Picking up where I left off last time, the next step of course, is attention to detail - namely, what role does 'economic slack' or the output gap play along with the anchoring of expectations?
Ryan Avent over at free exchange asks that if you factor in the change in central bank credibility over time, and assume that it was effective, then what happened to unemployment?
Anyway, the key here to take away is to zero in on the notion that slack in demand affects quantity shifts rather than price shifts. Essentially, "Workers expecting prices to stay flat amid falling demand will resist wage cuts, and firms expecting workers to resist wage cuts will be reluctant to cut prices. Instead firms will produce and sell less and lay off workers, turning a given shock into much more of a real output loss".
But that's not something new. To that extent, Avent draws back to an '88 paper by Mankiw, Ball and Romer on the inflation-output trade-off titled, "The New Keynesian economics and the Output-Inflation trade off". Essentially, they empirically observe the same - during high inflationary periods, firms and workers are likely to adjust prices and wages more thus increasing responsiveness to shifts in demand. In contrast, during low inflationary periods, nominal rigidity sets in.
What the authors conclude is this:
High inflation -> relatively flatter Phillips Curve (changes in nominal AD have significant effects on output). Low inflation -> steeper curve (shift in demand is reflected faster in the price level).
But back to Chapter 3.
I won't dwell much on output gaps but this is what the estimates suggest - Capacity Utilization decreased by about 5-6% since the beginning of the GFC while Unemployment gaps averaged roughly 2%. The study clearly states that what this suggests is a considerable share of the GFC unemployment increase being cyclical (the gap between current unemployment and NAIRU).
More importantly, on the anchoring of expectations angle, it turns out that although current and expected inflation are positively correlated (as you might expect), the slope is low, implying that expectations are anchored to targets rather than the current level.
The basic approach involved here is again, eerily simple. Two differences are used, the regressor is the difference in the actual inflation rate (at the time expectations are collected) and the central bank's target level. The dependent is the difference between the long-term expectation at a given time and once again, the central bank's target level rate. If you visualize this, you can see why:
1) If the regression coefficient estimate is zero, then the relationship between expectations and the actual inflation would not be significant
2) If the estimate of the intercept is zero, then expectations would be centered at the central bank's target rate.
The results are best explained in a graph of the coefficient estimates:
For the record, these are rolling (five year window) regression on a 12 advanced economy sample since 1990.
Further, evidence on the relationship between the inflation level and its responsiveness to economic slack shows that slack persists and that "the recent stability of inflation is indicative of greater anchoring of expectations and a more muted relationship between economic slack and inflation".
But these are naturally tentative observations (what about headline CPI, import-relative price inflation, lags, shocks etc?) - whether this approach holds consistently can be explored further in a more formal framework and model.
More on that soon.
From the chapter with a witty opening quote from Silver Blaze, here's a small excerpt from the forthcoming WEO which has a whole chapter (about time too!) devoted to inflation or in their own words - the dog that didn't bark, forget bite!
I just wanted to get in a quick reasoning on the whole inflationary quiescence in an era of unprecedented and unconventional monetary accommodation. But before that, here's a nice graph from the chapter that shows the staggered short-medium run behavior over the long-term between inflation and unemployment. As expected, it differentiates between the GFC and the rest - the '70-'79 decade is characterized by that vertical spike while the GFC has a horizontal extension closer to the principal axis:
The fund begins by looking at a New-Keynesian framework of a Phillips curve variant. It assumes that inflation (p(t)) is impacted by inflation expectations (pe(t)) and the level of cyclical unemployment (u(t)) (you can leave the cyclical/structural debate for later!).
So, p(t) = (pe(t)) - k.u(t)
where k is the parameter that is the slope of the curve. Using this basic framework, the following explanations can then be discussed retrospectively.
First - if the increase in unemployment had a dominant structural component instead of a cyclical one, then the change in u(t) will have little impact on p(t).
Second - (Bernanke might have a lot more to say on this), inflationary expectations may well be a lot more anchored than people presume they are. This could be a direct or indirect result of the difference in perspective of central bank credibility.
Third - prior to the GFC, inflation was still the dog that didn't bark and this initial level or "other changes" could well have impacted the response mechanism of inflation to cyclical developments. That is, you would expect a somewhat flatter curve and hence, a smaller coefficient for the slope (k).
I'll get more wonkish on this (as they do), tomorrow.
Here's Wolfgang Schaeuble in Berlin :
“Nobody in Europe sees this contradiction between fiscal policy consolidation and growth...We have a growth-friendly process of consolidation, and we have sustainable growth, however you want to word it.”
Here's what he's referring to (courtesy DeGrauwe/Ji) - fiscal consolidation versus growth (2011-2012):
Clearly some "growth-friendly" consolidation.
Now I'm aware of the sample, the time-frame and the other nuances. But what I'm not that aware of is:
a) What is meant exactly by "growth-friendly"
b) Growth friendly for whom? Everyone?
SMH.
