Archive for September 2015


Deflation has not returned to Japan

Tyler Cowen has a new post that discusses possible reasons why deflation has returned to Japan.  Unfortunately the post is based on a misconception—deflation has not returned to Japan.  Here are some facts:

Latest Japanese inflation — August 2015:  0.2% year over year inflation

Latest US inflation — August 2015:  0.2% year over year inflation.

So Japan has exactly the same inflation rate as the US, and it’s a positive number.  Has “deflation returned to the US?” Janet Yellen is so worried about inflation that she thinks we need to raise interest rates before the end of the year.

But what about the so-called core inflation rate, excluding food and energy:

Japan:  0.8%

US:  1.8%

This is a more realistic view of the trend rate of inflation in each country, and indeed Japan is lower than the US.  But still no deflation.

Tyler also says the following:

Japan Times reports:

Consumer prices excluding fresh food fell 0.1 percent in August from a year earlier, the first drop since April 2013, the same month Kuroda embarked on a campaign of record asset purchases to rid Japan of its “deflationary mindset.”

My goodness is economics a difficult subject.  (Scott Sumner is implicitly surprised too.)  So why is this happening?

The rest of the post discusses theories as to why this is happening.  But the theories are not very useful, because “this” is not happening.  Japan is not back in deflation, according to any reasonable definition of deflation.  The CPI minus fresh food is a price index used by no other country (AFAIK), and has no obvious justification.  Japan has exactly the same overall inflation as the US, after going several decades with lower inflation that the US.  How they caught up to us is the “this” that needs to be explained, and the answer is simple–Abenomics.

BTW, I was not surprised (implicitly or otherwise) by the Japanese data, which showed inflation unchanged from data reported last month, because I follow Japanese data quite closely.

PS.  It’s obviously possible that deflation will return to Japan — that depends on future monetary policy.  However I predict positive Japanese inflation over the next year.

PPS.  Economics may be a difficult subject, but inflation is not.  It’s always and everywhere a monetary phenomenon.

PPPS.  To show you how misleading headlines can be, consider the following from a recent Financial Times story:

However, core prices excluding food and energy were up 0.8 per cent compared with a year ago in August, a pace seldom seen since the 1990s. That suggests the domestic economy is running out of spare capacity, creating pressure for higher prices.

“Not surprisingly, energy prices continue to weigh on headline and core inflation in Japan, but the Bank of Japan would take comfort from further signs that domestically driven inflation is rising,” said Michael Moen, an investment manager at Aberdeen Asset Management.

“Once you exclude food and energy, inflation is actually rising very gradually as prices for services continue to increase. Against this backdrop it’s unlikely that we will see an increase in the QE programme anytime soon.”

So no need for more QE?  And what is the headline of this excellent FT story?

Japan Falls Back into Deflation for the First Time Since 2013

Just shoot me.

Conservative Keynesianism leads the Fed astray

From the Financial Times:

The Fed chair said she expected inflation to return to a 2 per cent annual rate over the next few years as temporary influences wane.

Why?  What will cause inflation to return to 2%?

Ms Yellen added that there were financial stability risks to holding rates at ultra-low levels for too long.

“Continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability.”

Why would low rates encourage excessive risk taking?  And if they do, how does the Fed remedy that situation?  Do they raise rates for a couple years, at the cost of lower rates for a couple decades, or do they lower rates for a couple years, at the cost of higher rates for a couple decades?  Where is the model?  How do they get from here to there?

“Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilising at 2 per cent,” Ms Yellen said.

Allowing the unemployment rate to fall below its long-run level for a period could also have the benefit of “speeding the return to 2 per cent inflation”, Ms Yellen argued. It could have the extra positive of reversing some of the supply-side damage suffered by the US economy in recent years.

Since when has the Phillips Curve been a reliable model for predicting inflation?

Keynesianism is usually considered a “liberal” model.  That’s a bit misleading, as most conservative economists also use a Keynesian framework for analyzing the economy. They talk about the various sectors of the economy; consumption, government, net exports, etc.  They worry that monetary policy is ineffective at the zero bound.  They think inflation is caused by low unemployment.  They think low interest rates can lead to excessive risk taking.

