The Big Picture |
- Monetary Policy When the Spyglass Is Smudged
- Big Banks Manipulate Physical MarketsPrices
- How to Win the Loser’s Game (Full Version)
- Insights From The Most Successful Investors In History
- 10 Thanksgiving Day Reads
- IRA Contributions Held Up by Washington Turkeys
| Monetary Policy When the Spyglass Is Smudged Posted: 28 Nov 2014 02:00 AM PST Monetary Policy When the Spyglass Is Smudged
An accurate measure of economic slack is key to properly calibrating monetary policy. Two traditional gauges of slack have become harder to interpret since the Great Recession: the gap between output and its potential level, and the deviation of the unemployment rate from its natural rate. As a consequence, conventional policy rules based on these measures of slack generate wide-ranging policy rate recommendations. This variability highlights one of the challenges policymakers currently face. It would be a mistake to characterize the Great Recession as simply a run-of-the-mill economic downturn, only larger in magnitude. In the post-World War II era the United States experienced both deep recessions and episodes of financial turmoil, but not since the Great Depression had the U.S. economy suffered both simultaneously. The degree of economic dislocation has been considerable, greatly altering the long-term structure of the economy and the outlook. Economists are still grappling with this new economic order and how to refine their thinking. Not surprisingly, implementing policy in such an uncertain economic environment has been specially challenging. This Economic Letter examines how this new environment has made traditional measures of economic performance harder to interpret. The tool we use to communicate these policy challenges is the well-known Taylor rule. This is the first in a two-part series. The second (Bosler, Daly, and Nechio 2014, forthcoming December 1) details mixed signals from the labor market. Large revisions to potential output The deviation of real GDP from its potential level has long been regarded as a standard measure of economic slack. When the economy grows faster than its potential, the effects are widespread: Overtime hours increase for workers, capital utilization rates go up for businesses, and inflation pressures mount for consumers. Not surprisingly, the difference between real GDP and its potential level, known as the output gap, is closely scrutinized by policymakers. Although potential GDP is not directly observable, the Congressional Budget Office (CBO) regularly publishes an estimate of its value. Data on both real GDP and potential GDP go through a number of revisions. Data on real GDP come from the National Income and Product Accounts (NIPA) published by the Bureau of Economic Analysis. The NIPA relies on a wide variety of data that differ in quality, coverage, and availability. Initial GDP estimates rely mostly on smaller-scale surveys, which are available reasonably quickly. Over time, survey data are replaced with large-scale census data, which are more exhaustive but take longer to collect. Figure 1
Sources: BEA and CBO, chained 2009 dollars. By contrast, potential GDP estimates are revised less frequently. Moreover, past revisions have usually been small so that even initial estimates about future values have been reliable. Potential GDP had moved slowly enough that the CBO releases yearly updates together with 10-year projections. However, the Great Recession eradicated this stability and has vividly demonstrated how quickly estimates of potential GDP can change in times of economic tumult. Between 2007 and 2014, the CBO revised its projection of real potential GDP for the first quarter of 2014 downward by almost 8%. Figure 1 depicts the CBO's 10-year projections of potential GDP from 2007, 2010, and 2014 alongside the path of real GDP for context. A primer on the Taylor rule How significant are these revisions of potential GDP, and how do they affect a policymaker's assessment of current economic conditions? This is difficult to answer considering only the data in Figure 1. We can get a more complete picture by examining how revisions to potential GDP affect the policy recommendations one would derive from a textbook policy rule such as the Taylor (1993) rule. This benchmark is designed with price and output stability in mind. The rule incorporates two essential elements to handle inflation's deviation from its targeted level and output's deviation from its potential level. If inflation is at its target and the economy is growing on par with its potential, these two penalty terms vanish and the policy rate equals the nominal equilibrium rate of interest. There are numerous modifications to the original rule in Taylor (1993). Taylor (1999), Rudebusch and Svensson (1999), and Coibion and Gorodnichenko (2005) provide good surveys. These modifications run the gamut, from using forecasts rather than current values of inflation and output to adding a smoothing term to capture the incremental way the policy rate is typically adjusted. The version we use here was discussed in Taylor (1999) and has since gained wide acceptance as a natural benchmark. According to this version of the rule, the policy rate can be expressed as follows: Policy rate = 1.25 + (1.5 × Inflation) + Output gap. We measure inflation using the personal consumption expenditures price index (PCEPI) excluding food and energy. This measure is commonly referred to as core PCE inflation. Although the Federal Reserve is ultimately interested in ensuring that headline inflation remains stable, core inflation is significantly less volatile and therefore offers a more reliable measure (see Bernanke 2007). We measure the output gap using the percentage difference between real GDP and its potential. The intercept in this rule is based on an estimate of the natural rate of interest; our conclusions would only be reinforced if we accounted for the greater uncertainty about the natural rate of interest in the wake of the Great Recession (Leduc and Rudebusch 2014). Figure 2
