Thursday, November 20, 2014

Japan is Bac… Maybe Not: Still A Long Way to Go

The late Milton Friedman once stated “monetary theory is like a Japanese garden, an apparent simplicity conceals a sophisticated reality.” Interestingly, experience of the last twenty years of Japanese economy shows us that the solving economic problems Japan has been facing requires not one-and-done expansionary monetary policy, but more sophisticated yet unfamiliar policy tools, including unconventional monetary policy, expansionary fiscal policy and structural reforms.

The period of Japanese stagnation was initiated by the falling asset prices in the early 1990s, which in turn led to large deleveraging process by households and firms . The deleveraging process further caused a decline in aggregate demand and a persistent deflationary period from the end of 1990s until recently. In addition to the aggregate demand deficiency, there is a deeper and unavoidable cause for the problem in the Japanese economic performance in the long-term: changing demography. As a big part of Japanese labor force is retiring and the fertility rate in the nation isn't high enough to keep the population growing, the labor force has not been sufficient to continue the economic growth Japan experienced during decades prior to the 1990s.

However, Japan is able to reach its current potential output through a combination of appropriate and perfectly timed fiscal and monetary policies under prime minister Shinzo Abe. The policymakers should note that expansionary monetary policy is appropriate only if there is significant under utilization of labor resources in the economy. Use of both expansionary fiscal and monetary policy even after the economy reaches its potential and shows signs of ability to maintain it without those only creates fear of repeating the mistake the BoJ made in the late 1980s to not tighten the monetary policy leading to soon-to-be burst stock market bubble. Considering the recent sluggish growth in 2014 and both medium-term and long-term economic goals of Japan, I propose that Abe’s government and the Bank of Japan continue quantitative and qualitative monetary easing (QQE) until the unemployment rate drops to and stays at the natural rate of unemployment* for a considerable amount of time and offset contractionary fiscal policies such as increasing tax and cutting government spending by further monetary policy stimulus to keep the nominal GDP growth on trend. The next blog posts will further elaborate on these proposals and more detailed policy recommendations.

Monday, May 12, 2014

When Are We Happy?

(Tune in while reading:
Every person has different answers for this simple question. But we don't know an exact answer for what makes us happy for what reasons. There are more questions that human kind has been trying to find an answer for like whether being happy is what people seek in life.
The word "happy" is itself very ambiguous. People can describe them happy in two different ways:
-depending on their mental state at the moment; reflecting short term condition
-depending on whether they are living lives they want; reflecting long term condition
Regarding the first sense of the term "happy", there have been studies and recommendations trying to find out in what condition people feel happiness. In an episode of the TED Radio Hour Show, guest speakers talked about their findings on being happy. Harvard PhD student Matt Killingsworth conducted survey based research on happiness, and his result shows that if we want to be happier, we should live at the exact current moment. In other words, according to his smart-phone app based survey, people in the study answered they are happy when their minds were focused on what they were doing at the exact moment. On the other hand, people answered that they are happy less times when their minds were on something else such as what they are going to do after they finish their current tasks. Simply put, if you want to be happier, enjoy the moment!
Also, on the same show episode, Carl Honore, an author, advises us to slow down our speed of lives to be happier. He argues that today, people speed in their most tasks, and this leads to less happiness, less productivity and less quality of life. Another speaker Graham Hill, a designer, talk about how we are happier when we have less stuff in life! More elaborately, his point is that we are happy when we have simpler stuff in life.
If we can be happier by following above advises, how can we be happier in our whole lives, in general? Even though I don't want to say this, most people feel pressure and unhappiness by choosing to compare themselves with others. We make ourselves unhappy by envying others. In other words, people choose to be less happy because of other's fortune, luck and possession. This tendency to compare ourselves with others come just naturally to us. However, people should try to control their happiness by what they possess instead of what others possess.
Also, in addition to comparing what we have with what others have, we seemingly compare what we have with what we thought what we would have. In other words, in some sense, we feel happy whenever we experience somewhat unexpected pleasure giving events. Then again even though I don't want to say this, we should lower our expectations in life to be happier. Maybe we can expect the worst and hope for the best!
Happiness has been a topic of economic researches for decades. Richard Easterlin's study on human's well being during 1970's has greatly shaped following studies by economists. His main finding, later called Easterling Paradox, was that well-being and happiness are greatly correlated with people's income, but until income reaches certain point. The latest research on happiness done by University of Michigan professor Justin Wolfers shows how economic and demographic factors play a role in being happy. Even though I don't believe the title is appropriately given, an article "Money can buy happiness, economist says" pinpoints results of his study. Here are some interesting ones:

