Archive for January 2015


Research bleg

In this post I’m going to throw out a bunch of graphs, and ask for advice.  First let me briefly discuss real wage cyclicality.  Many of the early macroeconomists believed that real wages should be countercyclical.  They held a sticky-wage theory of the business cycle.  When prices fell sharply, nominal wages seemed to respond with a lag (even in 1921.)  Thus deflation temporarily raised real wages, even as unemployment was rising.

Real wages were quite countercyclical between the wars, but after WWII many studies found them to be acyclical, or even procyclical.  Most economists thought this was inconsistent with sticky wage models of the price level, and new Keynesian models ended up focusing on price stickiness and inflation targeting.  Greg Mankiw and Ricardo Reis have a 2003 paper that shows that you generally want to target the stickiest price.

In 1989 Steve Silver and I published a paper in the JPE that showed real wages were somewhat countercyclical during demand shocks and strongly procyclical during supply shocks. We suggested that this finding was supportive of sticky wage models of the cycle.  It even got cited in some intermediate macro texts (Mankiw’s textbook and also Bernanke’s.)  But after a while it was ignored.  In the graph below I show real wages during the post war years:Screen Shot 2015-01-27 at 1.55.46 PM

You can see why people didn’t find much cyclicality. And if you look closely you can also see some support for the paper I did with Steve Silver.  When real wages rise during recessions (1981-82, 2001, 2008-09) it’s a demand-side recession. When they clearly fall (1974, 1980) it’s a supply-side recession.  However there are some smaller demand-side recessions with almost no change in real wages.

Now let’s switch over to the “musical chairs” version of the sticky-wage model.  In the real wage model discussed above, firms lay off workers because production is less profitable at higher real wages.  In contrast, in the musical chair version of the sticky-wage model real wages don’t matter, what matters is revenue.  When firms receive less revenue they have less income to pay wages, so they employ fewer workers.  This would even apply to a socialist economy.  Imagine all firms were owned by workers, who shared revenues.  Also assume sticky nominal hourly wages.  Then when revenues fell, hours worked at the firms would decline. That might mean a shorter workweek (as occurred in 2008-09 in Germany) or it might mean fewer workers (as occurred in 2008-09 in the US.)

If we are looking to explain total hours worked, we might divide nominal wages by NGDP.  If trying to explain the unemployment rate, it makes more sense to divide nominal wages by NGDP/Labor force.  Previously I’ve showed that this cycle fits the musical chairs model quite well:

Screen Shot 2015-01-27 at 2.20.45 PM

Unfortunately, we lack good wage data before 2006.  For earlier business cycles, all I could find was wages in goods-producing industries:

Screen Shot 2015-01-27 at 2.41.08 PM

Notice that the ratio of hourly wages to NGDP/Labor force has a level trend from the late 1940s to 1982, and then plunges by a third.  That could reflect many factors, such as a change in hours worked per worker, but I think it more likely reflects three other factors:

1.  More fringe benefits (good for workers)

2.  Smaller share of NGDP going to workers (bad for workers)

3.  More inequality within labor income (bad for non-managerial factory workers)

But what really impressed me is the strong correlation between wages/(NGDP/LF) and the unemployment rate.  And by the way, even if you just used W/NGDP, you’d still see a strong correlation, as labor force changes are fairly “smooth.”  But there would be even more trend issues to deal with.  In my view, the weakest correlation appears to occur during the 1991 recession.  But even there you see a brief flattening of what had been a steep fall in W/(NGDP/LF) during the 1980s and 1990s.

Here’s one question.  How would you test for a correlation?  I suppose you could compute changes in W/(NGDP/LF) minus a ten year moving average of the same variable, and correlate that with change in unemployment.  Just eyeballing the graphs, I’d expect a reasonably close fit, even for 1990-91.

I know what you are thinking, how about the interwar years?  I could not find unemployment data, so I used industrial production.  Unfortunately that makes eyeballing the graph tougher as the predicted correlation is negative.  Also, the NGNP data for 1921 at the St. Louis Fred is total crap.  If someone over there is reading this, please replace your prewar NGDP estimates with Balke/Gordon, which is far superior, and goes back even further.

Screen Shot 2015-01-27 at 3.06.16 PMWith the Balke/Gordon data, even 1920-21 would be a nice fit.  But you can see the W/NGDP ratio rise in 1929-33 and 1937-38 as IP falls sharply.

PS.  I was a bit surprised by the real wage series.  The fall in real wages from 1978 to 1993 didn’t surprise me—the rust belt took a toll on factory wages.  But the uptrend after 1993 was a bit better than I had expected, given all the gloomy articles on real wage growth.

The issue SNB defenders don’t address

A few weeks ago the Swiss National Bank stunned the markets and many economists by letting the SF appreciate by 20% against the euro.  On the face of it, this seemed inconsistent with Swiss policy goals (ending deflation.)  Switzerland is already in a mild deflation, and this is likely to make it more severe.

Nonetheless, some claimed the move was inevitable and even beneficial (in a “lesser of evils” sense.)  It’s pretty hard to claim a move was inevitable if the markets and most pundits expected exactly the opposite—unless the SNB had inside information.  But I’ve never seen anyone present a plausible argument for that proposition.  As far as being beneficial, John Cochrane presents the most frequently heard argument:

To defend the peg, the Swiss central bank had bought close to a year’s Swiss GDP of euros (short-term euro debt really) to issue similar amounts of Swiss Franc denominated debt.

This is a QE — a big QE. Buy assets, print money (again, really interest-paying reserves). So to some extent the news items are related. And, it’s pretty clear why the SNB abandoned the peg. If the ECB started essentially the opposite transaction — buying debt and selling euros — the SNB would soon be awash.

A peg depends on credibility. The dollar is pegged to 4 quarters. The Fed is not racking up huge dollar for quarters QE, because everyone knows it will always be thus. The fact that the SNB had to buy euros at all is a great signal that everyone knew the peg was temporary. As, in fact, the SNB had made pretty clear. Sometime or other, probably when it’s most important, investors thought, Swiss Francs will shoot up again. Might as well buy more of them.

An exchange rate peg is fiscal policy.  Really, the “credibility” a country needs is fiscal credibility.

The peg fell apart because the SNB was trying to do it alone. On the day of abandonment, the SNB lost about 20% of its balance sheet, since it owns Euros and owes Swiss Francs. Had things gone on any more before the plunge, they would have had to go begging to the Treasury for a recapitalization. “We just lost 20% of GDP, could you please send us some fresh government bonds to back our CHF debt issues?” That works seamlessly in economic models, but would be a political nightmare for a central bank.

One can certainly make a respectable argument that countries should not peg their currencies to another currency.  (I prefer NGDP targeting to exchange rate targeting.)  But otherwise I think Cochrane misses the point.

Unless I’m mistaken, the first paragraph is incorrect; the SNB did not buy close to one year’s GDP worth of euros defending the peg.  In fact, the SNB was buying massive quantities of euros before the peg, and their rate of purchases dropped off after they pegged the franc at 1.20 in late 2011.

The deeper problem here is the hidden assumption that without the peg the SNB would not have to buy as many assets as with the peg. That’s certainly true if they left the peg for a more expansionary monetary policy, such as we see in Australia (which lets its currency float.)  But the Swiss did the opposite.  Even the SNB admits that the recent move represented a tightening of monetary policy.  And here’s the problem that Cochrane and other miss.  In the long run, there is a very strong negative correlation between the rate of NGDP growth and the size of balance sheets as a share of GDP.  The faster the rate of NGDP growth, the higher the level of nominal interest rates, and the lower the demand for zero interest base money. Tighter money means bigger balance sheets. Thus in the long run the recent Swiss move will make their balance sheet even larger than the previous policy, which will lead the SNB to assume even more risk.  (To their credit, they did reduce IOR to negative 0.75%, which will lower base demand.  But why not stop there?)

Note that I said “in the long run.”  Obviously over short periods of time the opposite may be true; monetary easing may increase the balance sheet as a share of GDP.  But surely the issue of central bank balance sheets and risk is a long run issue, and it makes no sense to minimize the problem today at the cost of bigger problems down the road.

Don’t believe me?  It looks like my prediction came true just days after the recent depreciation:

The Swiss National Bank reaffirmed its willingness to intervene in markets, sending the franc to its weakest level against the euro since the institution abandoned its currency cap.

“We’re fundamentally prepared,” Vice President Jean-Pierre Danthine said in an interview with the Tages-Anzeiger newspaper published on Tuesday. The Tribune de Geneve and 24 Heures newspapers published similar comments.

Since abandoning its cap on the franc of 1.20 per euro on Jan. 15 and charging more for sight deposits, SNB policy makers have given a series of interviews to local newspapers saying the franc is overvalued and that they are prepared to wage further interventions.

SNB Spokesman Nicolas Haymoz declined to comment on speculation the SNB was intervening in markets.

The tighter the monetary policy, the more that foreigners will want to hold Swiss francs.  What if the SNB simply refused to provide them?  You mean like when the Fed refused to meet the market demand for dollars between 1929 and 1933?

HT:  James in London

Update:  Some commenters have questioned my claim that SNB purchases slowed after the peg was enacted in late 2011. Evan Soltas has a post explaining why this occurred.


Is the Fed behind the curve?

Quick follow-up to my previous post.  The 30-year T-bond yield just fell to 2.22%, the lowest ever.  Meanwhile Fed officials are itching to raise rates because the economy is in danger of overheating.

Is the Fed behind the curve?  Yes.  The real question is how many curves.  I say the Fed is just entering the first curve at Indy, while the asset markets are heading down the final stretch toward the finish line.  The markets get it—low NGDP growth and low nominal interest rates as far as the eye can see.  Let’s predict how long it will take the Fed to catch up with the markets. What do you think?

On another note, the Hypermind Q4 contracts concluded today.  The 4th quarter NGDP growth rate was 2.544%, which meant the contracts ended at 25.  I have heard about several winners.  And remember, you can’t lose any money at Hypermind.

For the last month we’ve been working on getting the Hypermind price embedded into this blog.  I guess it’s extremely difficult to do, given how long it is taking.  And iPredict should be up pretty soon.  I hope.  The frustrations of always having to wait for other people to act . . .

HT:  Brian Donohue

PS.  Ken Duda asked about the “audit the Fed” bill.  Does anyone know precisely what data the Fed critics want, that the Fed currently doesn’t provide?

The New Normal (Bill Woolsey wins)

In a post written 7 months ago I predicted that 3% NGDP growth would become the new normal:

It’s becoming increasingly clear that when the labor market recovers, RGDP growth will be very slow, maybe 1.2%.  Add in about 1.8% on the GDP deflator, and 3% NGDP growth looks like the new normal, assuming the Fed intends to stick with 2% PCE inflation targeting.  Bill Woolsey wins!!

The figures for 2014 were announced today.  NGDP growth was 3.70% (vs. 4.57% in the Year of Austerity.)  And RGDP growth was 2.48%, (vs. 3.13% in the Year of Austerity.)  Growth slowed because the Fed offset the easing of fiscal austerity with its own tapering, to prevent the economy from “overheating.”

The 3.7% figure suggests we are right on track for 3% trend NGDP growth.  Here’s why:

1.  Unemployment fell 1.1% in 2014.  Okun’s Law implies that output grew at about 2.2% above trend.  However recent Okun’s parameter estimates are a bit lower, so let’s say output grew about 1.5% above trend.

2.  Inflation in the GDP deflator was about 0.6% below the 1.8% that I expect.

If inflation rises by 0.6% and RGDP growth slows by 1.5%, then we are right at 2.8%.  Add in a couple tenths of a percent for people returning to the labor force.

The upshot is that with low NGDP growth we’ll have low interest rates, and we’ll hit the zero bound in every future recession.  If the Fed doesn’t give up its interest rate targeting regime, we’ll have a dysfunctional monetary policy going forward. Let’s hope they switch to an instrument with no zero bound (say the base, or NGDP futures prices.)  Alternatively, they could switch to level targeting.

Update:  I have a new post at Econlog showing how badly the CBO misforecast 2013.

Calomiris on Fed policy

Charles Calomiris suggests that the Fed will probably need to raise rates this year:

Furthermore, because the fall in energy prices is a positive supply shock, nominal GDP growth will not be reduced by the decline in energy prices; indeed, it is likely to accelerate going forward. That means real GDP growth will accelerate alongside nominal GDP growth. From the perspective of forward-looking inflation targeting, the Fed rightly understands that it needs to maintain its plan to begin to remove accommodation this year.

Overall it’s a thoughtful article, but I can’t help thinking that something is missing. First let’s review the difference between inflation and NGDP targeting.  If we use the equation of exchange:


You can think of the two regimes as offsetting velocity shocks, but responding differently to supply shocks.  Under strict inflation targeting, you shoot for 2% inflation no matter what.  Under flexible inflation targeting (such as the Fed’s dual mandate, or NGDP targeting), the Fed lets inflation rise and RGDP fall during a negative supply shock.  Calomiris correctly points out that in the near term it might make sense for the Fed to let inflation fall below 2%, and RGDP to accelerate, as long as NGDP is well behaved.

So far so good.  So what’s my nagging worry here?  My concern is that the Fed doesn’t seem to have the right REGIME in place.  So even if they handle the current oil price decline correctly, I’m not confident they will avoid the horrendous mistakes made in 2008-09, in the next recession.  To understand those mistakes let’s review three options:

1.  Stable inflation

2.  Countercyclical inflation (this is what the Congress, Calomiris and I all seem to prefer.)

3.  Procyclical inflation

You might be thinking; “Wait a minute, I don’t recall Congress asking for countercyclical inflation.”  Not explicitly, but it’s implicit in the dual mandate. Obviously the dual mandate rules out option #1, which ignores jobs.  Any loss function that worries about both inflation and jobs, will bias policy toward more stimulus when unemployment is high, and less stimulus when unemployment is low.  This means the Fed will face a “trade-off” and will tolerate slightly above target inflation when unemployment is higher than desired, and slightly lower than target inflation when unemployment is low.  Inflation should be countercyclical.

Let’s contrast this approach with its exact opposite.  Suppose Congress had instructed the Fed to target inflation at 2%, but, “while you are at it, try to be as cruel to the jobless as possible.  Create as much jobs market instability as possible, consistent with 2% inflation over time.”

Under that mandate (let’s call it the “cruel mandate”) the Fed would do a tight money policy when unemployment is above target.  Yes, they’d miss their inflation target on the low side, but that loss would be offset by the “benefit” that they’d receive from screwing the workers.  Under that sadistic policy they’d run a procyclical inflation rate, just the opposite of what they are currently supposed to do.

Now of course this is exactly what the Fed did in 2009, they ran inflation well below target during a period of 10% unemployment.  Defenders of the Fed will claim that this was unintentional.  I agree.  But it was also due to a flawed inflation targeting IT regime, which biases you toward procyclical inflation, especially at the zero bound.  And my fear is that that regime still is in place.

Let’s suppose the next 5 years are pretty good, and then we have another recession.   If you look at the next 5 years in isolation, the period would be a “boom” in a relative sense.  In that case Calomiris is quite right that the Fed should run inflation a bit below target right now.  But this policy only makes sense if it is offset by above target inflation during the high unemployment periods before and after the boom.  In fact, we did the opposite during 2009-13, and I fear we will again do the opposite in the next recession. I fear that instead of inflation rising in the next recession, (which would make Calomiris’s current recommendation appropriate, the Fed will let inflation fall, which will put us right back at the zero bound, and retrospectively make Calomiris’s proposed policy a mistake.

Robert Lucas emphasized that you need to think in terms of policy regimes, not day-to-day decisions.  I don’t care very much whether the Fed raises rates by a quarter point this year.  I care a lot whether they successfully make inflation rise during the next recession, or disastrously allow it to fall.

So what will it be; the pre-2008 dual mandate or a continuation of the post-2008 cruel mandate?

BTW, there are several options that could make the cruel mandate outcome less likely. One option is to raise the inflation target to 3% or 4%, to minimize the zero bound problem. A better option is NGDP level targeting, which also reduces the zero bound problem, at a lower inflation rate.  Best of all is NGDP futures targeting.  No zero bound problem.

HT  Ramesh Ponnuru