In fact, except in the very short run, interest rates reflect the conditions of economy, not the stance of monetary policy.  Inflation is not caused by low unemployment, but rather by excessive NGDP growth.

The latest TIPS spreads have fallen to shockingly low levels:

5 Year TIPS spread  = 1.19%

10 year TIPS spread  = 1.50%

30 year TIPS spread = 1.69%

Recall that the Fed’s CPI inflation target is around 2.3% (give or take a few tenths.) These TIPS spreads call for monetary easing, or else the Fed may soon lose credibility.

Fortunately there is a ray of hope:

“Inflation may rise more slowly or rapidly than the committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response,” Ms Yellen said at the Philip Gamble Memorial Lecture University of Massachusetts, Amherst.

If this happens (and pretty I’m confident it will) then the Fed needs to do more than “adjust the stance of policy.”  The Fed needs to rethink its entire approach to policy. The Fed needs to define what they mean by “the stance of policy.”  The Fed needs to revisit past decisions, and figure out what they did wrong.  I hope they will look at what their critics have been saying.  Then the Fed needs to start setting the stance of policy at a position where the markets expect the Fed to succeed.

PS.  I understand the Fed has a dual mandate, and I don’t think it’s a big deal if they undershoot their inflation target for a couple straight years.  I do think it’s a big deal if they undershoot for a couple straight decades, as the Japanese have done, and the Europeans are doing.  I expect more from the Fed, especially as they’ve had the benefit of seeing what happened with other central banks, when they tried to raise rates above the Wicksellian equilibrium rate.


Nominal shocks have real effects

Michael Darda sent me a graph that provides another good example of how nominal shocks have real effects.  The graph compares the spread between Baa bond yields and T-bond yields (white line) with an inverted measure of 30 years TIPS spreads (orange line).  The TIPS spreads are inverted because the BAA/Treasury spread is a countercyclical variable, whereas TIPS spreads are procyclical:

Screen Shot 2015-09-23 at 10.52.52 AM

I really love this graph, because it shows an underlying relationship that many people over look.  Always focus on the deep forces driving the macroeconomy, not the symptoms of those deep forces.

So here’s what’s going on.  Tight money leads to lower expected future NGDP growth.  I don’t think that can be disputed.  And I’d also claim that slower expected NGDP growth usually leads to lower TIPS spreads.  In addition, slower nominal GDP growth usually leads to increased fears of debt defaults.  Recall that NGDP represents total gross nominal income, the total resources that people, businesses and governments have available to repay nominal debts.  Squeeze that amount and defaults increase.

When NGDP grows more slowly, TIPS spreads fall and debt defaults increase.  That is even true in an economy where wages and prices are flexible, but debt is denominated in nominal terms.  But it’s even worse in the actual economy we live in, where wages are sticky.  In that case slower NGDP growth also leads to lower RGDP growth, which puts even more pressure on borrowers, leading to even more defaults.  Hence the Baa/Treasury spread widens.  And note that the Baa/Treasury spread is a real variable. Hence nominal shocks have real effects.

Of course the correlation is not perfect because TIPS spreads aren’t really the variable we care about, it’s NGDP expectations that really matter.  Notice the gap in the first half of the recession (roughly the first half of 2008.)  That was a period where inflation diverged sharply from NGDP growth.  Money was tighter than the inflation numbers suggested.

Asking too much of a central bank

Here’s an article discussing Bill Gross’s views on monetary policy:

Bond guru Bill Gross, who has long called for the Federal Reserve to raise interest rates, urged the U.S. central bank on Wednesday to “get off zero and get off quick” as zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds.

In his October Investment Outlook report, Gross wrote that the Fed, which did not raise its benchmark interest rates at last week’s high-profile policy meeting, should acknowledge the destructive nature of zero percent interest rates over the intermediate and longer term.

“Zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society,” Gross said. “These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8 percent over the long term.”

But with corporate bonds now at 2-3 percent, Gross said it was obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10 percent a year to meet the targeted assumption. “That, of course, is a stretch of some accountant’s or actuary’s imagination,” he said.

Not only are Bill Gross’s views wrong, they aren’t even defensible.  Let’s look at several perspectives:

1.  Money is neutral.  In that case the Fed can only impact nominal returns.  If it wants higher nominal returns then it needs to adopt a more expansionary monetary policy. That’s the opposite of what Gross is proposing.

