Janet Yellen: "A cushion of 2 percentage points of annual inflation over and above that produced by measurement error eradicates the zero-bound interest-rate problem.... And the zero-bound interest-rate problem is much, much easier to prevent than to cure. Since the risks are asymmetric, the policy should be asymmetric as well.... Such a policy is justified even when the odds of outright deflation are quite low."
Posted by DeLong at August 30, 2003 09:17 PM | TrackBack
"even when the odds of outright deflation are quite low"
Why all this insouciance about inflation? Are the odds of deflation really that low?
In the year ending July 2003, the core CPI was up 1.5 per cent which was a 37-year low. The core PPI increased 0.2 percent in July, accounting for the entire change in core PPI over the last twelve months.
Further, in the last few days, Merrill Lynch has expressed grave concerns about the lack of pricing power in the U.S., and HSBC, whilst revising its Q3 estimate from 2.4% to 4.5%, is worried the upswing is not sustainable and that core inflation will drop to 1% in 2004.
Wednesday, August 27 - 2003 at 12:19
HSBC revises its US forecasts
HSBC has significantly revised its US economic forecasts and has become more optimistic about the immediate outlook.
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HSBC were of the opinion that second half growth would disappoint. It appears that as far as the third quarter goes, we were wrong.
There is sufficient evidence now that GDP growth will be stronger than what we were initially looking for, as published in the Q3 edition of Global Economics.
We are changing our Q3 GDP estimate to 4.5% from 2.4%, and we are changing our Q4 forecast from 1.5% to 2.0%. This raises the 2003 year-average GDP forecast from 1.9% to 2.3%.
Partly due to more positive "shadow-effects" from 2003H2, our year-average 2004 GDP forecast has been upgraded slightly to 2.6% from 2.2%, but this is still consistent with our longer-term "stagnation" view.
We continue to believe that core inflation will drop to 1% in 2004, from 1.5% currently.
As a result of these upgrades to H2 growth, we have abandoned our forecast of a 25bp cut in Fed funds in September, postponing the cut to Q1 next year. So we are keeping our 0.75% Fed funds call intact (a view we first adopted in August last year), but it will take a little longer than we anticipated for it to come through.
As a result of the above factors, as well as the huge sell-off in Treasuries over the past two months, our year-end call of 3.0% for 10-year Treasury yields is now untenable.
Nevertheless, we think that a decent rally can still occur, and we now look for 3.9% 10-year yields at year-end, as we expect 2% GDP growth in Q4. We also expect employment to remain weak.
At the very least, this should take out the monetary tightening that the market expects in 2004, where futures markets are suggesting 1.75% Fed funds in July 2004 and 2.25%-2.50% for end-2004. We do not see the first Fed tightening until Q1 2005 at the earliest.
The taking out of the 2004 rate hike expectations should benefit the entire curve over the medium-term.
Why are we raising our Q3 GDP call? Data that feed into both consumer spending and business investment have all surprised to the upside. Specifically, July'sretail sales, together with upward revisions for June, have put consumption on a strong Q3 track.
We are raising our Q3 consumption forecast from 3.3% to 4.5%. Apparently, more of the tax cuts are being spent than what we thought likely, while cash-outs from mortgage refinancing is still high.
Meanwhile, the July durable goods report showed strong gains for non-defense capital goods (ex-aircraft) shipments, which puts business investment on a strong Q3 track, even if August and September were to show declines.
As a result, we have had to significantly raise our business investment forecast from 3.5% to 9.0%. Moreover, June's trade data has resulted in our export forecast being revised up while our import forecast gets revised down, so that net trade now contributes 0.3ppts to growth instead of the 0.6ppt drag we were estimating.
We are concerned about the sustainability of the upswing that we are currently seeing, and that is reflected in our 2% GDP call for Q4.
Specifically, the significant boost to consumption due to cash-outs from mortgage refinancing will tumble in Q4, due to the sharp rise in mortgage rates over the past two months. (It does not hurt Q3 consumption because despite higher rates, it takes banks a few months to clear the backlog of applications that are already in the system.)
This could seriously undermine Q4 growth. It would not be a problem if employment became strong, as the income generated from this source would easily offset the drag from lower cash-outs. However, there is little evidence that the upturn in activity is resulting in higher jobs growth anytime soon.
Indeed,despite the sea of positive economic news, the latest clues on jobs are worrying: August initial claims remain around 400,000; August continuing claims remain near cycle-highs; August Jobs Hard To Get index hits new cycle-high; and August Philly Fed and NY Empire employment
components both plunged.
Our longer-term concerns about the risks in a post-bubble environment, such as excess capacity, excess debt, poor retained earnings and persistent inflation undershoots, remains unchanged.
Some observers have suggested that it is becoming very difficult to justify a negative medium term view on the economy, given the recent data. We disagree. Yes, there's been a lot of good news, but as a long "not so good" list shows, the economy is not out of the woods just yet.
http://www.ameinfo.com/news/Detailed/27546.html
"Why all this insouciance about inflation"
It should read "deflation" of course.
Posted by: Pooh on August 31, 2003 04:48 AMPrices in Japan and Hong Kong are still falling. GDP growth last quarter was negative in Canada, Germany, Italy, the Netherlands, and Korea. China's GDP is growing rapidly, but prices were falling through the early months of the year.
Yes. We have to worry about sustained world GDP growth with what may still be too little price leverage.
Posted by: anne on August 31, 2003 06:09 AMAnne,
How does "Prices are falling in Hong Kong and Japan" square with "GDP growth last quarter was negative in Canada, Germany, Italy, the Netherlands, and South Korea."? Can't prices fall but GDP growth still be positive, because of continuing demand? Can't GDP growth be negative, but prices still stable or rising, because people don't have savings to produce goods at current prices? BTW, I am only an undergrad who is interested in economics as a hobby.
--James S. W.
Posted by: James S. W. on August 31, 2003 06:33 PMBrad, do you have a link/cite for Yellen?
Posted by: George Zachar on September 1, 2003 06:28 AMBrad, do you have a link/cite for Yellen?
Posted by: George Zachar on September 1, 2003 06:29 AMFolks,
You seem to be pulling Janet's comment out of context: what she attempts to highlight are the asymmetries (and wrenching cost effects of) deflation while at the same time providing prescriptive relief of acceptable rate-cushion levels. Very wise, good way to keep the Fed managers from driving the central bank car off the road.
FW
Willet expresses the same concern this way: "However, if allowed to linger deflation can represent a far more ominous threat – that being complete lack of central bank control."
http://www.fallstreet.com/oct1102.php
October 11, 2002
Blame The Fed - Then Pray They Don’t Fail Again
Greenspan has admitted that he did nothing to stop the stock market bubble from inflating, and the record clearly shows that he has done everything possible to fight economic recession. Perhaps he should have done the exact opposite?
First Greenspan (on Monday), then McDonough (on Tuesday), and then Hoenig (Wednesday) -- apparently the purpose of the closed door Fed meeting on Monday was to round up the troops and send them into a rhetorical ‘everything is alright’ campaign. However, and despite claims from numerous Fed members that the U.S. economy is smoothly riding through a bumpy recovery, everything is not alright.
Part I: The Fed did it
Greenspan took his share of criticism following his ‘don’t blame me for the bubble speech’. In fact, if it were not for the fact that Mr. G helped soothe investor fears following the crash of 1987 and helped keep the economy humming during the 1990s people would certainly be calling for Greenspan’s head today.
Even so, what is often overlooked when people criticize Greenspan is simple mathematics. To be sure, if an economy is growing at say 4% and the money supply is growing at say 15%, you don’t need a calculator to figure out that something is amiss. The simple truth, and one that Austrian economists often point out, is that expanding the money supply beyond the rate of economic growth creates inflation. Whether this inflation occurs as price inflation or asset inflation is irrelevant.
Question: did Greenspan and the Fed ever aim to expand the money supply beyond the anticipated growth rate? Yes. Did doing so help stoke the equity bubble and/or the housing bubble? Yes.
Deflationary Monster Has Many Tentacles
Put simply, deflation occurs when new money is no longer able to inflate either prices or assets. However, if allowed to linger deflation can represent a far more ominous threat – that being complete lack of central bank control.
For an example of this ‘loss of control’ consider what IMF Chief economist Kenneth Rogoff has this to say about Japan:
“I think that an aggressive move . . . including quantitative easing and a communication strategy (which clarifies) that the object is to end deflation . . . is warranted at this point.
He said BOJ should make clear to the markets that its policy is to end deflation and "to achieve a positive rate of inflation within a reasonably short time frame.””
Notice how Mr. Rogoff’s recommendations are not really recommendations at all, but simply vague and meaningless words. Think about it: how does a central bank achieve a ‘positive rate of inflation’ when a zero bound interest rate policy no longer stimulates economic activity? Furthermore, what does a ‘communication strategy’ mean? Does any investor on the planet actually believe that the BOJ has not been attempting to stymie deflation for much of the last decade? As for ‘easing’ – what a novel idea. In the case of Japan, what monetary constrictions are left to ‘ease’?
Point being, and as the Japan example aptly demonstrates, deflation can rendered a central bank helpless.
Fooled By the Maestro
With this in mind, we have all been tricked by Greenspan. For certain, as the Fed was recklessly expanding the money supply to help combat the Asian crisis and Y2K Greenspan would frequently herald that productivity growth had slain the inflation beast. Little did Greenspan know, or was willing to admit, that inflation was running amuck in equity markets, corporate debt markets, derivatives markets, etc.
Exactly why the Fed did not fear this asset inflation is unknown. After all, is not the Fed concerned about asset deflation today?
Part II Big Changes & Big Blow Ups
In a bear market characterized by seemingly never ending losses the one thing missing has been a memorable bankruptcy and/or bailout. Be it the demise of water stock issuance in the 1860s, the blow-up of railroad stocks in the 1890s, the failure of trust companies in the early 1900s (1907 Knickerbocker), or the collapse of investment trusts that began in October 1929, each ‘crash’ period is remembered for both the unprecedented amount of capital destroyed and the startling regulatory changes and/or bailouts that followed.
By contrast, all that can be said about the current period thus far is that the Fed gave LTCM some money. End of story.
Change Comes Slowly
Some would argue that internet blow ups and the demise of the stock markets in general rival any destructive period in history. And while this belief on the surface is very true, after all nearly $8 Trillion in stock market wealth has been erased, the fact remains that is the thud has not yet been heard.
During every previous destructive phase mentioned above either JP Morgan (Fed) tried to bail out the markets (companies) and/or swooping regulatory changes where required to bring confidence back to stocks. The end of water stock issuance, the closing of NYSE for 10 days following a Jay Cooke & Company induced panic, the end of JP Morgan as the lender of the last resort following the panic 1907, the formation of the SEC – these are real and memorable events in the history of the U.S. financial markets.
By contrast, absolutely nothing tangible and/or memorable has changed since the current destruction phase began (it is debatable whether or not Goodwill impairment rather than amortization has been a significant change). Yes, CEOs and CFOs have re-signed their financial statements and new laws have been created with the hope of sending criminals to jail. However, while the regulators have been busy tackling blatant fraud what they have not been doing is changing what are undoubtedly the loosest sets of accounting standards since the SEC was formed. What this suggests is that more changes are coming: special purpose entities and off balance sheet financing must be consolidated to balance sheets, stock options must be expensed against reported earnings, the OTC derivatives markets must be regulated, and a universal standard for operational EPS calculations must be crafted (the trend appears to be towards S&P’s ‘core earnings’ numbers).
Conclusions
As the Dow scratches 5-year lows and the Nasdaq spends the next 20-50 years trying to recapture 5,000, the Fed is beginning to learn that expanding the money supply beyond the expected rate of economic growth can be a dangerous practice. Furthermore, as merchant energy traders who were once ‘perfectly hedged’ go broke and rumors of an OTC derivatives default abound (first Commertzbank bank (Germany), then J.P. Morgan), what is becoming painfully clear is that the financial markets may not escape their current doldrums without a memorable blow-up. Suffice it to say, with such a blow-up what will be even more memorable are the swooping regulatory changes that follow.
As the SEC and FASB work to counteract falling investor confidence by creating new reporting standards, the Fed will endeavor to adopt new ‘unconventional’ anti-deflation policies. Furthermore, the current stock market rally notwithstanding, rising corporate spreads to that of Treasurys and slumping global stock prices suggest that a ‘100 year flood’ is near – that a selective (perhaps also secretive) bailout by the Fed lurks…
Blame Greenspan and the Fed for helping to create then completely ignoring asset price inflation. Furthermore, and as the Fed’s printing press loses its power, blame the Fed for failing to accept the much needed cooling off period (recession) as a welcomed inevitability. However, and after criticism of Greenspan and the Fed has been exhausted, pray the Fed does not fail in the future. After all, Mr. Rogoff suggests the BOJ needs an ‘aggressive move’…Greenspan and company, save bailing out the next LTCM, may have already used up all of their ‘aggressive moves’...
BWillett@fallstreet.com
Pooh,
The HSBC view is, I suspect, the work of Ian Morris. He is very good, but in this case, he is mostly alone. The general expectation among professional "up-and-down" economist is that a rate hike, rather than an ease, is the most likely Fed move in the first half of next year. The argument that the Treasury curve will benefit from pricing out such expectations is reasonable, if such expectations do, in fact, diminish. Yes, the HSBC view is evidence that it is possible for a good economist to hold grave doubts about US growth prospects, but again, it is not a standard view. The problem, I think, is that we have never seen anything like this expansion before. While that is true of every expansion, the difference is bigger this time. No "pent-up-demand" bounce, so no inventory short-fall to make up, so no capital spending spree (in nominal terms, anyhow), P/Es still high and bond yields still low. So there is no reason to ignore HSBC, but there is no reason for great confidence it HSBC's, or anybody elses, economic outlook right now.
Posted by: K Harris on September 2, 2003 09:22 AMSo according to Willett the only thing that ends a recession is a memorable regulatory action? It is an interesting theory.
Posted by: Stan on September 2, 2003 02:32 PMI think so.
Posted by: phentermine on December 5, 2003 11:45 PM