Archive for November 2018


What about the TIPS spread?

I’ve recently been asked about why I don’t put more weight on the TIPS spread, as compared to 3 to 5 years ago.  I still consider the TIPS spread a useful indicator, but there are a bunch of reasons why I talk about it less frequently:

1.  The TIPS spread does have a few biases, which need to be taken into account.  One is the lag in the adjustment of inflation-indexed bonds to CPI inflation.  In the short run, fluctuations in CPI inflation are caused by oil price fluctuations.  This causes the TIPS spread to change in the same direction as the level of oil prices, without changing the actual expected rate of inflation at all.  It’s an artifact of the lags, and this phenomenon has recently depressed the spread.

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2. I’ve known about the preceding issue for quite some time, and always took it into account when making comments.  But I’ve more recently become convinced that the risk premium is also an issue.  It seems likely that the TIPS spread slightly understates the expected rate of CPI inflation, due to the fact that conventional bonds are viewed as more liquid, and thus offer a slighter lower expected yield.  I don’t think this is a big issue, but it might bias the result by a couple tenths of a percent.

3.  On the other hand, the Fed is targeting PCE inflation, which runs about 0.3% below the CPI inflation used to adjust TIPS returns.  So the biases cut both ways.

A few years ago the problem with monetary policy was obvious.  Actual PCE inflation had been running substantially below target, and the TIP spreads were also well below the target.  In addition, unemployment was too high.

Today, unemployment is below the estimated natural rate, actual inflation has run roughly on target, and the TIPS spreads show only a small problem (at least when you adjust for the recent plunge in oil prices.)  Furthermore, wage inflation is up to 3%, as compared to 2% a few years ago, indicating increased long run support for a core inflation rate at close to 2%.  I suspect wage inflation will rise a bit more.

That’s not to say I’m completely sanguine about the situation.  While the consensus of private sectors forecasters is for 2.1% PCE inflation going forward, I believe that there’s at least a 25% chance that we still haven’t gotten inflation up to 2%, and that the TIPS spreads are correct.  So it’s something I’ll be watching.  But don’t put too much weight on the next few months inflation numbers, as the recent oil price plunge will surely lower the rate for a while.  (Back in July, the 12-month PCE inflation rate was running at 2.36%, whereas the actual underlying rate of PCE inflation was never that high–it was due to rising oil prices.)

Overall, I still believe monetary policy is roughly on target regarding inflation.  But if the data proves otherwise over the next 24 months, I’ll change my view.


What kind of Fed “put”?

This caught my eye:

The Federal Reserve has to be careful for appearing to flinch from hiking interest rates due to market volatility or investors will soon be banking on a “Powell put,” said Mohamed El-Erian, chief economist at Allianz.

The Fed’s most recent message, delivered by Fed Vice Chairman Richard Clarida, stressed the Fed is data dependent. This seems to be a shift from the earlier communication that there was a clear need to normalize policy, said El-Erian, the former deputy director of the International Monetary Fund and later the CEO of PIMCO. This shift seems to be a reaction to market volatility in October rather than any “great discovery” about the economic outlook, he said. . . .


“In the last week or so, the word data dependency has started coming back. So this is going to be a real test as to whether the Powell Fed is indeed a different Fed or whether at the first sign of market volatility they flinch like the Bernanke Fed and the Yellen Fed.”

Mohamed El-Erian 

“If they signal that they are going to be more dovish, I can tell you we will be talking about the ‘Powell put’ really soon, so they have to be really careful,” he added during an interview on CNBC.

Should there be a Fed put based on stock prices?  No.

Should there be a Fed put based on asset prices?  Yes.

It’s a mistake to put too much weight on stock prices.  While stocks do react to changes in expected growth in aggregate demand, they also react to lots of other stuff, such as corporate profits, growth in overseas economies, deregulation, tax cuts, trade wars, interest rates, etc.  Instead the Fed should put together a market forecast of expected NGDP growth.  Preferably they’d create and subsidize trading in a NGDP futures market, but at a minimum they should try to estimate the market’s forecast of NGDP growth, based on a wide range of indicators, including stock prices.

There’s nothing wrong with the Fed easing policy after a sharp setback in the stock market, but only if it’s associated with a decline in expected NGDP growth.  I’m not seeing evidence for that in the Hypermind prediction market, but that contract runs out in the first quarter of 2019, so one could argue that the slowdown is expected to occur later.  On the other hand, forecasts of slower growth in the future usually lead to slower growth in the near term as well.

FWIW,  I believe that the Fed should and will raise interest rates by less than they currently anticipate–perhaps just one or two more increases.  But my view is “data dependent”, and might change by tomorrow.

