Economics 607 - Core Macro

The CPI Report

This is from macroblog:

My Cost Of Living Went Down. How About Yours?: Whenever anything having to do with the inflation statistics comes up, I almost always check in with my colleague Mike Bryan to get his opinion.  Today I decided to share the wealth, and asked Mike to share his wisdom on macroblog.  In fact, I've asked Mike if he'd be willing to check in from time to time with his insights. Herein, his inaugural entry:

This morning's CPI report, like every other CPI report I have read in the past few decades, contains great news and awful news. Here’s what I mean. Suppose you’re a person who puts fresh fruit on your morning bagel, cozy in your gas-heated home before you go to the airport and jet off to some distant place. Boy, did you have a bad month. Each of these items—fresh fruits and vegetables, bakery goods, natural gas, airfare, and lodging away form home—posted double-digit (annualized) price hikes in October.

But if you’re the sort who’s still on the Atkins diet, likes to buy clothes for your young children (and shoes for yourself), prefers to drive used cars to avoid that potent new-car smell, talks on the phone or sends email on your personal computer while occasionally smoking a cigarette, well then, you had a pretty good month (except for that smoking part, which you ought to quit regardless of price.) All of these items—meat, infants’ apparel, shoes, used cars, telephone service, personal computers, and tobacco products—cost you less in October than they did in September.

And if you’re the mythical Bureau of Labor Statistics household who does a bit of all these things, then the cost of what you buy, reflected in today’s CPI report, was up 2.4 percent at an annualized rate. This was a bit higher than the CPI forecasters were predicting, but it was still the best overall CPI report we’ve seen since early summer.

I expect that financial markets are likely to pass over this number and go straight to the “core” CPI, a statistic that ignores the cost of food and energy. Yeah, I hear you, ‘Who doesn’t burn gasoline and eat food?’ No one I know. But while the core number might not mean very much to you as a consumer, it ought to mean something to you as user of dollars. See, in addition to measuring the cost-of-living of U.S. households, the CPI is also a gauge of U.S. inflation and no, these are not necessarily the same thing.

Containing inflation doesn’t mean the central bank can take the sting out of high energy costs or help you cut that growing prescription bill. These and all of the other costs you face are determined by the various factors at play in the marketplace—as they should be. What the Federal Reserve can do, however, is hold the overall purchasing power of a dollar constant, leaving to you the hard decision of how best to distribute it across your many needs.

This is where the “core” inflation measure becomes useful. It helps central bankers see through the relative price fluctuations in the monthly CPI report so that they can get a better bead on the longer-term patterns that determine the purchasing power of your money. What did the core CPI do this month? It was up a rather troubling 3 percent (again, at an annual rate). So is this a sign that inflation is getting less “contained”? Well, it certainly isn’t good news. But tracking core inflation amid the noisy price data is difficult. I think we need to slice and dice the data in many different ways to judge if there is a more permanent inflation pattern lurking in the price data. I like to look at the median CPI and its statistical cousin, the 16 percent trimmed-mean CPI (you can read about them here). At an annualized 1.9 percent and 2.3 percent respectively, these two inflation estimates look more in line with the overall CPI than the traditional core measure does.

So how would I counsel my boss about this morning’s CPI report? Well, I would first caution that a single month’s CPI number is not very much to gauge inflation by. Tossing that caution aside, I would argue that it’s hard to see in this data compelling evidence that inflation is any less contained this morning than it appeared to be a month ago. So if you are comfortable with a core CPI inflation trend of between 2 and 2 ½ percent—which is where we seem to have been for over a year now—there is not much in the October CPI report that would give you new cause for concern.

See also macroblog: The CPI Report By The Numbers and Angry Bear: Inflation Check.

Econoblog: Changing Times at the Fed

The latest Econoblog at the Wall Street Journal featuring Tim Duy and William Polley is at:

Econoblog: Changing Times at the Fed: Alan Greenspan will soon step down as chairman of the Federal Reserve and, if the Senate consents, hand the reins to former Fed governor and celebrated academic economist Ben Bernanke. But that's not the only change likely to be in store at the U.S. central bank.

To be sure, Mr. Bernanke has vowed that he'll follow closely on the policy path marked by the Greenspan Fed. But he could bring along some new tools -- such as inflation targets -- to help him navigate. Further, Mr. Bernanke will be stepping to the helm as the Fed appears to be nearing the end of a long tightening cycle. Will he continue to raise interest rates, or apply the brakes to the central bank's long campaign to lift borrowing costs to a "neutral" level?

The Wall Street Journal Online asked economist bloggers William Polley and Tim Duy to explore what the future might hold for the seat of U.S. monetary policy.

I encourage you to read the discussion as well as William Polley's comments at his blog. Thanks to both for doing this. Also, the subscription wall is down this week at the WSJ so all content is free.

Fed Watch: Another Meeting, Another 25 Basis Points

Tim Duy has a Fed Watch in anticipation of Tuesday's FOMC meeting:

The above title makes the Fed sound just a little too predictable. But the hawkish rhetoric from Fed officials has been quite clear, and last week’s data adds to the case for additional tightening at what we have come to know as the measured pace. Today we will see it again with, I suspect, little change in the accompanying statement.

Taken at face value, the GDP report confirms, once again, the resilience of the US economy. Final sales to domestic purchases clocked a 4.2% gain, virtually identical to the Q2 figure. Consumers prove, once again, they are down but not out. Investment spending looked a bit anemic, but this was foreshadowed in the most recent Fed minutes, as well as a lackluster September durable goods report. And while PCE inflation accelerated, core-PCE again decelerated, falling to a 1.3% rate. All in all, simply not much to worry about in this report see David Altig for a complete rundown on GDP blogging.

Still, if one were inclined to go looking for red flags in the report, where would they turn? The consumer certainly ended the quarter on a weak note, with real spending down a second consecutive month. The strong quarterly showing by consumers was driven by the July surge in durable goods spending, which in turn was driven by auto incentives. Any potential gain in September was lost to higher energy costs from Katrina and Rita. Consumers made it through the third quarter, but came out more bruised than the headline figure suggests.

But a strangled consumer is not a surprise for the Fed; the consumer confidence figures have been telling that story for two months now. Moreover, the Fed recognizes that some demand needed to be destroyed in response to the energy shock. The alternative would be a greater chance that energy inflation would spread into the core. And Fedspeak leaves no doubt on where policymakers stand on that issue. Also note solid growth – 0.5% ‑ in nominal income, after adjustment for Hurricanes Katrina and Rita. The means to spend was in their pockets, it was simply sucked away by higher energy costs. Indeed, with gasoline prices coming down, the consumer may be in better shape than expected despite higher heating costs this winter.

So, overall, incoming data suggests the economy remains on cruise control despite the series of speed bumps the Fed keeps laying down. Does this mean the Fed just keeps laying down more bumps? For the rest of this year, the answer appears to be yes. I think the Fed is comfortable chasing the 10 year bond. Indeed, the bond market has recently cleared the way for additional hikes, with the 10 year yield rising above 4.5%. Moreover, the minutes of the last meeting report that:

Even after today's action, the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required.

Rate “increases,” plural, being the important point, and I see little reason to expect that the FOMC’s judgment has changed on that point. Beyond December, things get a bit fuzzier, in my opinion. Perhaps I am feeling the same unease reported by David Altig last week, as traders were paring bets of a January rate hike. But despite an economy that has remained resilient to what by tomorrow will be 300bp in rate hike, I would hate to forget one of the tried and true mantras of Wall Street:

Don’t fight the Fed.

Eventually, rate hikes will start to dampen real activity. The Fed, of course, is aware of this. Again, from the last minutes:

However, some sentiment was expressed to consider changes to forward-looking aspects of the statement at upcoming meetings, in part because of the considerable reduction in monetary policy accommodation that had already been accomplished.

While policymakers might see the need for additional rate hikes, they realize a lot is also in the pipeline as well. With a considerable amount of accommodation removed, the Fed, I suspect, will soon start paying more attention to data that comes in on the weak side.

So what will the Fed be looking for in that respect? The Fed will be watching for additional evidence of a slowing housing market. Again, the point is not housing itself, but the expected negative impact of a housing slowdown on consumer spending. I doubt the early data and anecdotal evidence is enough to convince them that the housing ATM is closed, but if the housing bears are correct, we could see evidence in that direction pile up over the next couple of months.

Another red flag for the Fed would be sputtering investment spending. Greenspan’s speeches and the minutes suggest that policymakers expected investment spending to hold strong, and they were a little disappointed by what they were seeing at the last meeting:

Meeting participants noted that, even prior to the hurricane, business fixed investment had been somewhat weaker than expected. The softness was somewhat puzzling, as sales were growing, business balance sheets appeared quite strong in the aggregate, profitability was high, and financing was readily available and relatively inexpensive for most firms. Although the apparent sluggishness could reflect only short-term fluctuations in volatile data series, some evidence suggested that it may also have stemmed from concern among business executives about the effects of high energy prices.

Fed Atlanta President Jack Guynn reiterated this unease about the course of investment spending in his Oct. 20 speech.

Another question is if the Fed will deliberately invert the yield curve. To date, policymakers haven’t expressed much concern about the yield curve. But I suspect some posturing was involved here – you can’t maintain expectations for further rate hikes while at the same time fretting over a recession indicator. I doubt that Greenspan & Co. – or a future Bernanke & Co. – will push the fed funds rate above the 10 year rate. If the curve inverts, I believe it will be the result of the long end slipping. Right now, the Fed would be willing to go to 4.25%, maybe even 4.5%, essentially cutting the gap to zero. But if the long rate overshot in a post-Bernanke announcement frenzy and is due for a pullback……?

Also, with rates back into the “4’s,” the Fed is eventually going to focus on actual inflation data. And so far inflation appears contained to headline numbers, with what looks like a solid deceleration of core inflation in place, at least in the GDP report. To be sure, the recent energy price spikes haven’t had time to work their way through the system, but neither have recent and expected rate hikes. Moreover, it is difficult to imagine that inflationary expectations become entrenched without wage inflation to back them up. And last week’s Employment Cost Index report sure does not point to runaway wage inflation, with a paltry 2.3% wage gain compared to last year. In fact, I can’t remember a period of ongoing monetary tightening in such a weak wage environment.

Still, the inflation story was – and will remain for the rest of this year – useful justification for normalizing the fed funds rate, and I continue to expect additional rate hikes. But as rates head into the midpoint of San Francisco Fed President Janet Yellen’s 3.5-5.5% neutral range, the bar for additional hikes will likely rise.

Of course, none of these bearish things might happen and the Fed could happily keep raising rates well into next year, chasing strong growth, higher inflation and a falling 10 year bond. They are just the things I would be watching out for at this point. [All Fed Watch posts.] [Update: David Altig has the probabilities for increases in the federal funds rate through January.]

Oil Shocks and Inflation

From Brad Delong: Oil Shocks and Inflation:

Mark Thoma channels Bharat Trehan:

Economist's View: Oil Price Shocks and Inflation: This FRBSF Economic Letter looks at oil prices and inflation and finds that oil price shocks are often assigned too much responsibility for the high inflation of the 1970s because the effects of faulty monetary policy and drifting inflationary expectations are underestimated....

Oil Price Shocks and Inflation, by Bharat Trehan, Research Adviser, SF Fed: Oil prices have risen sharply over the last year, leading to concerns that we could see a repeat of the 1970s, when rising oil prices were accompanied by severe recessions and surging inflation. ... This Letter ... argue[s] that oil shocks are sometimes assigned too large a role in the run-up in inflation during the 1970s because analysts tend to ignore the part played by inflation expectations and by monetary policy during this period. The implication is that the recent oil shock should not lead to as much inflation as the 1970s would suggest. Financial markets provide confirming evidence. ... there is little evidence to suggest that markets are expecting substantially higher inflation as a result of the run-up in oil prices since the beginning of the year. As discussed ..., this could be because the markets are expecting the Fed to respond vigorously to the run-up in oil prices. But a look at the fed funds futures markets reveals that markets are not expecting very large policy moves. ... Thus, financial market expectations do not appear to be out of line with the statistical analysis. Markets do not expect the recent substantial rise in oil prices to lead to a substantial increase in inflation, and they expect this result to occur without the kind of funds rate increases one saw in the 1970s...

Jim Hamilton is quoted making similar points. Alan Greenspan views the degree of pass through as an area of considerable uncertainty, but if this research holds up, it implies less pass through of oil shocks to core inflation than commonly assumed, and hence less need for tightening of interest rates to prevent an outbreak of inflation.

It is, I think (or so I tell my classes), important to recognize that there are three things going on in the early 1970s:

1. A tripling of oil prices
2. The erosion of the Federal Reserve's credibility as an inflation fighter
3. A large productivity slowdown, as the rate of labor productivity growth in the American economy falls from 2.5% per year to 1.0% per year and stays there until 1995.

The stagflation of the 1970s is often blamed on (1) along. But I think--and have argued--that (2) and (3) are important factors. See http://www.j-bradford-delong.net/pdf_files/Peacetime_Inflation.pdf.

Productivity, the Fed, and Real-Time Data

New Economist has some reading for Fed watchers:

New Economist: Productivity and the Fed: Why you shouldn't always trust real-time data: For those interested in the debate over monetary policy "smoothing" and problems with real-time data, the Federal Reserve's quandary over productivity during the 1990s is salutary. A key challenge facing the Fed at the time was the inconsistent messages it was getting about productivity. Incoming aggregate data initially suggested low productivity growth, but anecdotal firm-level evidence hinted at an acceleration. Which was right?

A new St Louis Fed Working Paper by Richard G. Anderson, and Kevin L. Kliesen examines this period in detail, including long and fascinating quotes from FOMC transcripts. The paper, Productivity Measurement and Monetary Policymaking During the 1990s, shows clearly how Greenspan refused to take the real-time data at face value:

Chairman Greenspan’s view of the nascent acceleration in productivity growth was formed largely by both his numerous contacts in the business sector and his abiding belief that the published aggregate data were not correctly measuring the effects of information technological innovations that businesses were claiming to have garnered.

With few exceptions, Greenspan views were discounted by both the Board’s staff and his colleagues on the Federal Open Market Committee (FOMC). But the Chairman was not dissuaded. He noted, for example, that available data suggested that the service sector had achieved no productivity gain in twenty years, an unlikely event. If this measurement was wrong, how many more were incorrect? As the discrepancies widened, in 1996 he requested that the Board’s economic research staff conduct a project to assess the accuracy of the Bureau of Labor Statistics’ published productivity figures.

Although that study confirmed the picture painted by the then-current data, subsequent data revisions changed the picture. Later published aggregate data converged to the more rapid growth suggested by the Chairman’s anecdotal, firm-level data.

The authors conclude:

Our analysis highlights the difficulties in formulating monetary policy using preliminary, incoming data. Policymakers should be - and are - wary about placing too much faith in initial estimates because data revisions often have significantly challenged the perceptions that policymakers previous held in “real time.”

Recommended reading for all Fed watchers.

Global Imbalances

Brad DeLong (vita) writes:

Brad DeLong: Mark Thoma Summarizes Tim Geithner: He writes:

Economist's View: New York Fed President Geithner on Global Imbalances: Geithner:

1. sees substantial risks due to global imbalances, risks that are not fully understood.
2. is insistent that fiscal authorities need to regain control of the budget and says "Improving our fiscal position is the most effective means we have available to reduce our vulnerability during this prolonged period of adjustment."
3. in equally insistent that fixed exchange rate regimes must allow more flexibility.
4. worries that increases in demand growth in the foreign sector needed to offset a decline in U.S. consumption and increase in U.S. saving will have to overcome difficult political hurdles.
5. says smooth adjustment requires, in addition to improved fiscal management, a strong and flexible financial system and open and free trade.
6. says that avoiding protectionism calls for "improving educational opportunity and achievement in this country, and perhaps also in improving the design of the temporary assistance we provide individuals who bear the brunt of the adjustment costs than come with greater global economic integration."

...

Here's the full post if you are interested.

St. Louis Fed President Poole Describes the Fed's Monetary Policy Rule

William Poole, president of the St. Louis Fed, believes that Fed predictability is an important factor in macroeconomic stabilization. In this speech, he describes in detail the rule the Fed follows in setting monetary policy. He says the rule is too complicated to represent through a simple mathematical equation, but it is still a rule.  His goal in analyzing and describing the Fed's current monetary policy rule is to enhance the transparency and predictability of Fed behavior and in the process promote further macroeconomic stabilization. For those interested in monetary policy and how to interpret Fed actions, this is worth reading.  For example, at a recent meeting several regional banks did not propose increases in the discount rate. Poole discusses how to interpret such events, how to interpret what's written up in press releases and minutes, what the Fed considers in setting the target federal funds rate, provides estimates of a simple Taylor rule, and so on. The footnotes and references are in the original linked document:

The Fed's Monetary Policy Rule, by William Poole, president, St. Louis Fed: ...I’ve chosen a title designed to be provocative, for I suspect that few consider current Federal Reserve policy as characterized by a monetary rule. My logic is this: There is now a large body of evidence, which I’ll review shortly, that Fed policy has been highly predictable over the past decade or so. If the market can predict the Fed’s policy actions, then it must be the case that Fed policy follows a rule, or policy regularity, of some sort. My purpose is to explore the nature of that rule... Before digging into specifics, consider what the “rules versus discretion” debate is about. Advocates of discretion, as I interpret them, are primarily arguing against a formal policy rule, and certainly against a legislated rule. They believe that policy will be more effective if characterized by “discretion.” Discretion surely cannot mean that policy is haphazard, capricious, random or unpredictable. ... My view has evolved over time to this general position: Monetary economists have not yet developed a formal rule that is likely to have better operating properties than the Fed’s current practice. It is highly desirable that policy practice be formalized to the maximum possible extent. ... monetary economists should embark on a program of continuous improvement and enhanced precision of the Fed’s monetary rule. It is possible to say a lot about the systematic characteristics of current Fed practice, even though I do not know how to write down the current practice in an equation. It is in this sense that I’ll be describing the Fed’s policy rule. And given that, as far as I know, there is no other effort to state in one place the main characteristics of the Fed’s policy rule, I’m sure that subsequent work will refine and correct the way I characterize the rule...

A Few Short Readings in the History of Economic Thought

I feel the same way as Brad does.  I know how tight your schedule is the first year and it would be a lot to expect you to read these thoroughly, but if you haven't had a good course on the history of economic thought, it's a hole in your training that you should consider plugging, and you won't be sorry you did.  One shortcut would be to sit through Tim Duy's Econ 493 class at some point while you are here...

Brad DeLong, A Few Short Readings...:  Too many of our entering graduate students know too little about the history of economic thought. So I am going to see if I can do a little painless supercharging to my graduate history of economic thought reading list for the second quarter. I think I have settled on:

Thomas R. Malthus (1795), "An Essay on the Principle of Population," Book 3 http://www.econlib.org/library/Malthus/malPlong.html

Adam Smith (1776), The Wealth of Nations, Book I and Book V http://www.econlib.org/library/Smith/smWNtoc.html

David Hume (1752), "Of the Balance of Trade" http://www.econlib.org/library/LFBooks/Hume/hmMPL28.html

Karl Marx and Friedrich Engels (1848), "Manifesto of the Communist Party" http://www.marxists.org/archive/marx/works/1848/communist-manifesto/

Karl Marx (1849), "Wage Labor and Capital" http://www.marxists.org/archive/marx/works/download/Marx_Wage_Labour_and_Capital.pdf

Karl Marx (1867), "The Working Day," chapter 10 of Capital, vol. I http://www.marxists.org/archive/marx/works/1867-c1/ch10.htm

But additions and alternatives would be welcome... And kudos to econlib.org, and to marxists.org...

Some Recommended Reading

This is from David Altig at macroblog (a site worth checking regularly), research director at the Cleveland Fed with a message to his University of Chicago class:

Some Things You Should Read

School is back in session so, for the University of Chicago Executive MBA classs, here is some stuff that you might want to check out.  (The invitation extends to rest of you as well, of course.)

James Hamilton gives the best explanation of the macroeconomic effects of oil shocks that I've read.  Also, Nouriel Roubini shares his thoughts on oil and the global economy.

Andrew Chamberlain at Tax Policy Blog identifies "Ten Principles of Sound Tax Policy" (and I could not agree more).

The Earth-Based Initiative adds to its 2005 Social Security Meta-Archive.  Edward Hugh points to a conference on the economics of ageing (with links to papers and the promise of more commentary to come). 

Lynn Kiesling and John Irons discuss the economics of rebuilding, post-Katrina/Rita.  And while you are thinking about the subject, be sure to check out Gary Becker's and Richard Posner's discussions.  Mark Thoma links to a related article from the New York Times, and pgl at Angry Bear has some thoughts on government financing of relief efforts. 

The Eclectic Iconoclast channels the Hispanic Pundit and provides a worthy list of "classic economic articles" aimed a general audience.

Tyler Cowen asks some practice macro exam questions, Arnold Kling takes a shot at answering one of them, and William Polley adds a few questions of his own. While we are speaking of inside-macro, Brad Delong adds to Tyler's critique of the IS-LM model (chapter 9 in Abel and Bernanke for you XP-76ers).

Tyler also provides snapshots of the two newest Nobel laureates in economics, Robert Aumann and Thomas Schelling.

Tim Duy's latest Fed Watch, a service of Mark Thoma's Economist's View, is always a worthy read.  And while you are there, have a gander at Mark's thoughts on the business cycle, and the concurringt opinion from Stumbling and Mumbling.  (Andrew Samwick nominates the New York Times article in question for a "Voxy.")

The New Economist brings our attention to Robert Fogel's paper on post World War II economic growth.  See also his post on productivity growth in the OECD.

The PDS blog has some skeptical thoughts about development aid.

If you want to keep up to speed on the emerging news on the formation of the new German government, stay tuned to A Fistful of Euros.

If you want to keep up to speed on Chinese exchange rate policy, stay tuned to Brad Setser's Web Log.

Barry Ritholtz gives us his latest edition of the Weekend Linkfest.

Happy Columbus Day.

Fed Watch: Clearly Hawkish Signals

Here's the latest Fed Watch from Tim Duy:

This is something of an abbreviated piece today – I need to focus my attention on final preparations for the Second Annual Oregon Economic Forum. And, truth be told, Fed policy makers are taking some of the fun out of the game at this point with their clear warnings on inflation. Indeed, even “Mr. Eighth Inning,” Dallas Fed President Richard Fisher, who I had previously dubbed a dove, has delivered a series of market rattling comments. David Altig’s compilation of blogs from Mark Thoma and William Polley, among others, provides a great overview of this increasingly hawkish language that appears to point to only one thing – more rate hikes in the coming months. Indeed, this is the theme picked up in this morning’s Wall Street Journal.  And incoming data and anecdotal evidence remain supportive of that path.