Brad DeLong's Semi-Daily Journal (2004)

Mortgage rates are falling. That means that the Fed underestimated (perhaps purposefully) the anticipated market yield curve. The market then fell into line. But this is not a good thing. It means that asset prices are going to explode. Me and others have been arguing that we are in a speculative asset inflation bubble.

However the fall of mortgage rates means that we really are going to be in a no holds barred bubble. The thing about bubbles is that when you're in one, it's too late to do anything about it without a lot of pain. It's the nature of inflation. The Fed was behind the curve. That ensured what us bubble-watchers have been saying. If we weren't in a bubble, we are going to be in one now.

The role of the Fed is not to increase employment, and net employment is not increased in the long term by generating bubbles. Indeed speculative capital acquisition is more inefficient than long term income producing assets. More jobs are created in the long term if interest rates are high enough to create compelling investment choices. This takes longer however.

The quick and easy way to gain short term jobs is to keep interest rates low, but this ties up capital in inefficient ventures and in the long term depresses job creation. In addition there is no possibility of a soft landing, and the choices are reduced to the hard landing of hyperinflation or massive economic contraction.

There was still time to prevent a bubble, if we had seen the market rates steady as the Fed raised rates. Since we didn't, and we saw a collapse back into bubble-driven asset buying and credit expansion we will have a crash now that the Fed has set this course.

Way to stick the knife in at the end.

What Oldman is missing is that we normally shouldn't need to fight inflation when employment is slack. What Brad is missing is that normally we don't need to worry about stagflation wheras that is still a possible outcome here

Andy Xie's argument for more agressive Fed tightening is worth considering.

http://www.morganstanley.com/GEFdata/digests/20040712-mon.html

Not dissimilar to Oldmans point about bursting the bubble but with some global context.

The same link has a good bearish piece by Steven Roach and two more bullish counterpoints one by Richard Bernier who takes a similar view as Brad on slack in employment and one by Rebecca McCaughrin.

This is going to be an interesting year.

I dunno, I'm not sure that the lowest prime in almost half-a-century isn't a bigger sign of fiscal insanity than deficits roughly the GDP-adjusted size of <15 years ago?

I will admit that now we're down here in the mud you make a good argument for continued wallowing.

If my investment advisor is any indication, a solid a fiscal right-winger as they come, his community thinks that low interest rates are their birthright. But repeat after me:

The Stock Market Is Not The Economy.

Another friend's spouse runs a S&L, and these low interest rates have just killed fixed-income people.

I wonder if Brad might be kind enough to explain the recent BEA report regarding Personal Income and Outlays which can be found on the Bureau of Economic Affairs website at www.bea.gov.

On the theory that the consumer accounts for the vast bulk of economic activity in the US, strong trends one way or the other might shed light into the health of the overall economy, the path for asset values and, thus, to some degree, interest rates. The table provided by the BEA for the last 5-6 quarters (monthly as well) seems to show a deceleration in PCE from q3 2003 at which point activity appears have peaked. BEA claims this data is seasonally adjusted to account for the obvious holiday activity.

Brad (or anyone else who can help) I tried going to the source data at BEA to see if I could establish relationships between PCE (durables), interest rates and asset values. This was not easy as the data is tough to absorb but also the underlying detail indicates consumer activity is more than 40% related to autos - something which I was not aware of previously.

Any insights you can provide would be quite helpful and may provide further context for your terrific article in today's FT.

Thanks.

"It is also impolite to point out that there is still a near-record gap between the percentage of the adult population employed today and the percentage that was employed at the previous business cycle peak. "

But you keep on doing it.

It's kind of like the Laffer Curve, isn't it?

The Laffer curve makes the case that at 100% tax rates, not actual tax revenues will be collected. At 0% tax rates, likewise, no tax revenues will be collected. But that's trivial. What we do not know is where the peak revenue point is between 0-100. We do not know if there is one peak or two or several, we don't know where on the curve we are, with respect to those peaks, we don't know whether any given change in the tax rate toward, away from, or over-and-past a peak ... in short, the Laffer Curve is basically useless -- PARTICULARLY as used by Supply Siders to justify their (otherwise adorably charming) tax policies.

May we christen the curve of the desirability of all possible employment-to-population ratios the DeLong Curve? (Unfelicitous, that. People will hear it as "The Long Curve" instead of THE DeLong Curve. But it can't be helped.) Note that this is a different pattern than the historical record of peaks and valleys of percent plotted against a timescale of years, or quarters-of-business cycle. This is some theoretical "utility" or "goodness" or "socially correct"-ness expressed as a number plotted against the ratios 0 to 100.

At zero percent workforce/population, nobody works. All jobs are outsourced, everybody draws a gov't welfare or pension check, or does black market drug deals, migrant agricultural crop picking, etc. Or, they're in prison. This is so awful to contemplate we assign it a goodness of zero.

