Tim Duy's Fed Watch

More on Disinflation

 

Paul Krugman pulls together three charts to illustrate the link between high unemployment and disinflation in two major disinflationary episodes, 1974-1977 (Series 1 in chart below) and 1980-1986 (Series 2).  He then tracks the pattern of the current cycle (Series 3), which suggests that the combination of high unemployment and past disinflationary responses to such unemployment is very likely deflationary.  Krugman asks:

How can you look at this record and not conclude that deflation is a very real risk? I have no idea where the complacency of many at the Fed comes from.

An explanation for the Fed's complacency can be found by plotting all three episodes on the same chart:

 

I believe when monetary policymakers look at this chart, they ask a different question:  Why has the disinflationary response been so muted in this cycle?  It would have been reasonable to conclude that unemployment rates at this magnitude should have long ago pushed the US economy into deflationary territory.  What is the Fed's explanation for the relatively tame disinflation?  Krugman already has the answer:

All of this was to be understood in terms of a Phillips curve in which actual inflation at any point in time depends both on the unemployment rate and on expected inflation….

Fed officials will say that inflation expectations are currently well anchored.  Indeed, the early 1980's experienced a period of rapid disinflationary expectations:

Note that expectations by this measure are stable.  What about financial market expectations?  The difference between 5 year Treasuries and 5 year TIPS fell slightly in recent months, but nothing like the clear taste of deflationary expectations at the end of 2008:

 

 

But are stable inflation expectations written in stone?  Krugman concludes the above sentence  with:

...and expected inflation gradually adjusts in the light of experience.

The implication is that the Fed should not get too complacent as persistently high unemployment will eventually erode those expectations. 

 

Now - just thinking out loud - suppose downward rigidity of nominal wages, with workers unwilling to accept nominal wages declines.  Does this support positive - albeit low - inflation expectations?  Which thus prevents deflationary expectations from forming…which is good, but prevents the Fed from further action despite high unemployment rates?  And the lack of action that increases structural unemployment, ensuring NAIRU increases?  Something else to chew on...

Rising NAIRU?

 

 Brad DeLong reads Greg Mankiw and reaches the conclusion that:

Mankiw's broader point is that since we have seen nothing like this before except for the Great Depression, we should be humble and risk averse--and hence have the government stand back and wash its hands of the situation.

Paul Krugman concurs, adding a sense of urgency to the current situation:

Quite. I really don’t think people appreciate the huge dangers posed by a weak response to 9 1/2 percent unemployment, and the highest rate of long-term unemployment ever recorded…

 

...Right now, I’m reading Larry Ball on hysteresis in unemployment (pdf) — the tendency of high unemployment to become permanent. Ball provides compelling evidence that weak policy responses to high unemployment tend to raise the level of structural unemployment, so that inflation tends to rise at much higher unemployment rates than before. And the kind of unemployment we’re experiencing now, with many workers jobless for very long periods, is precisely the kind of unemployment likely to leave workers permanently unemployable.

 

And there are already indications that this is happening. Bill Dickens, one of the people has who worked on downward nominal rigidity, tells me that the Beveridge curve — the relationship between job vacancies and the unemployment rate — already seems to have shifted out dramatically. This has, in the past, been a sign of a major worsening in the NAIRU, the non-accelerating-inflation rate of unemployment.

Mankiw said something eerily familiar recently:

This recession looks very different, and much more troubling, than those in the recent past.  I wonder how this dramatic change in the nature of unemployment will alter traditional macroeconomic relationships, such as Okun's Law and the Phillips curve.

 

Some research suggests that the long-term unemployed put less downward pressure on inflation.  If that is indeed the case, then the increase in long-term unemployment may mean that we will see less deflationary pressure than we might have expected from the high rate of unemployment.  In other words, the NAIRU may have risen, perhaps quite substantially.  This is mostly conjecture, however.  It seems likely we will see more work on this topic in the coming years.

So Mankiw recognizes the problems posed by protracted periods of economic weakness, yet in his criticism appears to push for more caution while overlooking an obvious reason why the impact of fiscal policy was insufficient to significantly alleviate the recession.  It was simply too small - as economists predicted at the time.   Indeed, if he is so worried about the risk of rising NAIRU, he should be pushing for policymakers to pull out all the stops.

 

Mankiw is not alone in seeing the challenges posed by protracted unemployment.  From Federal Reserve Ben Bernanke's Congressional testimony:

Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects.

The difference between Mankiw and Bernanke is that the latter not only recognizes the problem, but could also do something about it.  Not that he is inclined to.  Of course, he is not alone.  Philadelphia Fed President Charles Plosser was quoted today:

“Lowering the interest rates closer to zero could have very disruptive effects on the financial markets,” Plosser said. “If we bought Treasury bills we could un-anchor expectations of inflation because the public might begin to think we are going to buy up the public debt.”

Plosser repeats the credibility story, arguing that additional action as suggested by Joe Gagnon will trigger an inflationary spiral.  Likewise, San Francisco Fed President Janet Yellen expressed an unwillingness to adopt a new inflation target:

Janet Yellen, President Barack Obama’s pick to be the Federal Reserve’s next vice chairman, said it would be “risky” to adopt a long-run inflation goal of 4 percent, and that supervision and regulation are “the first line of defense” against risks to the financial system.

 

She made the comments in written responses to questions posed by U.S. Senator Richard Shelby, a Republican from Alabama, following her July 15 hearing before the Senate Banking Committee. Yellen, president of the San Francisco Fed, is awaiting confirmation, along with Obama’s other nominees, Sarah Bloom Raskin and Peter Diamond…

 

...She said that while a higher long-run inflation goal would “give the Fed more maneuvering room in the future,” she agrees with Bernanke that such a move “would be a risky policy strategy.” Most policy makers regard 2 percent as a level consistent with price stability.

I would think that, despite having to endure a higher inflation target, Yellen would be eager to have more maneuvering room.  After all, there is not a lot of working room for conventional policy in a liquidity trap.  Yet Fed officials seem to prefer the idea that unemployment becomes a long term challenge rather than a short run cyclical issue over the risk of inflation. Like fiscal policy, monetary policy is now limited by imaginary obstacles. 

 

It is worth noting that the long term challenge may already be upon us.  David Altig puzzles over the implications of a shifting Beveridge curve, suggesting that extended unemployment benefits may have a role.  He then hones in on the possibility of a skills mismatch:

Now I realize that a few anecdotes don't make facts, but I have been in more than a few conversations with businesspeople who have claimed that the productivity gains realized in the United States throughout the recession and early recovery reflect upgrades in business processes—bundled with a necessary upgrade in the skill set of the workers who will implement those processes. This dynamic suggests that the shift in required skills has been concentrated within individual industries and businesses, not across sectors or geographic areas that would be captured by our most straightforward measures of structural change.

To be honest, I hear this complaint too, but have trouble swallowing it.  I believed it in the mid and late 1990's, but now?  The eight million people dropped into unemployment are all unemployable?   Firms are willing to lose profits than do the unthinkable, on the job training, actually invest in their employees?  I also have heard the opposite story, of overeducated temporary Census workers desperate for employment, completing assignments in a fraction of the expected time, not realizing that their productivity would only be rewarded with a shorter stint of employment.   And if we are experiencing all these magical productivity gains and a shortfall of workers, then wages should be rising quite smartly.  But from one of the articles cited by Altig:

Here in this suburb of Cleveland, supervisors at Ben Venue Laboratories, a contract drug maker for pharmaceutical companies, have reviewed 3,600 job applications this year and found only 47 people to hire at $13 to $15 an hour, or about $31,000 a year.

You get what you pay for.  To put this into perspective, the average national wage for Wal-Mart was $11.24/hour in 2009.  I would hope, however, that Ben Venue Laboratories pays better benefits.

 

I would really appreciate a good story that explained why we should be happy about high productivity growth if real wage growth is not surging.  The lack of the latter makes me question the reality of the former.

 

Putting my skepticism aside, if a skills mismatch is really a problem, then the solution is to ramp up activity until labor shortages raise wages and force employers to reach deeper into the barrel and in turn bring more people into the labor force to gain those missing skills.  Better to do it sooner than later.  If the productivity gains are real,  the wage gains should not be inflationary.  This was the story of the 1990s. Otherwise, policymakers sit and wait as the potential structural rigidities deepen, thereby ensuring a higher NAIRU in the future.  And, driven by fear of inflation, this appears to be exactly what policymakers intend to do.

Sunday Morning Light

 

Occasionally, a product comes along that is truly outstanding.  Apple, for example, has generated a number of excellent products, and even managed to convince me to carry around yet another electronic device, an IPad.  This post, however, is not about Apple.   While I typically - as in never - duse the blog to promote local products,  a little diversion on Sunday can be forgiven.  With that introduction, I invite readers to enjoy a taste of my new local favorite:  The products of Ninkasi Brewing Company.

 

I am stunned at how quickly Ninkasi has dominated my beverage choices.  More so given the seemingly overcrowded craft beer market.  For many years, I was a devotee of the Deschutes Brewery.  I can recall seeing the odd, severely overpriced Black Butte Porter at the Georgetown Whole Foods in 1999, and willingly, if not eagerly, paying $13 for a six pack.  I still enjoy Deschutes products, such as this summer's Hop in the Dark, a black IPA.  And the Mirror Mirror is a spectacular beer, but pricey at a retail of $11.79 for a 22oz. bottle.  I really won't touch it at that price, but have bought it by the case at $5.79.  Indeed, it appears to be just sitting on the shelf at the local brew stop at the higher price - funny how demand curves slope downward.

 

But my long love affair with Deschutes has been tempered with the rise of Ninkasi.  To be sure, their lineup is not as deep, but the quality is unbelievable.  Their first offering I explored was the Believer Double Red Ale, initially offered at the teaser price of $2.79 for a 22oz. bottle. I was instantly hooked on the clean, deep flavors.  Family members like the Tricerahops Double IPA, but my passion is the seasonal lineup.  The spring and summer see a succession of spectacular beers - Spring Reign, Radiant Ale, and Maiden The Shade:

 

My favorite is the slightly darker Radiant Ale, but all are complex yet easy drinking on a summer night.  Retail prices range from $3.79 to $5.79. 