Off topic: The GOP now believes that corporate decisions about where to locate new factories should be made by the federal government, not the private sector.

Update:  The Dems appears to have picked up 40 House seats, with California’s 21st flipping to the Dems yesterday after the GOP led by 7 points on election night.  Congrats to David Levey for predicting precisely this result.  I’d like to see a story explaining why the late votes in California are so overwhelmingly Democratic.  On election night, the media missed the Democratic wave, with pundits talking about Dem House gains of about 28 and GOP Senate gains of perhaps 3 or 4.  It’s now 40 and 1, or 2 at most.  We need better election technology.  There’s no excuse for the slow pace of vote counting.

Should we target total wages or average hourly wages?

This post was inspired by a recent Nick Rowe post, which uses an AS/AD diagram to compare inflation and NGDP targeting under various sorts of shocks.  I learned some things from reading the post, and George Selgin’s comments following the post.  I recommend people take a look.  But in the end I find sticky price models too confusing.  Or maybe I just don’t have the energy to try to get over my confusion, because price stickiness doesn’t seem to me to be the key issue.  For me, business cycles are all about employment fluctuations and wage stickiness.

Let’s start with a graph where (for simplicity) we assume a vertical long run labor supply curve (LRLS), and an upward sloping short run labor supply curve (SRLS).  Total compensation (TC) is a rectangular hyperbola, representing $12 trillion in labor compensation.  I assume wages of $40 per hour (including benefits), and 300 billion total hours (2000 hours a year times 150 million workers.)  These are ballpark numbers for the USA.   The LRLS determines the natural rate of employment—which is optimal in the context of monetary policy decisions.

Screen Shot 2018-11-25 at 2.02.48 PMNow let’s consider two types of shocks.  In the first case, there’s a sudden 10% boost in the labor force, perhaps due to a flood of immigrants:

Screen Shot 2018-11-25 at 2.03.05 PMNotice that the optimal solution is a 10% rise in employment, with no change in nominal wages.  That’s what happens with nominal wage targeting.  Under total compensation targeting the employment level rises by only 6%, which is suboptimal.  NGDP targeting would be the same.  This example might help people to better understand George Selgin’s version of NGDP targeting, which adjusts for labor force changes.  (Nothing changes if we assume a positive trend rate for wages that is fully expected.)

Now let’s consider a nominal wage shock.  Say that workers get greedy and demand higher wages, because Bernie Sanders is elected President.  But the LRLS doesn’t shift, which means the workers will eventually scale back their wage demands, at least in real terms:

Screen Shot 2018-11-25 at 2.03.32 PMThis case is just the opposite.  Now a monetary policy aimed at stabilizing total compensation gives you a better result.  With nominal wage targeting, employment falls by 10%, relative to an unchanged LRLS curve.  With total compensation targeting (and perhaps NGDP targeting as well) the fall in employment is smaller (only 4%).

In my view, the most pragmatic option is to try to target total compensation (or NGDP), adjusted for changes in the labor force, which is sort of in the spirit of George Selgin’s proposal.  As I recall, he wanted a productivity norm that adjusted NGDP for both labor force and capital shock changes, but I don’t recall the exact details.  Because I see the labor market as key, I’ve left out the capital stock issue, which seems secondary to me.  But his basic intuition seems exactly right.

PS.  It’s likely that this is nothing new, or maybe it’s wrong.  It’s a framing that occurred to me after reading Nick’s post.  I welcome any comments you might have.

PPS.  I had the honor of writing a forward for the brand new addition to George’s Less Than Zero.

PPPS.  Don’t be discouraged if all this theoretical analysis makes NGDP targeting seem “wrong”.  It’s less far less wrong than anything else on offer from the major schools of thought in macroeconomics—close enough to optimal for the USA.

PPPPS.  I didn’t look at productivity shocks, because they affect the optimal price level, not the optimal wage rate.

Australia and China keep chugging along

The Economist has a very good essay on the Australia miracle.  It’s not just that Australia’s avoided a recession since 1991, they’ve also done better than other developed countries on a wide range of indicators, such as GDP growth, median wages and public finances (i.e. a small national debt.)  Italy would do well to study Australia.

When I started blogging, some claimed that Australia’s success was due to luck.  They had a mining boom when China began growing rapidly.  But mining has gone into a slump since 2013, with mining investment plunging from 9% of GDP to only 3%.  That’s much worse than the 2006-09 US housing slump:

Yet the collapse in commodity prices was not the end for Townsville or Australia. In fact, it was a fillip for other industries, whose growth helped to make up for mining’s troubles. The plunge in investment allowed the central bank to lower interest rates, lifting the housing business. The sinking currency, which lost 40% of its value against the greenback between 2011 and 2015, caused the number of foreign tourists and students to surge. It also encouraged foreigners to snap up flats in Sydney and Melbourne, giving construction even more impetus.

Building work had reached a nadir in the first quarter of 2012, when construction firms completed projects worth A$20bn. In the last quarter of 2017, that reached A$29bn.

Screen Shot 2018-11-24 at 2.13.17 PMAnd yet Aussie RGDP keeps chugging along at a 3% growth rate.  How have they done it?  The RBA keeps NGDP increasing:

Screen Shot 2018-11-24 at 1.34.32 PMSo the secret of Australia’s success was not the mining boom, it was sound monetary policy.  BTW, Australia has a much higher rate of immigration than the US.  Keep that in mind when you consider the amazing rise in Australian median wages:

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China’s another country that almost everyone got wrong. The NYT has a long article entitled The Land That Failed to Fail.  Here’s the subtitle:

The West was sure the Chinese approach would
not work. It just had to wait. It’s still waiting.

There are lots of experts who know much more about China than I do, and indeed my commenters often suggest that I read those experts every time I do a post on China.  Unfortunately, most of those experts have been wrong, repeatedly predicting the China bubble would soon burst.

Two experts that got it right were Ning Wang and Ronald Coase, who wrote an excellent book explaining the reforms that led to the China boom.

Many experts now insist that China is not a market economy, but I’d put more weight on those who got it right.  Wang and Coase argued that China is much more market-oriented than it appears to outsiders, and so far they’ve been right about the effectiveness of China’s reforms.

That’s not to say China won’t have a recession at some point, most likely they will.  But as we saw in South Korea after 1998, even a severe recession doesn’t prevent an East Asian country from getting rich.

PS.  I wonder if younger readers will find this as hilarious as I do:

In October Mike Pompeo, the American secretary of state, accused Chinese state-owned firms of “predatory economic activity” in the region. Mr Pompeo’s predecessor, Rex Tillerson, had urged Latin Americans to reject “new imperial powers” like China, bent on extracting natural resources while issuing unpayable loans.

By all means, Latin America should avoid imperial powers.

RIP, Nicholas Roeg (plus Rage Against the Machine)

One of Britain’s greatest directors passed away today. Nicholas Roeg produced some lovely dreamlike films during the 1970s.

PS.  Scott Slumber pointed me to a National Geographic story, which explains why the sleep world is superior to the awake world:

[W]hen we’re sleeping, and we commence our first REM session, the most elaborate and complex instrument known in the universe is free to do what it wishes. It self-activates. It dreams. This, one could say, is the playtime of the brain. Some sleep theorists postulate that REM sleep is when we are our most intelligent, insightful, creative, and free. It’s when we truly come alive. “REM sleep may be the thing that makes us the most human, both for what it does for the brain and body, and for the sheer experience of it,” says Michael Perlis.

Maybe, then, we’ve been asking the wrong question about sleep, ever since Aristotle. The real wonder isn’t why we sleep. It’s why, with such an incredible alternative available, do we bother to stay awake?

And the answer might be that we need to attend to the basics of life—the eating and mating and fighting—only to ensure that the body is fully ready for sleep.

They also suggested that logic is turned off during dreams:

Belief in the unbelievable happens because in REM sleep, stewardship of the brain is transferred away from the logic centers and impulse-control regions.

Slumber then pointed to a related quote from André Gide:

Because of his multi-faced inconsistency, Proteus is, among all the gods, the one who has the least existence. Before he chooses, an individual is richer; after he chooses, he is stronger.

The dream world is richer, as logic doesn’t force us to choose, while the awake world is stronger.

Slumber added this:

People in the awake world tend to view the conflicts of society in terms of left vs. right.  But perhaps the real struggle is the best parts of humanity (creativity, freedom, love, intelligence, etc.) against “the machine”—a stupid oppressive bureaucratic structure built by both the left and the right.  I’m talking about the war on drugs, the military, organized religion, the K-12 educational system, health insurance, the IRS, the INS, the TSA and all of the other ways that society tries to crush our spirit and turn us into a cog in the machine.

Isn’t that just warmed over Foucault?  Don’t we need a “machine” to generate the GDP required to make the world safe for sleepers, so they don’t get eaten by wolves?

Slumber responds:

Maybe, but late in his life Foucault saw a possible “third way” between the authoritarianism of the left and the right, and began flirting with economic liberalism.  Had he lived, he might have developed a liberalism far more radical than anything espoused by more conventional thinkers such as Hayek.

What a nice dream.