• Men in recent decades in America are happier than women. “No one knows exactly why,” Wolfers told the audience. It may be that women have internalized several measures of success, more than the basic “am I popular” focus young women faced growing up in the 1960s, he said.
• In general, not only are the rich happier than the poor, but globally, richer nations are happier than poorer ones, Wolfers noted.
• Among Americans in the lowest 12 percent of income-earners, 21 percent said they were happy. Of those earning more than $150,000 per year (the top 10 percent), 53 percent said they were happy.
Flipping the question, among the lowest-earning 12 percent, 26 percent said they were unhappy in general, based on a set of factors such as enjoyment of meals, depression and feeling respected. Of the top 10 percent, only 2 percent reported feeling unhappy, he said.
The notion that riches are happier than poors isn't totally groundbreaking news even it wasn't true. But at the end, most of us seek to get higher salary jobs assuming that it makes us happier. Then from this study, we can advise ourselves that get rich to become happier!

Wednesday, April 9, 2014

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed's March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are "based on FOMC participants’ individual assessments of appropriate monetary policy." Therefore, these number's aren't actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials' own appropriate policy. 
In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member's policy recommendation.
The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed's policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.
 From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials' expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.
Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn't always mean expansionary monetary policy as Milton Friedman put it, "After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."
The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.
 The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.
So, what can we conclude about the Fed's future policy from these two charts?
The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation
 As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed's target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?
Then, given the the below target inflation rate, the Fed officials shouldn't be worried about their fed funds rate target expectation below the long-run expectation.
From the Fed officials' projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.- if we assume these projections are made with rational expectation

Friday, April 4, 2014

Fed, Raise the Inflation Target

Friday's report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed's target of 2 percent inflation rate for 21 consecutive months.
While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its "target" for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called "target". In my Monday's post, I made a case for the second question getting an answer "yes!". If the Fed is indeed targeting inflation rate lower than its 2 percent "target", the points following are useless since the Fed policymakers want low inflation anyways.
Now if we are in the world where the Fed has actually been unable to hit its inflation "target" given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.
The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let's look at the Fed's latest statement:
"To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored."
The Fed, in my policy prescription, should change "run below the Committee's 2 percent longer-run goal" to "run below 3 percent" (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn't been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.
But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn't seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson's paper?

Monday, March 24, 2014

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed's target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman's inflation target of somewhere around 4 percent. We can see an evidence for the Fed being dovish.
In the Fed's recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed's former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.
The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed's statement still includes the inflation target of 2 percent. The Fed's latest statement reads:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Let's now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:
First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won't have to do either of above.
In other words, from the Fed's current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.
Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.
Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).

