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).

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.

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" 

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:in 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.

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.

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.