Archive for June 2019


The next 3 years will definitely be interesting

[Before starting, let me point to a very interesting new working paper at Mercatus, by Robert Hetzel.  He was somehow able to preserve his monetarist perspective while working for decades at the Richmond Fed.  Lots of interesting discussion of how the Fed needs to make the rate setting process clearer.  In addition, I have a new piece on the Fed, at The Hill.]

Given that the past 10 years have seen a pretty boring recovery, how can I be sure that the next 3 years will be interesting? Because one of three things must happen:

1. A dramatic change inflation, to a rate far from 2%
2. A recession
3. Continued growth with 1% to 3% inflation

The first two are obviously interesting. But why the third?

It turns out that the US has never had a soft landing. Other countries have, but not us. We’ve never had three years of low inflation growth once unemployment fell to cyclical lows.

Consider the following claims:

1. Inverted yield curves predict recessions.  (True)
2. Tight money causes recessions.   (True)
3. Inverted yield curves show that money is too tight.  (False)

It would seem like if the first two claims were correct, then the third claim would also be true. But that’s not the case.

The 3 month/10 year yield spread inverted slightly in September 1966, May 1989, September 1998 and January 2006. In 2 of those 4 cases a recession occurred within two years.  But in none of those 4 cases was monetary policy clearly too contractionary at the time.  Even in May 1989 and January 2006, the actual policy mistakes occurred a year or more later.

Today the inverted yield curve shows that there is a heightened risk of recession.  That’s true.  But that doesn’t necessarily mean that money is too tight.

Nonetheless, monetary policy is slightly too tight, as a bit easier money would help reduce the risk of recession without causing inflation to overshoot the 2% target.  Policy is not far off course, but it is a bit too tight.

On balance, I believe the most likely outcome over the next three years is a soft landing, although the risk of recession is probably at least 30%.  I view the risk of high inflation as being well under 10%.

This rather optimistic take is based on several factors:

1. Previous recessions were often triggered by tight money policies aimed at restraining inflation.  I see little risk that the Fed will adopt tight money for that reason.  It might adopt tight money for some other reason, like inertia in adjusting the policy rate to the fast moving equilibrium rate.

2. It seems to me that we are nearing a major turning point in the zeitgeist.  Policy was dovish in the 1960s and 1970s, because people thought dovish policy was appropriate.  That view gradually became discredited, and then policy became hawkish in the 1980s.  The hawkish era now seems to be ending, partly because the recent predictions of the doves have been consistently more accurate.  Over time, the hawkish warnings about inflation get tuned out, especially by the younger generation.

James Bullard’s recent dissent is a straw in the wind.  Bullard has taken both dovish and hawkish stances at various points in time.  His recent advocacy of policy easing is one indication that this view is ascendant.

These changes in the zeitgeist are associated with changes in policy, with a lag.  The easy money of the 1960s came several years after President Kennedy called for faster growth, and the tight money of the 1980s came several years after Volcker was appointed.  While monetary policy is inertial, when it turns the new trend often lasts for decades.  I’d expect the next few decades to feature a Fed bias towards dovishness.

I also believe that the Fed learns something from its mistakes.  After WWII, they did not repeat the errors of the post-WWI period.  After the 1970s, they did not repeat the mistakes of the Great Inflation.  I suspect that the Fed has learned some lessons from the Great Recession.  They won’t formally adopt NGDPLT, but they will quietly try to make sure that NGDP follows a path that is not too far from what NGDPLT would call for.  (Just as inflation targeting was adopted informally, long before it was adopted formally.)  Deep down they probably understand that NGDPLT would have done better in 2008-09.  Again, Bullard is ahead of the curve.