Saturday, March 22, 2014

Economic History: Panic of 1896

In my blog posts, I have been trying to write multiple type of posts, such as posts on someone's paper, someone's article, or the WSJ articles. This time, I wanted to do little bit of research on economic history.
The Panic of 1896 is one of the pre-World War I economic contractions that was caused by the gold standard of the late 19th century and declining world price in terms of gold. The panic, according to the NBER business cycles dates, dated from December of 1895 to June of 1897. During the panic, the business activity declined by 25.2% and the unemployment rate increased from 13.7% in 1895 to persisting 14.5 % in 1896 and 1897 following a decrease in unemployment rate from 18.4% in 1894 (Romer, 58). At the beginning of the contraction and the end of brief recovery from the Panic of 1893, the aggregate output of the economy hadn't reached the peak of the previous business cycle; therefore, the Panic of 1896 is often considered as a continuation of the Panic of 1893. The Panic of 1896 was caused by a huge
drop in the Treasury’s gold reserve because of the public suspicion for departure from gold standard, whereas the Panic of 1893 was caused by bank runs due to concern over the solvency of the banks.
Cause of the Panic
Deflationary period
The panic relates to the US business cycle contraction defined by NBER as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
A slowing of the rate of increase of the world’s stock of gold, an increase in the number of countries on the gold standard and a higher growth rate of the total economic output resulted in a deflationary period from 1875 to 1896 with a rate of 1.7% a year in the US (Friedman, 69). The US money stock increased only 6 percent from 1891 to 1896. In meantime, the nominal net national product decreased by 1 percent per year on average, whereas the real net national product increased by 2 percent per year (Friedman and Schwartz, 97). The rate of growth of the real output, which was greater than that of growth of the money supply during this period, put pressure on nominal price.
Prior to 1873, the US was under bimetallistic standard. The Coinage Act of 1873 essentially demonetized silver by omitting the silver dollar of 371.35 troy grains of pure silver, and the Resumption Act of 1875 further established the gold standard. During this deflationary period, political movements for free silver coin and departure from the gold standard in the
US were increasing as the United States needed an increase in the money stock to stop the deflation. Farmers, being unable to pay their debts with lower prices, and silver producers, who was hit by lower silver price, formed the People’s party and The National Silver party.As the gold reserve in the Treasury dropped to $45 million in January of 1895, the public’s worry for the maintenance of the gold standard, which was proximately originated by the Sherman Silver Purchase Act of 1890, put more pressure on gold reserves.
Election of 1896
In July of 1986, William Jennings Bryan’s nomination from the Democratic Party for the 1896 presidential election further intensified the pro-silver movement because of his platform for “free silver.” Hoping he would win the election, the People’s party and the National Silver party also nominated him for the election. After his nomination, the demand for foreign exchange increased as the dollar holders wanted to convert their dollar to the currencies that were backed by gold. To do so, dollar holders demanded to convert their dollars to gold first by putting more pressure on gold reserves. In other words, the election accelerated net gold outflows (Friedman and Schwartz, 112).
Another view on the cause of the panic is cotton harvest fluctuations due to exogenous variables, such as weather (Hanes and Rhode). Among the main three crops, wheat, corn and cotton, the cotton production fluctuation was the only one to affect the industrial production of post bellum period (Hanes and Rhode). Way the cotton harvest affected the downturn of the business cycle was through the decrease in the reserves in banks and stock price decline. The poor cotton harvest year in 1896 caused a decrease in cotton export and the decline in gold inflow. The cotton export revenue accounted for 25% of the total merchandise export revenue from 1880-1913 (Hanes and Rhode), so a fluctuation in the cotton harvest was one of the factors that could change the business cycle.
The way out of the panic
To stop the gold outflows, a group of gold-shipping and foreign exchange houses agreed to block the outflows. The group borrowed funds in foreign currencies from abroad and exchanged it with the American investors wanting foreign currency and foreigners holding dollars. By doing so, people transferred their dollars into other currencies without first converting them to the gold; therefore, the decline in gold reserves was managed.
When the harvest time came at the end of the August of 1896, crop
export season started and gold inflow started to increase. The victory of the
Republican Party in the presidential election eased the public’s worry about
the US’s departure from the gold standard.

Friday, March 21, 2014

The Fed Ties Interest Rate Raise (*remotely) to the Tapering Instead of Unemployment Rate

Following today's Fed's meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed's move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed's decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed's weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored [emphasis added].
It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it's  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn't been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market's expectation of inflation in certain time horizons :
Considering the low expected inflation in next few years, Mr. Kocherlakota's worry of weakening the credibility of the Fed's commitment to the 2% inflation is indeed valid. The Fed's main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it's another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.
Now let me interpret the Fed's statement in my way. The WSJ posts an interesting post on how the latest Fed's statement changed from last month's. The following passage shows the change made in the statement from last month:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate
well past the time that the unemployment rate declines below 6-1/2 percentfor a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal
. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.
As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed's tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.
This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed's raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

*UPDATE: After posting this, I watched Mrs. Yellen's press conference following the FOMC meeting. When one of journalists asked exactly how much time the Fed will take to raise the interest rate after it completely stops its large-scale asset purchase aka QA, she answers (from the press conference transcript):
 So, the language that we use in this statement is considerable, period. So, I -- I, you know, this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends -- what the statement is saying is it depends what conditions are like.
I don't want to make a big deal out of that "around six months" as some are doing. But it gives "considerable" idea of how long is that "considerable" 