2.  Money is non-neutral.  In that case the Fed can raise nominal returns on debt with a tight money policy, but only in the short run.  And Gross says the problem is that long-term returns are too low.  However to raise them you need to raise NGDP growth, which means easier money.  Even worse, a contractionary monetary policy that raises the return on T-bills will reduce the return on stocks.

Why is there so much confusion on this point?  Perhaps because people forget that most central bank decisions are endogenous, on any given day or week the Fed usually follows the market.  Here’s a perfect example of why people get confused, look at the first paragraph of a recent Reuters article:

Euro zone government bond yields dropped by more than 10 basis points on Friday after the U.S. Federal Reserve prolonged the era of nearly-free money amid concerns about a weak world economy.

Most readers probably think there is a connection between these two events.  And there may be one.  But it’s not the connection you might assume at first glance. It’s obviously not that case that the Fed deciding to keep rates steady on Wednesday caused eurozone bond yields to fall on Friday.  That makes no sense. Instead both the Fed and the bond market are reacting to the same facts—a weakening global economy.  People see short and long-term rates rise and fall at about the same time, and draw the erroneous conclusion that Fed policy is causing those changes.

The Fed can’t magically produce strong long run real returns on investment for insurance companies, especially with tight money.  That’s far beyond their powers, according to all models I’m aware of (monetarist, Keynesian, Austrian, etc.)  If Bill Gross has a new model, I’d love to see it.  In the 21st century, insurance companies will have to learn to live with lower returns.  They may have to raise the price of insurance. If they lose business, then . . . well, tough luck!

Off topic, Tyler Cowen recently noted that China’s September PMI fell to 47, and then asked:

How quickly do services have to be expanding for the entire Chinese economy to be growing at anything close to six percent?

Since I’m on record predicting 6% RGDP growth, I’ll address this question.  First we need to determine how fast industrial production is growing.  Here’s a graph of the growth rate of IP since 1990:

Screen Shot 2015-09-23 at 11.12.40 AMOther than the post-Tiananmen crash, China’s industrial production has maintained a strong upward trend.  However there are three notable slowdowns.  The slowdown in the late 1990s was caused by China’s currency being overvalued due to its peg to an appreciating dollar, at the same time the emerging markets were struggling and devaluing, and at the same time the US and Europe were growing. Sound familiar? And notice that the gradually slowdown since 2012 looks a lot like the late 1990s.  And then there was a sharp but brief slowdown during the global recession of 2008-09.

The most recent figures show 6.1% growth (YOY) in August, and September may show further deterioration.  After than I expect Chinese IP growth to begin recovering, although the YOY figures may worsen for some time.

So to answer Tyler’s question, if industry is growing at 6%, then services would also need to be growing at roughly 6%, in order to produce 6% GDP growth.  Is it plausible that China’s industrial production could be growing at 6% with such horrible manufacturing PMIs?  See for yourself, here’s the PMI index as far back as I could find:

Screen Shot 2015-09-23 at 11.20.34 AM

The recent numbers are a bit worse than usual, but as you can see the PMI often dipped to 48, with no obvious ill effects on the China boom.  I believe that this time China is slowing a bit more than usual, which explains my bearish forecast of 6% growth in 2016, vs. the consensus of 6.7% by China experts.  So like Tyler I’m currently bearish on the Chinese economy, just not as bearish.  My bearishness comes from the fact that I believe China experts are underestimating the impact of the strong dollar, which is making China’s currency overvalued.

I’m also more bearish than the Fed on the US economy, for much the same reason.

Williamson on NeoFisherism (define “loosening”)

Stephen Williamson has a new post that interprets recent monetary history from a NeoFisherian perspective.  It concludes as follows:

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require “tightening” in the face of low inflation.

I partly agree, but disagree on some pretty important specifics.  I thought it might be instructive to start out by rewriting this paragraph to express my own view, with as few changes as possible (in bold):

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP results from low inflation. We should also not be surprised that NIRP results from even lower inflation. Further, experience with QE and inflation forecasts embedded in TIPS should not make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than eventually having a nominal interest rate target well above zero, on average. To get there from here may require “loosening” in the face of low inflation.

Why do we reach such differing conclusions?  I think it’s because I have a different understanding of recent empirical data.  For instance, Williamson’s skepticism about monetary stimulus in Japan is partly based on his assumption that the recent sales tax increase raised the Japanese price level by 3%. But there’s never a one for one pass through, as it doesn’t cover major parts of the cost of living, such as rents.  So the Japanese price level (net of taxes) has risen by considerably more than Williamson assumes (albeit still less than 2%/year).  Even more importantly, Japan had persistent deflation prior to Abenomics.  And if Williamson is going to point to special factors such as the sales tax rise, it’s also worth mentioning that his recent data for Japan (and the other countries he considers) is distorted by a large one-time fall in oil prices.  Almost all economic forecasters (and the TIPS markets) expect inflation to soon rise from the near zero levels over the past 12 months.  Abenomics drove the yen from 80 to 120 to the dollar—-is that not inflationary?

In the Swiss case Williamson mentions low rates and asset purchases, but completely misses the elephant in the room, the huge upward revaluation of the franc earlier this year, which was widely condemned by economists (and even by many Swiss).  This policy was unexpected, unneeded and undesirable.  It immediately led forecasters to downgrade their forecasts for Swiss inflation, and those bearish forecasts have turned out to be correct.  I hope that’s not the sort of “tightening” of monetary policy that Williamson believes will lead us to higher inflation rates.

Seriously, I’m confident that Williamson would agree with the conventional view that currency appreciation is deflationary. That should send out warning signals that terms like “loosening” are very tricky.  Before we use those terms, we need to be very clear what we mean.  You can achieve higher interest rates through either loosening (a crawling peg devaluation forex regime) or tightening (open market sale of bonds), it all depends how you do it.  More specifically, it depends on the broader policy context, including changes in expectations of the future path of policy.

I think he also gets the Swedish case backwards.  The Swedish Riksbank tried to raise interest rates in 2011.  Instead of producing the expected NeoFisherian result, it led to what conventional Keynesians and New Keynesians and Market Monetarists would have expected—falling inflation. It led to exactly the type of bad outcome that Lars Svensson predicted. So Svensson was right.  And contrary to Williamson, the Riksbank did not turn around and adopt Svensson’s preferred policy, which is actually the “target the forecast” approach; rather they continued to reject that approach.  They continued to set rates at a high enough level so that their own internal forecasts were of failure. Once a tight money policy drives NGDP growth lower, the Wicksellian equilibrium rate falls and policy actually tightens unless the policy rate falls as fast or faster.  That did not occur in Sweden.

Let me try to end on a positive note.  I have a new post at Econlog that took a position roughly half way between the NeoFisherians and the Keynesians.  Brad DeLong had noted that Friedman often claimed that low rates are a sign that money has been tight. I’d emphasize, “has been.”  Krugman said this was wrong, at least over the time frame contemplated by Friedman.  I disagreed, defending Friedman.  I believe that Keynesians overestimate the importance and durability of the so-called “liquidity effect” and underestimate how quickly the income and Fisher effects kick in.  At the same time, as far as I can see the NeoFisherians either ignore the liquidity effect, or misinterpret what it means.  (My confusion here depends on how literally we are to take the “tightening” claim in the quote above.)

Question for the NeoFisherians:

I often discuss the Fed announcements of January 2001, September 2007 and December 2007.  That’s because all three were big shocks to the market.  In all three cases long-term interest rates immediately reacted exactly as Irving Fisher or Milton Friedman might have expected.  In the first two cases, easier than expected policy made long-term rates (and TIPS spreads) rise.  And in the last case tighter than expected policy made long-term rates (and TIPS spreads) fall.  Please explain.

To me, that’s the Fisher effect.  But here’s the problem, the Fed produced those three results using the conventional manipulation of short-term rates.  Thus in the first two cases the Fed funds rate was cut more than expected, and vice versa in the third case. From a Keynesian perspective this is really confusing—why did long-term rates move in the “wrong way”? From the NeoFisherian perspective this is also really confusing—why did moving short-term rates one way, cause TIPS spreads (and long term rates) to move the other direction?  From a market monetarist perspective this all makes perfect sense.  (It doesn’t always play out this way, but if you look at the really big monetary shocks the liquidity effect is often swamped by the long-term effects.)

HT:  Marcus Nunes