But at 100% workforce/adult-population, nobody is retired, but works up until the day he or she dies. Nobody collects welfare or remains in school past an 18th birthday. Prisoners, too, must work for their keep. A number of new jobs are created for Labor Dept Bureau of Statistical Enforcement --cracking down on black market jobs. Nobody is allowed a nanny or gardner or watermelon picker unless such worker is documented on Dept. Labor stats. Also, beyond a few days maternity leave, no adult women is allowed to remain home with a child -- she MUST work at a statistically significant job. (There will be an increase in the workforce among day-care providers...) In this enforced policestate anti-family 100% economy, the "goodness" level as indicated on the DeLong Curve is -- what? Zero, I would think. (But I defer to the expert...)

Now, the question is: Is there one peak of goodness between the extremes? Or perhaps more than one? Is more people retiring earlier -- lowering the percentage -- a force raising or lowering the "goodness" level? More criminals imprisoned -- higher goodness or lower? More mothers at home with children?

If a high percentage of jobs are "outsourced" to a more productive economy -- say some tens of millions of auto-workers are laid off, but Japanese automakers start providing $5000 six passenger 200-mile-per-gallon hybrid-electric automobiles -- does the "goodness" go up or down?

It seems to me we haven't really looked deeply at the question yet. So far we seem to correlate "goodness" to the historical trend towards higher and higher percentages of the adult population entering the workforce. And because times are "gooder" now than 30 or 50 years ago -- the higher the ratio, the better. When everybody is busy working, goodness ensues. The "working assumption", if I may joke with you slightly, seems to define social democracy as empowering via EMPLOYING every adult body.

But is it in fact reasonable? Perhaps the last boom pushed the peak too high; dragging student-aged persons who MIGHT have stayed in college into immediately productive, but less-than-their potential, employment? Eh? Who knows?

More to the point, who's trying to find out?

We're in a period of monetized inflation and the only reason it hasn't shown up yet is the whole juggling act of the artificial leverage going on in the currency market, asian bank US treasury purchase, and current account deficit financing our low interest rates. If interest rates were to revert to trend I'd guess they'd be already 4% on the short end or 3% higher than the lows.

When and if they do revert to market efficiency there is going to be a lot of pain on the debt service end. This monetized inflation deal is tricky though because the traditional aggregate production and consumption relationships have been broken. When so many goods are imports, stocking inventories for instance will not necessarily increase domestic hiring and therefore wage inflation. GDP growth from aggregate demand is therefore decoupled from inventory building, and therefore the demand link to increased capital asset investment is broken.

That's how you can see inflation surges in a low demand employment market, and hence the stagflation scenario.

Pouncer states that "What we do not know is where the peak revenue point is between 0-100 [marginal rates of taxation]."

In fact, research has been done and it indicates that tax revenues are optimized at 70% marginal rates.

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The more likely source of concern is what happens if there is capital flight ala Argentina, which Professor DeLong barely touches on. High interest rates deter capital flight although they also deter growth. Also, although corporate profits are currently wonderful, they hardly make up for the huge capital demand generated by deficits. They could also drop like a stone if there's a renewal of recession.

Currency makes monetary policy a difficult balancing act. Movements in currency markets, like movements in stock markets, are often fear-driven. Unlike movements in stock markets, they have large, real and immediate consequences to the broader economy. Right now, there is plenty of fear in the currency markets.

If we could be guaranteed that Bob Rubin would be in charge of Treasury, with Brad DeLong heading up the Fed, and a Congress of genuinely compassionate deficit hawks, I wouldn't have any qualms. And if it were guaranteed that pigs had pool cues, I wouldn't doubt they might play billiards.

Oh, I see, the Fed is hiking interest rates to puncture the Bond/Housing bubble. I was being told that it was to keep inflation in check.

That's good, since I didn't get the "inflation in check" explanation, the current inflationary trends seem's to be due to commodity scarcity (oil, steel, milk), rather than worker wage inflation. In this inflationary enviroment I would expect interest rate increases to just add to the inflationary pressures, since interest would have to be factored into the cost of production. (I assume I'm wrong somehow in this thinking, but I can't see it).

But anyway, we're killing the dual bubbles, I'm happy now.

"...the belief that the fed need to raise interest rates far and fast is strong..." Strong where? The Fed funds strip, as far as I can tell, is pricing in 3 more rate hikes plus a little but for the rest of this year. That means 0.25% at a pop, skipping one meeting (logically the September meeting). This is, as I understand it, what the Fed means by "measured." So we have expectations of measured Fed tightening for the remainder of the year, if I am reading this right. The the data I have in front of me (which I suspect are not right) show the funds contracts flattening out just over 3%, mid-way through 2005. Thus expectations are for not very fast, and not very far. Brad, what belief do you have in mind?

If there is an excess of capital (oversupply/overcapacity) does that imply that small changes in Fed rates will have very little effcect on total investment??

Are Fed rates most influential when changes in interest rates affect the ability to provide capital? Will slight increases in the Fed rates change the amount of capital available or the willingness of investors to borrow in the current climate?

Do high bond prices reflect too much capital chasing not enough investment opportunities?