Monday, March 17, 2014

Shedding Light on the Labor Force Participation Rate

Original post on March 10th, 2014
Last Friday, February job report came with a little surprise of higher than expected job growth of 175,000 and an increase in the unemployment rate to 6.7%. The increase in the unemployment rate came from non-participants getting into labor force in last month. While we watch the FED's move to wind down QE and plan on raising the interest rate as the economy slowly recovers, we should look at more data to see whether the recovery is bringing back the U.S. economy to the track. A recovery should bring back the economy to the long run trend.
The puzzle we see after the recession is a historically low level of the labor force participation rate. The labor force participation rate is unchanged February at 63.0%, which is the lowest in 35 years. The following graph shows the labor force participation rate (LFPR) for the total population and population from age of 25 to 54.
It is now clear that the LFPR for the total population has been decreasing since the onset of the recession. This decrease has partially been linked to the baby boomers' retirement since 2010. But increasing data we see is that the LFPR for the group of age of 25 to 54, the prime age workers, has also been decreasing during the recovery. For this group, retirement is less relevant to the decreasing LFPR. Therefore, we should worry that there might be a cyclical decline in the LFPR.
Timothy Dunne and Ellie Terry have recently written on the subject of low LFPR. According to them, a decrease in the LFPR for prime age workers is a key contributing factor to the low overall LFPR. They separated the effect of a change in the LFPR of each age group on the overall LFPR change. The following chart shows how change in the LFPR decomposes:6a00d8341c834f53ef019b034b7184970c-800wiin their own words on the result:
Three key results emerge. First, increases in labor force participation for the youngest age group boosted overall labor force participation by 0.075 percentage points. Second, the growing population share of the 55+ age group reduced LFPRs over the period by 0.21 percentage points, accounting for roughly 40 percent of the overall decline. Third, labor force participation for prime-age workers continued to fall. The combined within effect for the prime-age individuals (25–34, 35–44, and 45–54) reduced the participation rate by 0.28 percentage points—or a little over half of the overall decline in labor force participation. Additional declines in labor force participation were associated with the reduction in population shares of prime age workers.
In other words, we see that much of the decline in the LFPR has come from decrease in the LFPR for workers of age of 25 to 54. For this group, the LFPR was 82.5% when the recession ended; whereas it is now 81.1%. A question we should ask is whether the labor force participation rate can get back to its highest level of above 84% once the unemployment rate reaches its natural rate and the economy recovers (we should define when a recovery ends).
From the first graph, it seems like the LFPR reached its highest level at around 66%. Considering increase in retirement of baby boomers in coming years, getting back to this level of LFPR is unlikely even after a solid recovery. However, the recovery should bring the LFPR for the prime age workers back to its pre-recession level unless there are some structural factors that are reducing the rate. There is high possibility that the LFPR for prime age workers might not reach its high level as the economy recovers and the unemployment rate decreases. In this case, Christopher J. Erceg and Andrew T. Levin have suggested the  monetary stimulus policy to continue until some other labor market conditions, specially the labor force participation rate, pick up, not just until the unemployment rate drops to low level if the LFPR is still relatively low.

Thursday, March 13, 2014

Is There Wage Inflation? and Is That a Problem for the FED?

In the recent Wall Street Journal's daily report, Jon Hilsenrath writes about a possible wage inflation happening in the U.S. job market as discussed by Torsten Slok and Joseph Lavorgna, who are both analysts at Deutsche Bank. On one hand, Torsten Slok points out that there has been increase in hourly earnings recently. Indeed, hourly earnings of production and non-supervisory workers increased by 2.5% from a year ago.
This surge in hourly wage could make the FED worry about inflation pressure and change their timeline of raising the interest rate. However, as Mr. Lavorgna points out, this increase in hourly earning could be just a result of a decrease in average weekly hours worked as the case where,indeed, the average weekly hours  worked has dropped for last three months.
This drop in average hours worked could be a result of a bad winter we are seeing right now. But we have to be careful when reading Mr. Lavorgna's argument. We should take his argument strongly only if most workers are salaried workers since earnings for salaried workers are fairly less uncorrelated to the hours worked than earnings for hourly waged workers. That hasn't been the case recently; 59% of the total workers were paid on hourly basis in 2012. Therefore, there are factors we should be careful about on the both sides of the argument on the possible wage inflation. Once sunny days come again, we should look at the same data on hourly wage increase and change in hours worked to see whether wage is accelerating. 
Now, let's turn to the question: if wage inflation is indeed happening, does that mean there is a possible inflationary pressure coming?
The idea behind inflation driven by wage inflation is that when there is increase in aggregate demand for some reason and a following increase in demand for labor from firms, increase in wage accelerates. Facing the accelerating wage, the firms would raise their product prices.
However, this argument for wage inflation driven price inflation lacks some other factors that could make make the price inflation unnecessary. As discussed by Gregory D. Hess and Mark E. Schweitzer in their paper "Does Wage Inflation Cause Price Inflation?", the wage increase could be from increase in labor productivity. Also, the argument that the firms will raise their price to pay higher wage for workers isn't necessarily true if the firms are in competitive market and have no power over the prices. Moreover, in their paper they concluded the other way around that price inflation could drive wage inflation. Even though more study is need on the subject, the FED could be not worried about the existence of the wage inflation and the consequence of it if it exists for now.