 

The Ninkasi lineup makes the warm season beers enjoyable rather than just bearable.  I say bearable because my preference is the dark seasonal beers only available in the fall and winter.  And it is in the winter that Ninkasi has truly stolen my heart, with their Sleigh'r Dark Double Alt Ale.   If there ever was a beer to stave off the wet and chill of a Pacific Northwest winter, this is it.  It quickly supplanted my long time - 20 year! - favorite, Snow Cap Ale from Pyramid Brewing Company.  I plan to grab up at least three cases of Sleigh'r (only in 22oz. bottles) when it hits the shelves this winter.  It goes quick.  It is even better on tap, but I think you need to visit Oregon for that treat.

 

Bottom Line:  While it is easy to feel down in a weak economy, it helps to remember that there are still good people doing good things.  The employees of Ninkasi Brewing Company are just such people.  I hope you are able to sample their products.  I dare say it is even worth a trip to Eugene.  In the winter, no less.

 

Please drink responsibly. 

Anomalous Capacity Shrinkage

 

I am drawn to this topic like a moth to a flame.

 

In this week's Congressional testimony, Federal Reserve Chairman Ben Bernanke notes:

Both U.S. exports and U.S. imports have been expanding, reflecting growth in the global economy and the recovery of world trade. Stronger exports have in turn helped foster growth in the U.S. manufacturing sector.

Typical of policymakers, Bernanke ignores the negative impact of rising imports on US growth.  In reality, as global trade has recovered, the external accounts have weighed on US GDP growth.  Putting that aside for a second, officials are also quick to point out that the export recovery is aiding manufacturers.  It is worth considering how far they can continue to push that argument given the path of manufacturing capacity this decade.

 

To illustrate the anomalous pattern of manufacturing capacity growth, I focus on the path of capacity for thirty months after the peak of each business cycle, scaling capacity to 100 at each peak:

 

 
Note that although the pace of capacity growth slowed since the 1940's, capacity continued to grow even during the typical post WWII recession.  This pattern changes dramatically this decade, with very little capacity growth in the wake of the 2001 recession and actual capacity declines after the most recent recession.  Arguably, the traditional increases were at risk in the 1990's as well, but the technology revolution intervened. 

 

One interpretation of this data is that the failure to add capacity is actually a good thing, as a more rapid absorption of excess capacity will speed economic healing and provide the incentive to add additional capacity, providing a desperately needed boost to investment spending.  Of course, this interpretation is completely at odds with history.  Typical post WWII recessions experienced V-shaped recoveries even as capacity grew.  Now we get jobless recoveries and no capacity expansion.

 

Another interpretation is that US firms have no intention of adding net new capacity, planning instead to source any excess demand from overseas.  This implies that the manufacturing recovery will not be a net positive to US growth.  It also implies that the trade deficit will widen further and that the challenge of global imbalances will remain unresolved.  The rise of Dollar assets abroad will with either force a fall in the US dollar which would then create more incentive for export and import-competing industries  or, more likely, encourage the accumulation of reserve assets among foreign central banks.

 

In short, I continue to worry that policymakers are ignoring the possibility that increasing reliance on external production to satisfy US demand has contributed significantly to the jobless recoveries we have seen this decade.  Something is very different this decade.  I think it is a mistake to write off this decade's shift in manufacturing as simply a repeat of the agricultural experience.  At least agricultural output continued to rise as its relative  employment importance fell.  The capacity numbers are telling us the same can not be said of manufacturing any longer. And in the past, the relative decline in manfacturing jobs was matched by a more than corresponding increase in service sector jobs.  No longer the case; job growth is flat for a decade.  If we intend to ignore this issue, the supposed reality of tradable services had better get a lot more traction very quickly.  Otherwise, we are further solidifying a permanent underclass of citizens who require the constant support of fiscal authorities.

Bernanke Post Mortem

Federal Reserve Chairman Ben Bernanke's Congressional testimony should leave little doubt about the stance of monetary policymakers.  Swift reaction came from Mark Thoma, Paul Krugman, Scott Sumner, and Joe Gagnon.  Simply put, an incipient second half slowdown and fears of an outright double dip are insufficient to prod additional action on the part of the Federal Reserve.  Policymakers are comfortable with the idea that neither objective of the dual mandate will be met in the foreseeable future.  And even should the economy deteriorate such that they are forced into additional action, the likely policy candidates are woefully insufficient to meaningfully change the path of economic activity.

 

For all intents and purposes, the Fed is done.  To be sure, the Fed would roll out its new set of lending facilities in response to another financial crisis.  But setting the possibility of crisis aside, it is not clear what data flow short of a significant drop in activity would prompt a change of heart at the Fed. 

 

Market participants set themselves up for disappointment.  The set up began back with the Washington Post article suggesting that policymakers were actively considering the next set of policy options in light of recent data.  I suggested the threshold for such actions was actually quite high, but the story fed upon itself until it became rumored that Bernanke would signal an end to providing interest on reserves.  As Neil Irwin and Ryan Avent pointed out, the Fed Chair was simply not going to make a major policy announcement of that sort in Congressional testimony. 

 

Worse, Bernanke did not appear overly concerned with the incipient second half slowdown.  To be sure, he acknowledged the relatively weak data flow, but incoming information has only made the outlook "somewhat weaker," implying very little real shift in the fundamental view that the recovery is self-sustaining and sufficient to consume excess capacity over time and thus provides little reason to consider new policy options.  Indeed, a substantive portion of the prepared remarks were devoted to tightening mechanisms, with the notion of additional easing left to the throwaway lines:

Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability.

Participants may also have been rattled by Bernanke's seemingly nonchalant attitude regarding additional easing options.  From the Q&A:

SHELBY: Thank you.

 

Mr. Chairman, the minutes of the June FOMC, the Federal Open Markets Committee, meeting stated, and I'll quote, "The committee would need to consider whether further policy stimulus might become appropriate if the Outlook were to worsen appreciably," end quote.

 

Aside from taking the federal funds rate and the interest rate paid on reserves to zero, it's not clear to me what further policy stimulus would mean. If further stimulus were to involve more asset purchases that you alluded to by the Fed, would the Fed buy treasuries or would they try to channel credit to specific segments of the financial market, such as housing or perhaps even municipal debt?

 

BERNANKE: Senator, I think it's important to preface the answer by saying that monetary policy is currently very stimulative, as you, I'm sure, you're aware.

 

We have brought interest rates down close to zero. We have had a number of programs to stabilize financial markets. We have language which says that we plan to keep rates low for an extended period. And we have purchased more than $1 trillion in securities. So certainly, no one can accuse the Fed of not having been aggressive in trying to support the recovery.

 

You know, that being said, if the -- if the recovery seems to be faltering, then we would at least need to review our options, and we have not fully done that review, and we need to think about possibilities.

But broadly speaking, there are a number of things that we could consider and look at. One would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time, giving more information about that. That's certainly one approach.

 

We could lower the interest rate we pay on reserves, which is currently one-fourth of 1 percent.

 

The third class of things, though, has to do with changes in our balance sheet, and that would involve either not letting securities runoff as they are currently running off, or even making additional purchases.

We have not come to the point where we can tell you precisely what -- what the leading options are. Clearly, each of these options has got drawbacks, potential costs. So we are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have, recognizing that, as I said, the policy is already quite stimulative.

The aforementioned Washington Post article suggested that plans for additional easing were pretty well fleshed out.  A subsequent interview with Boston Fed President Eric Rosengren in the Wall Street Journal cemented that inference.  Bernanke is much less clear:  "…we have not fully done that review."  Why have they not fully done that review?  Because they are simply less concerned about a second half slowdown than most of the rest of the free world, instead considering the flow of data to simply be choppy, not worrisome.  From New York Fed President William Dudley today:

“U.S. economic activity has expanded for four consecutive quarters, but at rates that can only be described as modest when compared with early stages of past recoveries,” he said. “The road to recovery is turning out to be a bit bumpy as relatively weak consumer spending and the ongoing problems in financial markets are keeping growth far less robust than we would like.”

Still, like Bernanke, Dudley views policy as quite stimulative.  Why are Fed officials not willing to do more in the face of what is obviously suboptimal outcomes?  First, consider the three options Bernanke lays out.  The first two - committing to sustained low rates and cutting the interest on reserves - are not likely to have much impact.  The implicit promise of low rates is likely already reflected in the short end of the yield curve.  And while in a perfect world the Fed wouldn't charge interest on reserves, that last 25bp is likely not stifling much if any lending activity.  Moreover, Bernanke appears to believe it is important to market functioning:

Each of those options carries drawbacks, he told a Senate committee Wednesday. Testifying before the House Financial Services Committee today, he elaborated on the risks of doing one of them: Lowering the interest rate it pays on excess reserves — now at 0.25% — could create trouble in money markets, he said.

 

“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.

 

“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”

In short, promising an extended period of low rates and ending interest on reserves would be minimally positive, but would not meet up with the expectations that would surround such moves.  Indeed, the failure to meet expectations would be the real cost to the Federal Reserve.  Taking these two off the table leaves expanding the balance sheet.  Option 3a, not letting securities runoff, is more of an effort to maintain the status quo rather than provide additional stimulus.  Again, I suspect relatively little impact.  Which then brings you to Option 3b, purchase of additional securities - the only real option in my opinion.  Optimally, the Fed would tie those purchases to some numerical target, such as Joe Gagnon's suggestion that the Fed purchases Treasury securities to target a 25bp target on the 3 year bond.  You have to go out to three years to get some traction - at least there you have a whopping 90bps to play with. 

 

Why will the Fed ignore Gagnon?  Perhaps David Wessel has the answer:

Why wait? Put yourself in Mr. Bernanke's chair. When the Fed began buying mortgages, the gap between yields on mortgages and Treasurys was wide; now it isn't. Mortgage rates are very low and the housing sector is still moribund; it isn't clear pushing mortgage rates down another one-quarter percentage point would do much.

 

The Fed could buy more Treasurys, trying to push yields on 10-year Treasurys below the already low 3%. But that could backfire. With all the deficit angst around, a Fed move to buy Treasurys could provoke cries of "they're monetizing the debt" and push up long-term rates rather than lowering them.

 

As scary as this sounds, the Fed can't be sure of the net effect of buying more assets. It might not make things better. It would be, in short, a Hail Mary pass. And Mr. Bernanke isn't ready—yet—to throw it.

When it comes down to it, fear of the being seen as monetizing the debt will keep the Fed on the sidelines unless it becomes clear that the economy is actually trapped in a deflationary spiral.  The bond vigilantes win again. 

 

It is worth noting that the fear of high long-term rates is somewhat irrational.  Wessel continues on with a discussion of inflation expectations:

Mr. Bernanke's former Princeton University colleague, Nobel laureate Paul Krugman, has become the loudest critic of Mr. Bernanke's inaction, calling the Fed "feckless" (lacking in vitality, unthinking, irresponsible) in his New York Times column. In a prescient 1998 paper about Japan, Mr. Krugman warned that other countries might similarly confront the feared "liquidity trap," the circumstance at which the central bank has cut interest rates to zero and the economy remains very weak. His advice then: "Monetary policy will be effective…if the central bank can credibly promise to be irresponsible"—by promising to create inflation in the future.

 

The textbook point: Interest rates that matter are the inflation-adjusted ones. In recessions, the Fed effectively pushes inflation-adjusted rates below zero. But with nominal interest rates at zero, the only way to get inflation-adjusted rates lower is to get everyone believing that inflation will go up.

So far so good.  But then Wessel makes an odd detour:

The practical point: This is easier to advise than to do safely. It would, at the very least, be hard to explain to a public already suspicious of the Fed. And it, too, could backfire. Manipulating inflation expectations is hard to calibrate. And the move would mean higher nominal (though lower inflation-adjusted) long-term interest rates. And outside of economic textbooks, higher nominal rates can hurt, pinching cash-strapped households for instance. It's risky. 

So economic textbooks are wrong?  The nominal, not the real rate, of interest is the relevant variable?  Was he sourced this view from the Fed? And would high nominal rates really pinch cash-strapped households?  Perhaps we can think of an alternative view:  Higher inflation expectations lifts wage growth, which in turn lowers the real cost of sustaining current debt loads and reduces the urge to reduce that debt via foregoing current consumption. 

 

Rising long rates would indicate that policy is getting traction - that policy is actually stimulative.  If there is no pressure for long rates to rise, then policy is not very stimulative.  Fear of inflation and rising long nominal rates look sufficient to make policymakers accept a suboptimal outcome.  Sad given that neither of these are an obvious problem now.

 

At the risk of making an already long post longer, I would point out a disturbing outcome of Scott Sumner's last  two posts.  In his review of the Bernanke testimony, Sumner opines:

The Fed has reduced its implicit inflation target below 2%, indeed below even 1.5%.

Marry that with Sumner's concerns about the Fed's pursuit of opportunistic disinflation.  You quickly get to the conclusion that the Fed is not reacting to disinflation concerns because they are secretly happy, and have no intention of accelerating the healing of the labor market if that entails any risk the latest round of opportunistic disinflation is lost.  So what the rest of us see as a failure to meet either of the dual mandates, the Fed really believes they are meeting the most important mandate, a strict definition of price stability.

 

Bottom Line:  The Fed shows no sense of urgency with respect to the current economic situation, and appears prepared to endure a weaker second half with no policy shift.  Moreover, even if the economy does worsen more than they expect, the likely candidates for policy action are more smoke than fire.  The Fed knows this, and doesn't want to lose credibility on actions with little likelihood of success.  A more aggressive policy stance Gagnon-style appears off the table as long as the Fed fears the possibility that such policy might actually work and push up long term rates.  That means more significant action only after outright deflation expectations are evident.  Appears extreme, but central bankers tend to be a conservative lot.  Lacking a financial crisis, the need for more action is not apparent to them.   They fundamentally believe they have done pretty much all that can be reasonably expected.  Moreover, we need to reassess the Fed's inflation comfort level; they may think they are hitting one mandate just fine.

The Dance Continues

 

The Fed dance continued today with the release of the minutes.  In most ways, the content of the minutes was largely expected, as reported by Free Exchange.  Forecasts for growth and inflation were knocked down, while the forecast for unemployment was edged up.  Overall, the Fed concluded that:

The economic outlook had softened somewhat and a number of members saw the risks to the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion as likely to be strong enough to continue raising resource utilization, albeit more slowly than they had previously anticipated. In addition, they saw inflation as likely to stabilize near recent low readings in coming quarters and then gradually rise toward more desirable levels. In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place.

They did inject some uncertainty over the path of policy:

However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably

Still, the minutes read as if additional policy stimulus is a remote chance.  As has been reported, recent Fedspeak has been decidedly more mixed. 

 

Paul Krugman bemoans the fact that the Fed understands and is largely comfortable with meeting neither of its dual objectives.  The minutes are quite clear on this point:

A number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate, but they anticipated that, with appropriate monetary policy, both would rise over time to levels consistent with the Federal Reserve's objectives.

I  guess you are not all that worried about high unemployment for "several years" when you have a 13 year appointment.  Two additional gems in the minutes:

Participants also noted that several uncertainties, including those related to legislative changes and to developments in global financial markets, were generating a heightened level of caution that could lead some firms to delay hiring and planned investment outlays.

And:

Reportedly, employers were still cautious about adding to payrolls, given uncertainties about the outlook for the economy and government policies.

These two lines imply that some Fed members are buying the story that the lack of business confidence is due to all the uncertainty created by the Obama Administration.  Convenient excuse to avoid additional stimulus.  Nothing we can do, this is a problem caused by those silly fiscal policymakers.

 

And another point I find odd:

Participants also noted a risk that continued rapid growth in productivity, though clearly beneficial in the longer term, could in the near term act to moderate growth in the demand for labor and thus slow the pace at which the unemployment rate normalizes.

Rapid productivity growth should never be a problem.  It is only a problem if policymakers hold demand unnecessarily low such that the additional potential output cannot be absorbed.  Answer:  Do more to stimulate demand.

 

Bottom Line:  The minutes paint a picture of monetary policymakers slightly more concerned about an already questionable outlook, but not concerned enough to do anything about it.  This stance appears a bit more vulnerable in light of flow of data since the last FOMC meeting, and that flow of data may be exactly what recently pushed some Fed officials to emphasize the "we can do more" story.  In effect, a preemptive effort to alleviate the seemingly hawkish stance of the minutes.  Hopefully,  Federal Reserve Chairman Ben Bernanke will provide additional clarity of the Fed's stance with regard to additional easing at next week's semi-annual testimony. 

Back to Trend Growth, Not Trend

 

The retail sales report for June was weak, as expected.  From Bloomberg:

Sales at U.S. retailers dropped in June for a second month, indicating the economic recovery dissipated heading into the second half of 2010.

 

Purchases decreased 0.5 percent, more than projected, after declining 1.1 percent in May, Commerce Department figures showed today in Washington. Excluding auto dealers, demand fell 0.1 percent, matching the median forecast of economists surveyed by Bloomberg News...

 

...“The consumer is losing some momentum,” said Harm Bandholz, chief U.S. economist at UniCredit Group in New York. “Job gains are not enough to bring the unemployment rate down. It means the recovery goes on, just at a slower pace.”

Looks like the pent-up demand was been satisfied.  Retail sales excluding gasoline have now reverted back to the pre-recession growth rate (growth rates are log approximations):

 

For those counting, the gap between prerecession trend and actual sales now exceeds a trillion dollars - correct, a trillion dollars of foregone spending relative to the previous trend.  That gap is growing by over $50 billion each month.  One can argue that the previous trend wasn't sustainable, but where would sales be if unemployment rates were closer to 5% rather than 10%?

 

Just more evidence that the US economy is settling into a suboptimal equilibrium.

Push Back

 

Free Exchange pushes back on my concerns about the widening trade deficit and the declines in manufacturing capacity.  I appreciate that - I am well aware that I am taking an unpopular position.  Not quite so sure it is "lazy," but definitely unpopular.

 

Regarding my disbelief that higher paid grocery clerks are the answer to declining manufacturing capacity, Avent writes:

This is a lazy and unpersuasive assessment of what's involved in service sector activity. Obviously there is much more to service employment, including work in financial, information, education, and health services, much of which is (and will increasingly be) tradable.

True enough, I oversimplified service sector jobs.  Maybe.  Yes and no.  To begin with, it is not exactly clear that the expansion of the financial sector has yielded a good outcome, unless you believe that greater financial volatility and widening income inequality is good.  More importantly, Avent is arguing that service jobs are just as tradable as manufacturing jobs, and therefore a job is a job.  Refer to Alan Blinder's hypothesis back in 2007:

We economists assure folks that things will be all right in the end. Both Americans and Indians will be better off. I think that's right. The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest. There's nothing new here theoretically.

 

But I would argue that there's something new about the coming transition to service offshoring. Those two powerful forces mentioned earlier -- technological advancement and the rise of China and India -- suggest that this particular transition will be large, lengthy and painful.

 

It's also going to be large. How large? In some recent research, I estimated that 30 million to 40 million U.S. jobs are potentially offshorable. These include scientists, mathematicians and editors on the high end and telephone operators, clerks and typists on the low end. Obviously, not all of these jobs are going to India, China or elsewhere. But many will.

Avent is essentially arguing that the US has a comparative advantage in service sector jobs.  Blinder views these jobs as very vulnerable to offshoring, suggesting a lack of comparative advantage.  If Blinder is right, then America apparently has little  left in the comparative advantage department. 

 

Avent continues:

As far as I can tell, Mr Duy seems to want to embrace a crash programme of protectionism against China. I don't know how this is supposed to boost America's long-term economic fortunes or what evidence he can present that it will. I don't know why Mr Duy is convinced that another spurt of manufacturing capacity growth, similar to that observed in the 1990s, isn't a possibility. And I have no idea why he is so confident that a return to the manufacturing economy observed in the immediate postwar decades—a time when technologies were vastly different, when the global economy was vastly different, and when a much larger share of the world's population lived in dire poverty—is a good idea.

I will deal with the protectionism argument later.  I don't view American manufacturing as incapable of rebounding.  But there are no price signals to prompt that rebound.  That price signal should be delivered via currency values.  The dollar should adjust to spur a net increase in export and import competing industries.  It is not complicated.  For some reason, however, that process is not happening.  Something is interfering with the adjustment.  That interference prompts American firms to expect that any new innovation needs a China strategy for production, if you believe the Andy Grove hypothesis.

 

Also, whenever you stick your neck out and say that manufacturing might be important, you suddenly get accused of being a barbarian trying to reinvent the 1950s.  Of course manufacturing technology has fundamentally changed, as well as the mix of goods produced.   But in the past, that productivity growth yielded more overall output and more manufacturing employment, even if the proportion of manufacturing jobs decreased relative to overall jobs.  I can even buy into that story when capacity is rising and employment is stagnant.  But something very different happened this decade.  Capacity stagnated as millions of jobs were lost. 

 

Avent continues:

This is simply a very empty and disappointing view of the evolution of economic activity. Mr Duy is implying that there is only so much producing of good stuff that can go on, and America used to have most of it and now China is taking it all and America needs to fight to get it back. He's wrong. The movement of some kinds of economic activity to China is creating new opportunities in America. America's problem isn't that some jobs are leaving. It's that it's doing a poor job of preparing its workers to take advantage of the new opportunities.

If that is true, then there should be millions of jobs available to soak up the workers released from manufacturing, and wages should be soaring because we have a structural flaw in economy - the skills of the released workers do not match those needed by expanding sectors.  That structural flaw should be sufficient to encourage workers to gain more education and employers to provide more on the job training.  While I am sure that is true in a few sectors, in aggregate real wages and nonfarm payrolls have been stagnant for a decade.  Where are these high wage paying jobs?  Or even median wage paying jobs at this point?   Silly me, I actually believe the unapologetic and unquestioning supporters of free trade need to answer this question.  We are millions of jobs below trend, and we have lost millions of jobs in manufacturing - the manufacturing of goods that we still consume, no less.  Moreover, these two trends occurred in the same decade, in concert with a third trend - the sharp rise in foreign official reserve accumulation.  How can you not be even allowed to suggest that there just might be a connection?

 

As always, questioning the nature of trade patterns this decade means you are an ignorant protectionist.  Blinder tried to get ahead of this argument:

What else is to be done? Trade protection won't work. You can't block electrons from crossing national borders. Because U.S. labor cannot compete on price, we must reemphasize the things that have kept us on top of the economic food chain for so long: technology, innovation, entrepreneurship, adaptability and the like. That means more science and engineering, more spending on R&D, keeping our capital markets big and vibrant, and not letting ourselves get locked into "sunset" industries.

What is amusing about the whole analysis is that I believe free trade works, but I also believe we don't really have free trade.  In reality, foreign central banks manipulate currency levels such they accumulate massive amounts of foreign exchange reserves that effectively recycle Dollars back into the US to support consumption activities, and thus impact the dynamics of trade flows in an obviously mercantilistic fashion.  This has been accomplished with the full acceptance and even cooperation of the US Treasury.  It was an outcome of the strong Dollar policy, and it is why China has not been named a currency manipulator since 1994.  But those central banks are immune from criticism on free trade because they interfere in the financial side of the external accounts, not the current transactions side.  Indeed, one cannot even question the negative impacts of this dynamic.  Avent essentially falls back on the same argument I lamented about last week:

... every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley.  Therefore, the examination ends.  Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

Another version of this argument:  International trade is driven by comparative advantage.  If manufacturing jobs are lost from international trade, is must be the result of a relative comparative disadvantage.  The financial side of the account is irrelevant.

 

If you fall back on the pro-free trade argument that service sector jobs will compensate for the offshoring in manufacturing, you ignore the fact that the currency manipulation that impacted manufacturing will have the same impact on the service sector jobs if they are truly tradable.  If service sector jobs are just as offshorable as manufacturing jobs, then Blinder's prescription is destined to fail unless there is a concerted, sustained effort to control the accumulation of reserves among foreign central banks. 

 

I very much recommend Michael Pettis for an another view of what I consider to be the same problem:

...As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge.  And at first they will surge.  Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

 

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit.  This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

 

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior.  It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

 

The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market.  It is far more likely to be swamped by a tsunami of foreign capital.  This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment.  It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.[Emphasis added]

 

Therein lies the problem.  A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite.  Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge.   So the problem isn’t too little capital inflow or a sudden boycott of USG bonds.  On the contrary, the US will see too much capital inflow.

 

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets.  Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit?  I would be willing to bet that we do.

The patterns of capital flows and how those flows have impacted production and consumption location outcomes is a critically important issue.  Even more so if the flows into the US are simply supporting consumption spending via fiscal deficits but creating relatively few jobs because that spending is quickly directed overseas, and the pace of that direction accelerates as industrial capacity contracts.  Yet if you even suggest the shift in production outcomes is creating very serious and long lasting problems, your thoughts are considered "fairly poorly reasoned."

 

Bottom Line:  When I express concerns over free trade, I am really expressing immense frustration over an international financial architecture that sustains and maintains global imbalances that yield outcomes that I believe are very difficult to justify and yet are accepted due to a blind faith in free trade.  In essence, the ability to manipulate capital flows has made a mockery of the free trade crowd.  I know.  I used to be in that crowd, and in many ways still am.  But I can no longer wrap myself in the free trade flag to justify the negative impacts of financial account manipulation.  And if the US cannot seriously address financial account manipulation on a global basis - and if the Pettis article is correct, the US Treasury will fall short of what is needed even with the announced adjustment to Chinese currency policy - what choices are you left with?  Either accept continued economic stagnation, or act unilaterally on the current transactions (tariffs) or financial (reciprocative devaluation or capital controls)  side of the accounts.  None of which are pleasant options.

Deficit Widens, Again

The US trade deficit rose on the back of an import surge.  From Bloomberg:

The trade deficit in the U.S. unexpectedly widened in May to the highest level in 18 months as a gain in imports outpaced an increase in shipments abroad.

 

The gap expanded 4.8 percent to $42.3 billion as U.S. companies imported more automobiles and consumer goods, Commerce Department figures showed today in Washington. The deficit was projected to narrow to $39 billion, according to the median forecast in a Bloomberg News survey. Imports and exports rose to the highest level since 2008.

As noted by Calculated Risk, you can't blame this one on oil - the petroleum deficit actually improved in both real and nominal terms.   Overall, the goods deficit widened in real terms as well:

 

International trade looks likely to detract from overall growth for a fourth consecutive quarter.  So much for the rebalancing.  The Obama Administration can continue to prattle on about export growth, but trade is a game with two sides - if you lose more jobs to imports than you gain from exports, doubling exports is not a particularly effective stimulus.

 

It is important to recognize that as the global activity rebounded from the depths of the recession, the improvement in the US external balance came to a screeching halt and then reversal.  The reason is simple - we have offshored so much production capacity that it becomes impossible to grow without an expansion of the trade deficit.  Policymakers have not allowed for sufficient currency adjustment or relative growth differentials for any other outcome to occur.  Indeed, the picture is likely to deteriorate further in the months ahead:

The increase in trade flows shows how the global expansion lifted sales at companies like Alcoa Inc. Export growth may cool in coming months as the fallout from the European debt crisis limits overseas demand and a recent strengthening of the dollar makes American goods less competitive.

The challenges of addressing what is a structural trade deficit are magnified when one recognizes that manufacturing capacity is now shrinking in the US:

 

 

This makes the US more reliant on foreign production in the future, and also raises questions about the ability of the US economy to generate the output necessary to return those goods at some point in the future.

 

Also, this is relevant to the corporate cash debate.  Are firms sitting on cash because of weak demand or distress over the implication of deficit spending?  I find myself in the "weak demand" camp, but with a twist:  When firms begin to deploy that capital, where will they put it go?  To expanding capacity in the US?  Or China? And will China ultimately just absorb the capital inflow, swelling currency reserves further?

 

What I fear is the latter.  As production facilities in the US depreciate, firms are looking to replace that capacity with Chinese production.  The owner of a chemical manufacturing firm explained it to me quite succinctly:  When all of his customers moved to China, he really had little choice but to do the same.  The tiny - although officially exalted - renminbi adjustment does nothing to change this trend.  Simply put, only very large currency adjustments would be sufficient to deter US firms from continuing to pursue a China strategy.

 

One can continue to hold the fantasy that an army of well paid massage therapists or clerks at Trader Joe's can offset the impact of not just absolute declines in manufacturing employment but also absolute declines in manufacturing capacity.  Holding onto that fantasy is much easier than recognizing that maybe, just maybe, the economic consequences of trade with China have been much more severe and long lasting than officialdom is willing to acknowledge.   

A Deepening Divide?

 

Last week the Washington Post raised expectations that the Fed was seriously considering additional policy action:

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

Today nonvoter Richmond Fed President Jeffrey Lacker pushed back hard on those expectations:

Federal Reserve Bank of Richmond President Jeffrey Lacker said any consideration of further monetary easing by U.S. central bankers “is very far away.”

 

“It would take a very substantial, unanticipated adverse shock” for further steps at stimulus to be appropriate, Lacker told reporters today in Richmond. “Consideration of further easing steps is very far away.”

And note this morning I concluded with:

My concern is that policymakers will view a retrenchment in growth as a natural "pause," simply a delay on the path the strong rebounds that have traditionally followed deep recessions.

This is not dissimilar to Lacker's interpretation of the data:

“I’m comfortable with rates where they are now,” Lacker, who doesn’t vote on rate decisions this year, said today at the opening of an exhibit at the Richmond Fed on the history of the central bank. “You have some surges, some slower periods. It’s just going to be a choppy recovery.”

Interestingly, he appeared to be joined by Governor Elizabeth Duke:

Separately, Fed Governor Elizabeth Duke said in an interview with CNBC that the central bank is “in the right place” on its monetary policy and that she sees a “moderate recovery” taking place.

It sounds as if a battle is brewing within the Fed, with the Washington Post's unnamed sources trying to keep monetary policy options open while another contingent is happy shutting down those options.  Separately, Felix Salmon opines that the debate has already been decided:

Bernanke is a consensus builder, as Krugman knows, having been part of the Princeton economics department during Bernanke’s tenure as its head. And it may or may not make sense for the Fed to ease much more aggressively. But so long as that remains outside the general consensus, Bernanke’s not going to do it.

Salmon believes that Federal Reserve Chairman Ben Bernanke - a Republican - will not break from that party's consensus that too much has been done already.  Some of Bernanke's defenders may find that paints a too narrow view of his motivations.  But Salmon also notes that even Democrats are not eager for additional policy action.  If the White House is not willing to push for more, why should Bernanke, especially when it will apparently require him to expend political capital internally?

 

If Salmon's thesis is correct, it is a particularly sad outcome given Bernanke's own words from 2002:

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.  

Politics could be every bit a problem in the United States as it has been in Japan.  More to the point, it already is.