Bernstein has a similar take on Fed rates but approaches from a different angle:

http://www.prospect.org/web/page.ww?section=root&name=ViewWeb&articleId=8095

The key words: "transitory factors." What they're (Fed) trying to say here is that whatever inflationary pressures are ongoing come from the supply-side–constrained supplies of certain food items, health care, and anything that uses gas. But the Fed's tool -- the federal funds rate -- works to slow demand. Sure, that could take some pressure off the commodities and services just noted, but with all this labor market slack, this is a lousy time to slow demand. In fact, it's much tougher for the Fed to scratch an inflation itch coming from the supply side. They're more effective at pushing back against wage-push inflation, as when a very tight labor market enables workers to push for higher wages.

onthe tape-- generally accepted pratice is to assume roughly a one year lag between changes in fed funds and changes in consumer spending.

Right now is widely accepted belief that consumer spending has peaked and will slow significantly over next year -- debate is around how much it moderates not if it will slow.

My question -- it looks like for a decade China was exporting deflation, but now China is starting to export inflation as one source of higher inflation is consumer goods import prices.

Second point -- monetary velocity is inversely related to real interest rates with key level around 4% -- if real rates above 4% monetary velocity falls -- if below 4% velocity rises.

Looks like we just completed a 20 year cycle of high real rates and falling monetary velocity.
and now real rates are lower and monetary velocity is starting to rise. Does anyone have
any strong arguments pro or con on this thesis?

"Research has been done": can we please see a citation for this study that purports to show that tax revenue is optimized -- and can we also see an explanation of what this means? -- at marginal rates of 70%?

D. Fullerton, J. Public Economics October 1982, cited in P.A. Samuelson and W.D. Nordhaus, Microeconomics, 15th ed.McGraw-Hill, 1995 says that the optimum upper marginal tax rate, in terms of raising tax revenue, is about 75%, Mr. Carr.

The evidence is not on the side of what Herb Stein called punk supply-side economics.

I'd also like to see a coherent answer to Steve's excellent point about Fed tightening not fighting commodity (as opposed to wage-driven) inflation.

Charles, this is your evidence? A paper that it sounds like you haven't even read, published in the middle of a fervid political debate by a scholar with a clear ideological stance? Forgive me if I'm not convinced.

What's remarkable to me is that you think that anyone who thinks that having the government take 75 cents of every marginal dollar might not be good for innovation, production, or work effort is advocating "punk supply side economics." I would be very surprised if economists like Larry Summers, Brad DeLong, or James Poterba would advocate raising the marginal rate back to 75%. If you could find evidence to the contrary, I'd like to see it.

As regards questions of what kind of inflation the Fed is fighting, I'm not sure the Fed is fighting inflation. The Fed, by its own estimate, is still quite accommodative in its policy. The Fed is still fostering inflation, not fighting it. The June rate hike, first in a series, is meant to bring monetary policy back to neutral, an effort to avoid the onset of inflation, rather than an effort to kill off a nascent inflationary threat. Fed officials have said that the recent pick-up in inflation (3-month annualized pace of core CPI rise was 3.3% in May, headline CPI 5.5%) is likely at least partly transitory. That view recognizes that commodity prices are the source of the pick-up, rather than wages. Greenspan, in his most recent testimony to congress, said that unit labor costs are key to the Fed's thinking about inflation. So the Fed is, in fact, willing to differentiate between commodity and wage inflation, and claims to be more sensitive to the latter than the former. So the Fed is not fighting inflation, and is not confusing China (and US and other Asian) driven commodity price fluctuations with domestically driven wage inflation. If the Fed makes a mistake, it will not be as simple as mistaking the source of current price change. The problem, if it comes, will be because the Fed mistook the future direction of inflation, which means it will have misundstood the structural dynamic of inflation. Fed officials are quite willing to admit to misunderstanding structural change.

And before casting the Fed as over-eager in fighting inflation, take a look at any historic relation between growth, jobless rates (flawed, I know), inflation, whatever, and the real Fed funds rate, and you are likely to find that the Fed is erring far more on the side of stimulating growth than fighting inflation. Same is true if you use a Taylor rule.

My own personal rule is more of a psychological one. People who tend to own homes already in inflated markets (like the SF Bay Area) tend to like low interest rates because their properties are valued at ridiculously high levels, and they feel rich. Dr. DeLong would happen to be among that group.

I am in favor of raising interest rates back to neutral sooner because 1. I believe that the Southern California housing market is in an absurd asset bubble, and 2. I don't own property right now.

Anyone else want to bet there might be a correlation?

Mr. Carr, may I suggest that you would not be convinced if Jesus Christ Himself came down and whispered it in your ear?

I don't waste very much time on true believers; I merely post the evidence and allow the lack of any credible response do the talking for me.

No one wants marginal rates at 75%, but if Republican policies create crippling deficits, that may be the only way to keep this country from becoming another Argentina... or worse. You may prefer to be strung up with piano wire to paying more taxes, but not everyone feels the same.

By the way, the phrase "punk supply side economics" is Herb Stein's. As is clearly stated in my post. You may recall him as Nixon's economic adviser. Fiscal responsibility used to be a conservative bragging point.

Now the punks rule "conservatism."

Is capital abundant in the USA? Does the USA have a high savings rate? Does not the USA need to import a significant amount of savings / capital from people in other countries?

Inquiring minds want to know.

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