Saturday, March 8, 2014

What Does Say Say?

In Econ 101, we learned or were told something called Say's Law. What I assumed the main statement of Say's Law was that when a producer or supplier increases its production of output, demand for the good will increase no matter what. In other words, I interpreted a famous rephrase of Say's Law, "supply creates its own demand", as simply that as long as there is supply of a good, there will be demand for it. I thought of the law as a statement about only one certain good. But it turned out that not only was my short interpretation of Say's Law plain wrong, but also it assumes and claims interesting behavior regarding demand and supply in the economy. So, what does Jean-Baptiste Say say?
In 1803, he argued that a producer supplies a good to receive other goods he or she would like to consume in return. In his word :
It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J. B. Say, 1803: pp.138–9)
An interpretation of the above paragraph is that, in short. when one wants to consumer more goods, he or she will produce more or increase the supply of goods he or she supplies. Once the supplier get money by selling its product, he or she now has to get rid of the money because, according to Say, the value of money decreases over time. Therefore, the supplier of X increases demand for Y by supplying more of X.
According to David Glasner on his blog post on Say's Law, Walras Law tells same story as Say's Law:
Walras’s Law says that the sum of all excess demands and excess supplies, evaluated at any given price vector, must identically equal zero. The existence of a budget constraint makes this true for each individual, and so, by the laws of arithmetic, it must be true for the entire economy. Essentially, this was a formalization of the logic of Say’s Law.
In other words, according to Walras's  Law and Say's Law, there will be no shortage of demand in the economy. Therefore, the economy will not experience cyclical unemployment caused by shortage of demand. Opposing views soon came from Malthus, J. C. L. de Sismondi  and later John Maynard Keynes in his famous the General Theory. Keynes argued the assumption made by Say, which says that the supplier of good X has to spend the money received by selling good X on other goods, such as good Y and good Z. Keynes wrote that the supplier doesn't necessarily spend all of the money received as revenue; in fact, in some condition, he or she may think saving that money under a mattress is more reasonable than spending it on some other goods. Basically, Keynes claimed that supply doesn't create its own demand. Moreover, Keynes was bold enough to reverse the statement to that demand creates its own supply. 
Also, Oskar Lange deduced that Walras's Law and Say's Law can be equivalent only in a barter economy, where goods are exchanged directly for other goods. In that case, there isn't intermediary like money, which can make Say's Law not necessarily true.
One implication of Say's Law, if we assume it implicitly holds in reality, if the monetary system can be engineered in a way that it can closely imitate a barter economy, a recession caused by inadequate aggregate demand could be avoided.

Monday, February 24, 2014

Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.
While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.Europe 80s Unemployment
His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.
Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.BudgetTighten  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.Untitled
Phelps further states:
"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."
He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.
To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):
Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.
In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)