Sources: BEA, CBO, and authors' calculations. Potential GDP and the Taylor rule Figure 2 depicts three different policy rate paths using the 2007, 2010, and 2014 vintages of the CBO's potential GDP plotted against the actual target for the federal funds rate, the U.S. policy rate. The estimated policy rates track the federal funds rate and each other fairly closely until the end of 2008, when the federal funds rate hits the zero lower bound and the three alternative policy paths begin to diverge significantly. This divergence comes from the sequential revisions to potential GDP. Mechanically, the recommended policy rate increases as the output gap diminishes. With time and more current data, a more accurate picture of the recession and how it had affected potential GDP emerged. Notice that the 2007 and 2010 estimates of the output gap are so large and negative that the benchmark Taylor rule suggests the policy rate should be negative for most of the period since 2008. Based on the 2007 estimates of potential GDP and the value of actual GDP today, the Taylor rule would recommend a policy rate of –8.7%. This striking number underscores the importance of the revisions to potential GDP. From output gap to unemployment gap with Okun's law A popular alternative for assessing slack in the economy is to use the unemployment gap, the gap between the unemployment rate and its natural rate. This alternative gap measure offers two main advantages for policymakers. First, unemployment data are available monthly as opposed to quarterly for GDP data. Second, unemployment numbers offer a more direct discussion of the one of the Fed's explicit mandates, full employment. It is natural to ask then whether the unemployment gap provides a cleaner measure of economic slack than the output gap and to determine how these measures are related. Okun's law is a popular rule of thumb that relates changes in the unemployment rate to GDP growth at an approximate two-to-one ratio. However, underlying this empirical regularity are important economic mechanisms that justify the result and illuminate the link between the output and unemployment gaps. For example, when businesses face declining demand, they reduce production using a blend of fewer hours per worker, reduced staffing levels, decreased capital utilization levels, and changes in technology. Historically, Okun's law has been a remarkably stable relationship, but the Great Recession has muddied the waters, as discussed in Daly, et al. (2014). Using Okun's law, the Taylor rule can easily be rewritten to incorporate an unemployment gap in place of the output gap: Policy rate = 1.25 + (1.5 × Inflation) – (2 × Unemployment gap). The unemployment gap is measured as the percentage point difference between the unemployment rate and the non-accelerating inflation rate of unemployment, or NAIRU. The NAIRU, just like potential GDP, is not directly measurable. However, the CBO regularly releases estimates of its value. These estimates are closely linked to those of potential GDP and include several adjustment factors, for example, based on the potential size of the labor force or potential labor force productivity. The version of the Taylor rule that uses the unemployment gap is discussed in Rudebusch (2010). Figure 3
Sources: BEA, CBO, BLS, and authors' calculations. Before 2008, the policy rates recommended by the output and unemployment gap versions of the benchmark Taylor rule remained within a few fractions of a percentage point of each other and reasonably close to what the federal funds rate turned out to be, as illustrated in Figure 3. Note that we use the most up-to-date measures of potential GDP and the NAIRU to abstract from the variation induced by revisions and focus exclusively on the different signals provided by each gap measure. Policy recommendations diverged considerably once the Great Recession was under way. If we ignore the zero lower bound on nominal interest rates, the unemployment gap version of the Taylor rule called for policy to be set about 3 percentage points lower than the output gap version would have suggested throughout 2010. The differences between the two narrowed over the next few years, and by 2012 they appeared to be as close as in the past. Recently, however, the unemployment rate has been gradually improving, whereas economic performance, as measured by real GDP growth, has remained lackluster. As a result the difference in the suggested policy rates has flipped: the unemployment gap version of the Taylor rule now calls for policy to be about 2 percentage points higher than the output gap version. Once again, it appears that Okun's law and the margins firms use to adjust to the new economic environment have temporarily diverged from normal. Conflicting signals from labor markets may shed some light on this recent divergence, an issue that will be explored in the second part of this series (Bosler, Daly, and Nechio 2014). Conclusion Determining whether the economy is overheating or underperforming is critical for monetary policy. Policymakers cannot simply rely on one indicator to make this judgment. This Letter has shown that in times of economic turmoil it is especially difficult to get a clear read on the economy's potential, and different indicators can generate conflicting signals. Our analysis highlights the difficulties of using the Taylor rule as a practical guide to implementing monetary policy in real time. Early Elias and Helen Irvin are research associates in the Economic Research Department of the Federal Reserve Bank of San Francisco. Òscar Jordà is a senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco. References Bernanke, Ben. 2007. "Semiannual Monetary Policy Report to the Congress." July 18. Bosler, Canyon, Mary C. Daly, and Fernanda Nechio. 2014. "Mixed Signals: Labor Markets and Monetary Policy." FRBSF Economic Letter 2014-36 (forthcoming, December 1). Coibion, Olivier, and Yuriy Gorodnichenko. 2012. "Why Are Target Interest Rate Changes So Persistent?" American Economic Journal: Macroeconomics 4(4), pp. 126–162. Daly, Mary, John Fernald, Òscar Jordà, and Fernanda Nechio. 2014. "Interpreting Deviations from Okun's Law." FRBSF Economic Letter 2014-12 (April 21). Leduc, Sylvain, and Glenn D. Rudebusch. 2014. "Does Slower Growth Imply Lower Interest Rates?" FRBSF Economic Letter 2014-33 (November 10). Rudebusch, Glenn D. 2010. "The Fed's Exit Strategy for Monetary Policy." FRBSF Economic Letter 2010-18 (June 14). Rudebusch, Glenn D. and Lars E.O. Svensson. 1999. "Policy Rules for Inflation Targeting." In Monetary Policy Rules, ed. John Taylor. Chicago: University of Chicago Press. Taylor, John B. 1993. "Discretion versus Policy Rules in Practice." Carnegie-Rochester Conference Series on Public Policy 39, pp. 195–214. Taylor, John B. 1999. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank." Journal of Monetary Economics 43(3), pp. 655–679. |
| Big Banks Manipulate Physical MarketsPrices Posted: 27 Nov 2014 10:30 PM PST Giant Banks Take Over Real Economy As Well As Financial System … Enabling Manipulation On a Vast ScaleTop economists, financial experts and bankers say that the big banks are too large … and their very size is threatening the economy. They say we need to break up the big banks to stabilize the economy. They say that too much interconnectedness leads to financial instability. But – as shown below – the big banks are getting bigger and bigger … and getting into ever more interconnected markets. Indeed, big banks aren't even really acting like banks anymore. Big banks do very little traditional banking, since most of their business is from financial speculation. For example, we noted in 2010 that less than 10% of Bank of America's assets come from traditional banking deposits. The big banks are manipulating every market. They're also taking over important aspects of the physical economy, including uranium mining, petroleum products, aluminum, ownership and operation of airports, toll roads, ports, and electricity. And they are using these physical assets to massively manipulate commodities prices … scalping consumers of many billions of dollars each year. More from Matt Taibbi, FDL and Elizabeth Warren. A 2-year bipartisan probe by the Senate Permanent Subcommittee on Investigations has shined a light on this problem, culminating in a new 400-page report. Senator Levin – the Chair of Subcommittee – summarizes the findings from the investigation:
Of course, the Federal Reserve – instead of regulating the banks, encouraged them to buy all of these physical assets. As Reuters notes:
Pam Martens is points out:
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| How to Win the Loser’s Game (Full Version) Posted: 27 Nov 2014 01:00 PM PST Bored with the family? Here’s how to kill an hour and a half: How to Win the Loser’s Game: Full Version
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| Insights From The Most Successful Investors In History Posted: 27 Nov 2014 09:00 AM PST
“If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring.” “Smart investing doesn’t consist of buying good assets, but of buying assets well. This is a very, very important distinction that very, very few people understand. ” “If you have trouble imaging a 20% loss in the stock market, you shouldn’t be in stocks.” “The public buys the most at the top and the least at the bottom.” And, “When all the experts and forecasts agree – something else is going to happen.” “By far the biggest problem for professionals in investing is dealing with career and business risk: protecting your own job as an agent. The second curse of professional investing is over-management caused by the need to be seen to be busy, to be earning your keep. The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals.” “For all long-term investors, there is only one objective – maximum total real return after taxes.” “Quantitatively based solutions and asset allocation equations invariably fail as they are designed to capture what would have worked in the previous cycle whereas the next one remains a riddle wrapped in an enigma.” “It is absurd to think that the general public can ever make money out of market forecasts.” "The stock market is filled with individuals who know the price of everything, but the value of nothing." “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.” “You can't develop a portfolio strategy around endless possibilities. You wouldn't even get out of bed if you considered everything that could possibly happen….. you can use history as one tool for shaping reasonable probabilities. Then, you look at the world of economic, sentiment and political drivers to determine what's most likely to happen—while always knowing you can be and will be wrong a lot.” “The average long-term experience in investing is never surprising, but the short term experience is always surprising. We now know to focus not on rate of return, but on the informed management of risk” “The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don’t always accurately reflect your weight, the markets don’t always accurately reflect that information. Usually they are too pessimistic when it’s bad, and too optimistic when it’s good.” "Every business is manmade. It is a result of individuals. It reflects the personalities and the business philosophy of the founders and those who have directed its affairs throughout its existence. If you want to have an understanding of any business, it is important to know the background of the people who started it and directed its past and the hopes and ambitions of those who are planning its future." "We have bloated bureaucracies in Corporate America. The root of the problem is the absence of real corporate democracy." “Investing without research is like playing stud poker and never looking at the cards.” “It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized.” “If you don’t have integrity, you have nothing. You can’t buy it. You can have all the money in the world, but if you are not a moral and ethical person, you really have nothing.” “An economy is simply the sum of the transactions that make it up. A transaction is a simple thing. Because there are a lot of them, the economy looks more complex than it really is. If instead of looking at it from the top down, we look at it from the transaction up, it is much easier to understand.” “I can calculate the movement of stars, but not the madness of men.” |
| Posted: 27 Nov 2014 05:00 AM PST My Turkey day reads:
Let me guess what you are eating today . . . ?
The Cost of a Thanksgiving Food Coma
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| IRA Contributions Held Up by Washington Turkeys Posted: 27 Nov 2014 03:00 AM PST IRA Contributions Held Up by Washington Turkeys
The spirit of Thanksgiving notwithstanding, our dysfunctional federal government is in the throes of turmoil. President Obama and Senate Majority Leader (soon to be minority leader) Harry Reid are embroiled in an outright war. In the House, a renegade from the Tea Party is derailing attempts of the Boehner-led middle to achieve some reasonable year-end activity. In the old, new, "wannabe," and "gonnabe" Senate, all are trying to maneuver while they use the lame-duck session for many decorations on their personal Christmas trees. There is a mess in Washington, DC. Add to that mess the victims of current policy affecting every US charity. The special tax-extender provision that allows Americans with IRAs (only IRAs and not 401ks) to give money to charities expired on December 31, 2013. Right now, that provision is not in the US tax code. Universities, hospitals, supportive charities, and every other correct and properly filed charitable source waits while Congress makes a mess. If you are 70½ years old or older and have an IRA, you were allowed to give up to $100,000 per year to a charity. You could reduce your required minimum distribution by the amounts of the gifts. The gifts that you gave from your IRA to charities were not tax deductible. You did not have to take the distribution as taxable income. The whole transaction was a wash under the old law. This wonderful provision that helped to fund charitable activity throughout the US, in every Congressional district and in every state, expired, and the House, Senate, and president have not found a way to restore it for all Americans who would like to do charitable acts. Here we are at Thanksgiving time, with a few weeks left in the year. It's the season of the spirit of giving and support, yet we have no provision in the law to make sizable, needful charitable gifts possible. Every person over age 70½ who has an IRA and is seeking to do charitable acts should consult a tax advisor on how to handle this matter. The lame-duck idiots could pass the tax-extender provision tomorrow. In the Senate, the majority wanted to, and Senator Harry Reid held it up. The House came together in a bipartisan bill and passed a version of this tax extender. The president will not permit it or make a deal. Everyone is in a shooting war with each other. The provision has not passed the Congress or been signed by the president. We will keep readers advised if there is a change. In the meantime, let me wish all a happy Thanksgiving. If I could make one Thanksgiving wish, it would be that this season could be a happier and less anxious one for those in need whom charities all across the US seek to serve. This holiday season they do their work with one hand tied behind their backs, metaphorically speaking, as generosity is held hostage by selfish bull-headedness and dysfunction in DC. Let’s work together to change that, and now. David R. Kotok, Chairman and Chief Investment Officer |
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