The biggest risk of recession comes from a “shock”.  In the past I’ve argued that the housing/banking shock of 2008 did not cause the Great Recession; tight money was to blame.  At the same time, it’s clear that the tight money error would have been much less likely to occur if we had never had a financial crisis.  In this case I see two possible shocks that might cause the Fed to screw up:

1. A Eurozone crisis, probably triggered by Italy leaving the Eurozone.

2. A major trade war (which I do not expect to occur.)

I suppose a war with Iran might qualify, but I have trouble seeing how that could trigger a recession.  They no longer export much oil.

Brexit is also a possible flashpoint. Ironically, I believe the biggest risk here is that Brexit goes well.  If it is seen as going well, it might encourage the Italians to leave.  That would probably destroy the euro.  I just can’t see how the other weaker Eurozone members could withstand a run on their financial systems if Italy left.  In the long run, Europe might be better off without the euro.  But as we saw in 1931, the short run impact is contractionary when one country leaves this sort of regime.

Thus Macron will be very tough with Boris, pour encourager les autres.

PS.  The current ruling party in Italy was founded by a clown.  The new Ukrainian leader is a comedian.  And now another clown looks set to become the new British PM.

And let’s not even talk about the USA . . .

As Marx said; history repeats itself, the first time as tragedy, the second time as farce.  I’m sure glad to be living in the farce era.

Surprising trends in air travel

I’d first like to correct one point from an earlier post on Chinese airline travel. I suggested that Michael Pettis believed the Chinese government was somehow faking the GDP growth data, which is not accurate. Pettis did not question the fact that Chinese statisticians were measuring some sort of economic activity, rather he argued that a substantial portion of this activity had little economic value, due to misallocation of resources. He views reported GDP growth as more of an input into the system, which may or may not be effective at producing useful output.

Tim Peach sent me an interesting article on international air travel:

This is one of those dynamic (moving) graphs that I find kind of mesmerizing. (Like those moving graphs of world history over the past 5000 years.) The top 8 countries were not that surprising; the European big four plus the US, China, Russia and Canada. But where is Japan? The ninth country is South Korea, followed by lowly Ukraine. Sweden makes the list with fewer than 10 million people, while Japan has 126 million. Even worse, airlines are basically the only way for the Japanese to visit other countries, whereas Europeans can travel internationally by train or car.

I hit replay, and tried to take a quick screenshot:

Now Japan’s well up the list at number 7. But no South Korea. Even today, Japan is slightly richer than South Korea, and 2.5 times as populous. Does anyone know what’s going on with Japan?

Perhaps the Japanese did some travel in the boom years, and then decided there was no point in leaving home. When I visited Japan last year I noticed that the people were extremely polite, and things like trains and subways tended to work perfectly. To the Japanese, the rest of the world must seem barbaric. Or perhaps the Japanese worry that their limited skills in speaking English will be a drawback.

Any thoughts?

PS. In the early 1400s, the Chinese sent a huge armada under Admiral Zheng He across the India Ocean, and then decided the rest of the world had nothing of interest. They stopped exploring.

PPS. I presume the UK figures are inflated by London being a stopover point to Europe. And the hub and spoke system might inflate some of the other European countries as well. But five years ago, I flew to Singapore via Tokyo, so even the Japanese figures are a bit inflated. Also note that Japan has recently seen a huge boom in inbound tourism.

Two ways of thinking about the Phillips curve

There are two ways of thinking about the Phillips curve relationship:

1. Falling inflation causes higher unemployment.
2. Higher unemployment causes falling inflation.

Irving Fisher invented the Phillips curve back in the early 1920s, and employed the first interpretation. Milton Friedman also approached it that way, although he refined the model by emphasizing unanticipated changes in inflation. In a world of sticky nominal wages, an unanticipated fall in inflation tends to raise real wages, resulting in more unemployment.

New Keynesians use the second interpretation. In their view, higher unemployment creates “slack”, which drives inflation lower. That’s become the standard approach, although I’ve never liked it for reasons I’ll explain in a moment.

Greg Mankiw has a new post that suggests the Phillips curve is alive and well. Interestingly, he uses nominal wages:

Reading Mankiw’s post I suddenly got a brainstorm. Start with the fact that inflation is obviously not the right variable for the Phillips curve. Every day that goes by, that becomes more and more obvious to me. But what is the right variable? There are two directions one could go, depending on whether one wants to highlight the Fisher/Friedman approach, or the New Keynesian approach.

Mankiw points to a paper that he co-authored with Ricardo Reis to justify the use of nominal wages. I think he’s right that wages are the correct nominal aggregate in the new Keynesian model, not prices. If you want to argue that slack reduce inflation, it’s most likely to show up in wages, as prices reflect both AS and AD shocks. And wages are stickier than prices, and thus a better target for monetary policy.

Using the Fisher/Friedman interpretation of Phillips curve causality (nominal shocks have real effects), NGDP is the right nominal aggregate. Recall that nominal wages are sticky in the Fisher model, and unexpected changes in inflation cause movements in real wages, and hence unemployment. But that’s obviously much more true of NGDP than price inflation. Unexpected NGDP shocks clearly do drive changes in employment when wages are sticky. Again, price inflation reflects both AS and AD shocks.

So we have a world where the true model of the economy is all about NGDP and nominal wages. NGDP shocks in a country with sticky wages create business cycles. But we’ve weirdly decided to use an ambiguous intermediate variable—price inflation—which is sort of like NGDP and sort of like wage inflation. Because it is ambiguous, its causal role in the Phillips curve model can be interpreted in two radically different ways, as either the cause of business cycles or the result of business cycles.

If we dump the ambiguous price inflation from macro and replace it with the very unambiguous NGDP and nominal wages, we get a much clearer sense of what’s going on. Cause and effect are immediately obvious.

PS. I can’t even imagine what our undergraduates make of textbook macro. Taken as a whole, it MAKES NO SENSE. Inflation comes from MV=PY? Or does it come from having less “slack”? If you replace the textbook model with NGDP and wages, everything suddenly becomes clearer. Monetary policy (including velocity shocks) drive NGDP. Real GDP fluctuations are caused by NGDP fluctuations interacting with sticky wages. And once you have growth rates for NGDP and RGDP, then price inflation is simply the difference.

PPS. Sorry for being so long-winded. I wish I could write like Mankiw, a man of few words. Or zero words in the post I linked to, to be precise.

PPPS. If only I could write my own textbook. Oh wait, I did.

. . . If only I could write a textbook without worrying about sales figures.

Never assume the markets are wrong

Here’s the FT:

One can look at equities and bond yields and conclude that one of these markets is very wrong.

Of course markets are always wrong in the sense that each day new information comes in and prices move to new levels reflecting that new inflation. Ex ante, however, there is no reason to assume that the stock and bond markets cannot both be correct. Here’s what I see as the most likely explanation:

1. Long run changes in saving and investment are gradually producing a lower “new normal” of global real interest rates. For any given flow of corporate earnings, that’s bullish for stock prices.

2. Over the past year, expectations regarding economic growth in the US and elsewhere have fallen somewhat. These slower growth expectations have reduced the expected future flow of corporate earnings.

Both factors tend to depress bond yields, whereas factor #1 boosts equity prices while factor #2 depresses equity prices. Taking everything into account, you’d expect bond yields to be much lower than 9 months ago, and you’d expect relatively little change in equity prices. And that’s exactly what has happened.

Bubbles are such a useful concept!

Yes, I’m being sarcastic. I’m long past the point where I regard “bubbles” as an intellectual idea that should be taken seriously.

A few months back, I did a post mocking all of the (failed) previous predictions about Bitcoin being a bubble. Yet because the price at that time was well down from the peak, there continued to be lots of claims like the following:

We can safely say the ICO bubble is over now.

That was in March, when Bitcoin was at $4000. Today it’s up over $10,800.

If these are bubbles, then please give me more, and more, and more of them. I’ll laugh all the way to the bank.

HT: MSGKings