Deadline is here: NBA trade deadline

(This is a post I wrote on last Wednesday, a day before the NBA trade deadline.)
While trying to find what to write about on today's post, I realized I was so exhausted by today's exam questions on macro economy. Also, I have recently been writing about monetary policy pretty much, so I thought why I shouldn't write about something totally different but still related to economics.
Tomorrow, February 20th is the last day on which the National Basketball Association (NBA) teams are allowed to trade their current players. For people who follow the professional sports, this kind of trade deadline is pretty familiar. Major European professional soccer leagues and American professional sport leagues have this deadline.
For people who might not be familiar with the NBA roster system, it is like this:
New players out of college basketball or foreign countries enter the NBA draft in each summer to get selected by the NBA teams, And the team and the player signs a contract which is guaranteed at least for two years. In other words, the player is now the teams's asset. (You remember a guy named Trey Burke, right? Well, he isn't doing bad out there)  The team has full control over where the player plays until the contract expires. In other words, if the team wants to trade the player, the team can do it without an agreement from the player in general. Once any given contract between a team and a player expires, the player can sign with any team he wants (with some exceptions). A player with no current contract is called a free agent.
Right now, I am pretty sure almost all 30 managers of the NBA teams are phoning each other to offer a trade to other teams. The main reasons any given NBA team wants to use this deadline and trade players are following:
First, a team believes they are contender for the championship, therefore it tries to maximize its possibility of becoming champion by adding better players to their current roster, This decision is almost a pure basketball decision. We can see this type of trade offers from the Houston Rockets to the Boston Celtics for Rajon Rando.
Second, a non-contender team which has a very good player whose contract is expiring after this year might want to trade this player for the best possible returns if the star player is unlikely to sign again with the team. This decision is half basketball and half financial decision. Since the team wants solid players whose contracts aren't expiring in next year in return for their star player, it still considers its future basketball success. But also the team doesn't want to just let the star player go away in the summer and leave the team with nothing in return. Therefore, the team is trying to maximize the benefit from the player by trading him. This type of decision is made for economic reasons. Again, the Boston Celtics is a team that might want to trade their superstar point guard Rajon Rondo because of his expiring contract.
Third, some trades could be seen as a pure financial decision. A team with a player who has very high salary but doesn't have great value to the team might want to trade this player for some players with low salary before the deadline. By doing so, the team will have more salary space under the salary cap, which is the upper total salary limit for any team, and it will be able to sign a big contract during the summer. In other words, the team is emptying its balance sheet to have enough space to sign a big contract in the future. The team doesn't really care about its success in this season, so it is not a basketball decision in short-run. Right now, one of the hottest trade rumors has been circling the Los Angeles Lakers and Pau Gasol, whose contract says he will make $19.3 million next year compared to average NBA player salary of $3.8 million (even though that says average, that is still...)
I hope, as a basketball fan, to see one or two blockbuster trades involving a superstar or two before tomorrow trade deadline. I am sure NBA team general managers will surprise me tomorrow. The clock is ticking.

Tuesday, February 18, 2014

Public Perceptions of the Forward Guidance

In my recent posts (here and here), I have been writing on the FED's forwards guidance program. To me, the forward guidance program is as interesting as the FED's co-unconventional tool, the quantitative easing, is if not as effective as it is. (Actually, I am interested in writing on the QE's aggregate effect on the recovery, but it is scary stuff to touch on) The FED implements the forward guidance (or open-mouth-operation) program to inform the market on when how long the FED will pursue the low interest rate policy and by doing so, it hopes to induce greater investment and consumption from the firms and consumers through the expected low short-term interest rate.
In their recent paper on the effects of forward guidance on the public's perception, Sack et al. suggested two possible public's interpretations of the change in the FED's forward guidance program. Here, the change in the forward guidance program means an extension on the current low interest rate policy. This is exactly the case we are in right now, where the FED has created market expectation that it would raise the short term interest rate as the unemployment rate reaches 6.5%, but now it faces an apparent slight change in their forward guidance policy. According to the authors, the FED's change in the forward guidance policy can get two possible reactions from the market.
First, the market could see the delay of the increase in short-term interest rate as a bad news. In other words, the private sector could interpret the FED's move as a sign of a weak recovery because it believes that the FED extended the low interest rate policy because the economy isn't recovering as the FED presumably forecasted when it set its former policy or the date of the increase in interest rate. In other words, this change in the forward guidance can lower the private sector's confidence in the recovery.  If this is indeed the case, the extension on the low interest policy can't have a positive effect on the behavior of firms and consumers.
The second way the public may interpret the change in the forward guidance is that it could think the FED extended the low interest rate policy to "maintain a more accommodative policy position for a longer period for a given set of macroeconomic conditions."  Unlike the first case, if the public indeed sees the more period of low interest rate as the FED's more aggressive stand on the recovery, the public expect the economy to recover sooner. In that case the, the effect of the forward guidance program on the investment and consumption will be positive.
Therefore, to have a positive effect it initially hoped to have on the consumption and investment through the forward guidance program, the FED now has to tweak its forward guidance policy in a such manner that the public will see the change in the policy as a more accommodative policy rather than just a weak recovery fix.
I want to finish the post asking Ben Bernanke to summarize the points made in this post. Bernanke explained this two possible perceptions very clearly in his following statement made in 2012:
"Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC's forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector's revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery."