2013Q2.

I’m sure that the major modelers have access to better data than me, and their models are far more sophisticated, but it will be very interesting to see the final results and where who has been wrong and why.

The reported figure was 1.7%, which suggests that Mark was closer than the experts, who predicted 1%.  Not to rain on his parade, but these early numbers are often revised.  And the revisions done by the BEA have in no way resolved the puzzle that I discussed last month.  In the 6 months between 2012:3 and 2013:1, NGDP rose at a rate of 2.2% and NGDI rose at a rate of 5.1%.  The first number is borderline recession and the second is boom.  So which is right?  Probably neither, but the 2.2% seems especially wrong.  RGDP growth averaged only 0.6% over those 2 quarters.  Yet industrial production rose at a 3.4% annual rate, housing starts were up at a 50% annual rate, there was relatively rapid job growth.   Sorry, but that’s not an economy skirting recession.  I also suspect the 5.1% figure is too high.  We could average the two (3.65%), but my hunch is 4% is about right.

The Federal government really needs to fix this problem, it’s inexcusable.  And set up an NGDP futures market while you are at it.  They should probably base the payoffs on the average of NGDP and NGDI, at least until the problem is sorted out.

I wonder what Mark’s model tells us about GDP growth in the prior two quarters.

PS.  2013:2 NGDI numbers are released next month.


About the GDP number

Back in April I predicted a weak 2nd quarter RGDP number, mostly due to the sequester.  Tomorrow morning we will find out whether I was right.  In any case, I still expect about 2% RGDP growth for 2013, about the same as 2012.  I doubt the fiscal austerity will have a significant impact, due to monetary offset.  Although I certainly concede it might slow growth in Q2.

Morgan Warstler sent me an article that’s much more optimistic about GDP growth than I am, which makes some interesting points.  It’s not really my area of expertise, so I don’t quite know what to make of numbers like tax revenue rising 6% even adjusted for tax rate increases:

Judging by the figures for growth, the U.S. economy is in the doldrums. Labor-market data tell a more positive story.

Payrolls climbed by 202,000 a month on average from January through June, up from 180,000 in the second half of 2012, according to the Labor Department. Such gains are typically linked with gross domestic product growing close to 3 percent, about double what government data may show next week, say economists at UniCredit Group and Deutsche Bank Securities Inc.

“The employment numbers are closer to the true picture,” said Harm Bandholz, chief U.S. economist at UniCredit in New York and the top payroll forecaster in the past two years, according to data compiled by Bloomberg. “I’m confident GDP growth will pick up in the second half and even more in 2014.”

The weight of the evidence also tips the balance toward a more favorable outcome as federal tax receipts rise at the fastest pace in six years, measures of consumer confidence reach the highest levels since at least 2008, and sales of autos and homes and housing rebound. That helps explain why companies from General Electric Co. (GE) to Texas Industries Inc. (TXI) plan to keep investing and hiring.

After adjusting for the increase in rates that took effect this year, employee income-tax withholdings were up about 6 percent in June compared with a year earlier, the best showing for that month since 2007, according to calculations based on Treasury data by Joseph LaVorgna, the New York-based chief U.S. economist at Deutsche Bank. More receipts point to gains in employment, rising wages or a combination of both.

Tax Receipts

“Tax receipts are confirming the improvement in the labor market, but GDP seems to be overstating the weakness in output,” said LaVorgna. GDP in the first half of the year gives the impression of a “lousy” economy whereas it’s actually been “decent,” he said. It “reinforces the view that the second half will be better.”

.  .  .

Growth in the first half of 2013 was restrained by the effect of federal government cutbacks and increase in taxes which is likely to wane. Slower inventory building and a wider trade deficit also curbed the expansion last quarter, when GDP rose at a 1 percent annualized rate, according to the median forecast in a Bloomberg survey ahead of Commerce Department data due on July 31. The economy grew at a 1.8 percent pace in the first quarter.

.  .  .

Expanding job openingshome prices that are growing at the fastest pace since before the recession and record-high equity values are helping shore up household confidence. The Bloomberg Consumer Comfort Index (COMFCOMF) climbed last week to match the highest level since January 2008 as Americans grew more upbeat about the economy. A similar measure from Thomson Reuters/University of Michigan issued today reached a six-year high for July.

More confident consumers are spending on big-ticket items. Cars (SAARTOTL) and light trucks sold in June at the strongest pace since November 2007, according to Ward’s Automotive Group. Ford Motor Co. (F) on July 23 said it will hire 3,000 salaried employees this year, 800 more than originally planned.

Housing Rebound

The housing rebound is another sign of an improving economic outlook.

.  .  .

Annual Revisions

The disconnect between hiring and growth may begin to narrow when, along with second-quarter growth figures, the Commerce Department next week issues GDP revisions, said Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York.

The government annually updates the growth data by incorporating more complete information that is only available with a lag. This year will be a more comprehensive overhaul, something that is done about every five years, and will include changes in the way GDP is calculated, which could potentially affect the figures back to 1929.

GDP “looks increasingly like the outlier” relative to other data such as corporate profits, said Dutta. “Overwhelmingly, the signals are that the economy is not only doing OK, but doing better than a lot of people think.”

A stronger economy would make Federal Reserve projections easier to achieve this year and next, said Dutta. In June, Fed officials forecast the U.S. will grow 2.3 percent to 2.6 percent this year and 3 percent to 3.5 percent in 2014.

Income Gains

Gains in income and profits are another sign that growth is probably stronger than currently thought, according to Joseph Carson, director of global economic research at AllianceBernstein LP in New York.

Fed research has shown that gross domestic income, or the money earned by the people, businesses and government agencies whose purchases go into calculating growth, is a better gauge of the economy. After multiple revisions over time, the growth estimates tend to align more closely with the income figures, rather than the other way around, according to a 2010 paper by Fed economist Jeremy J. Nalewaik.

GDP has increased at a 3.4 percent annualized rate since the third quarter of 2012 before adjusting for inflation, while GDI grew at a 4.9 percent pace, Carson said. He projects the economy’s growth rate will be revised up for the past few years when the update is released on July 31.

Lingering Effects

While the lingering effects of the worst recession in the post-World War II era — including diminished productivity following the plunge in business investment — have contributed to slower growth, “it’s certainly credible that the GDP number has been undercounted,” said James O’Sullivan, chief U.S. economist at High Frequency Economics in Valhalla, New York.

“The employment data are strong enough already to be consistent with at least a 3 percent pace of GDP growth,” he said.

President Obama needs to put the interests of the country ahead of his personal views

What do most progressives, market monetarists, Wall Street economists, James Hamilton and John Taylor agree upon?

Answer: Yellen is a better choice than Summers.

Reply to Peter Boettke

Peter Boettke recently took issue with my paper on NGDP futures targeting:

Ignore the contradiction that Scott in this paper had already brushed aside the abolition of government’s monopoly status over currency as unrealistic, but now is asking us to unrealistically assume away public choice problems.  The issue I want to raise is different.

Once one really gets the public choice logic, I always thought, you must endogenize politics into any analysis of public policy.

Here’s how I think about this issue.  There are three dimensions to monetary policy:

1.  How should the value of money be controlled?  (I.e. stable P, stable M, stable PY, stable growth path for PY, etc.)

2.  Who should control the value of money?  (I.e. the Fed, free banks, etc.)

3.  What technical mechanism can be constructed to make it easier to control the value of money in the desired way?

I tend to think of these problems separately, although I concede that it’s theoretically possible that the optimal target for free banks might be (let’s say) P*Y stability whereas the optimal target for central banks might be stable P.  But I see no evidence of this being true.  That’s because I also believe that the welfare effects of bad monetary policy (public or private) are overwhelmingly external.  That is, the costs of unstable employment and NGDP vastly outweigh the fluctuations in gains or losses to the balance sheets of central banks or free banks.  Thus I believe it makes sense to think about the optimal path for the value of money using macroeconomic theory, not micro-market efficiency models.

In an earlier Mercatus paper I tried to show that Hayek was correct in arguing that NGDP targeting is the best policy for the value of money.  Or at least close to being best.  In the more recent paper I took that goal as a given, and argued that NGDP futures targeting is the best way to implement NGDP targeting, if that’s what we’ve decided to do.  On the other hand if society (or free banks) decide price level stability is best, then I think CPI futures targeting is the best way to go.

Now let me address Peter’s comment, to which I would normally be very sympathetic.  For instance, public choice issues cannot be pushed aside when deciding on public policy in health care.  But I see this issue somewhat differently.   I favor NGDP futures targeting regardless of whether the monetary system is operated by a central bank or a collection of free banks—for the reason that the external costs to society from unstable NGDP are so high.  The analogy I would prefer is electricity production.

Suppose I’m hired to design the optimal electricity system for a publicly-owned electricity company.  I might advocate the stacking model, where you run low MC/high capital cost technologies 24/7 (hydro, nuclear), then medium cost (coal), and then low capital cost/high MC cost for peak demand (oil and gas.)  Even though I’d designed this structure for a publicly-owned utility, I’d also argue it’s equally desirable for a privately-owned utility.  It’s a technical solution to a technical problem.

Now of course one might argue that I shouldn’t even be picking something like NGDP targeting, the market should pick the target.  That’s where my “externality” argument comes in.  NGDP instability has huge external costs.  If free banks happen to maximize profits at stable NGDP growth, then fine.  If they don’t, then they need to be nudged in that direction.  I certainly agree that society doesn’t need a government-run central bank.  But I think it unlikely that free banks would just happen to produce the optimal policy for employment and nominal stability, and so I favor having the public sector set the target, at a minimum.  Even if we decide to adopt free banking.

PS.  Bill Woolsey made some related points in a comment.

HT:  David Levey.

Update:  Lars Christensen has an excellent post that addresses the “defeatist” aspect of some public choice arguments.