Desmond Lachman writes in responding to the FT editorial on the BoJ's unprecedented moves. But naturally, if you're writing in from the right, then you just have to play the debt card which he does immediately, but not before accusing the editorial of understating the downside risks to the BoJ's moves:
"With a gross public debt to gross domestic product ratio in excess of 240 per cent, and with a primary budget deficit of 7 per cent of GDP, Japan’s public finances are clearly on an unsustainable path"
But unsustainable path to where? Till the vigilantes strike? What's the alternative? Slash spending and spiral downwards into contraction upon contraction? Impose a dose of severe euro-style austerity till the debt level drops? What about some more deflation? What does that do to the real debt burden?
Lachman goes on to write:
"Equally troubling is the rapid rate at which Japan’s population is ageing and the correspondingly rapid rate at which its domestic savings rate is declining. This has to raise serious questions about how the Japanese government will finance itself over the longer haul without permanent resort to the BoJ’s printing press."
Fair enough, no one's claiming that Japan's demographics are in its favor but from a savings-investment dynamic, shouldn't this sort of unconventional and aggressive monetary expansion help out a little?
He then goes on to talk about the yen's depreciation and how, coupled with inflation (towards the 2% target), it would lead to exit-problems for the BoJ. Also, with a depreciating currency and rising inflation, investors will begin to find JGBs highly unattractive and the love-affair will soon end (cue the vigilantes!)
Anyway, what does Lachman advocate?
"...a medium-term strategy to place the country’s public finances on a very much sounder footing, there is the all-too-real risk that the BoJ is leading the country down the well-trodden path of very much higher inflation"
What kind of consolidation does a "medium-term" strategy involve? I wouldn't be one to deny that Japan needs some sort of fiscal initiative. Short-term? No! Medium-term? Long-term? That's the grey area. Does medium-term imply action now? Or after some effects of the monetary expansion have been seen? Moreover, with low growth (but also low interest rates!), would there really be a significant impact on the debt-GDP ratio?
I'm not sure. No one's saying this is a perfect and optimal solution but you can be sure the BoJ's probably warned themselves more times than others have warned them before setting off on this untrod path. And each time they warned themselves, they probably asked, "What's the other alternative?"
Exactly.
What's left to say of Abe, Kuroda and the rest of them that have pulled off such a stunner?
Not much, I would think - just a hell of a lot left to do.
The BoJ has pulled out surprisingly powerful weapons and the experiment has officially begun. Heck, Abe even managed to surprise Noah Smith! But how does this compare to the QEs that we've already witnessed courtesy the Fed? Well, for one, this is quite unprecedented.
If you were to listen to Soros or a few of the research teams, you'd hear (fairly aptly methinks) that it's about thrice the size and in a way, a fair bit more diverse. For one, in addition to buying longer dated JGBs, the BoJ will also dabble in stock and real estate.
Anyway, I tried to pinpoint a time when this movement basically took off and I'm guessing it's late 2012. So what's been happening since then and what's been happening in the past couple of years?
Basically this:
The Effective rates are based on the BIS Indices for countries. The Bilateral USDJPY rising implies a depreciation of the yen and for the sake of visual convenience, I indexed them to January 2011. As you'd expect, the NEER and REER don't really diverge but they start their downward plunge around mid-2012.
Much in the same manner, here's the Nikkei 225 from the beginning of 2012 along with the bilateral USD-Yen Bilateral Rate - both have been indexed to 100 from the start (to compare the pace of bilateral depreciation to the rapid equity spurt). Again, from here, the race starts in November 2012 (on the 8th to be a bit precise).
This is the BoJ's Monetary Base over the past couple of years. Significant expansion (about 100 to 130 trillion yen). What happens if you zoom out of this a bit and project what the BoJ projects for its MB (the grey shaded area)? You get this:
Yup, that's just one of the reasons why this is huge, figuratively speaking too!
There's clearly not enough detail on structural reform and the third prong on a whole but the excitement being generated just by the monetary policy announcements is more than palpable.
The mandate is strong and its been given a chance. This is more than worth watching.
From the action-packed BoJ, here's the simplest chart in the world that shows two year projections for the Monetary Base and the Government Bonds. It also shows the projected expansion in the central bank balance sheet which is roughly 40% and 30% for '13 and '14!!:
(TRILLIONS OF YEN)
Some more quick highlights (or what you already know!):
- In line with the projection of the expansion in the monetary base (what you see above in blue), the BoJ will achieve the price stability target of 2% in a yoy % change in the CPI as quickly as possible but realistically within two years (note: there was a motion to remove this '2 year horizon' claim but it was shot down 8-1 in a vote).To do this, the monetary base will be doubled (visible above). This will also apply to the JGBs and the ETFs (while also pushing further on the average remaining maturity of its JGB purchases).
- Conceivably, its target for money market operations would be through the monetary base (from the uncollateralized overnight call rate).
- A unanimous vote to increase JGB purchases as well as their maturity extensions to spur a further reduction in rates across the curve. Additionally, even maturities including 40 year bonds would come under this purchase-net while the average remaining maturity of its purchases gets extended from slightly less than 3 years to about 7 years.
- To reduce the risk premium in asset prices, REITs and ETFs would be purchased at the proposed pace, while the Asset Purchase Program naturally bids farewell.
- Here's what the statement has to say about the 'banknote principle' - that all these government bond purchases are for the purpose of monetary policy implementation and not to finance its fiscal deficits. Then there's the usual brouhaha on "establishing a sustainable fiscal structure...ensuring the credibility of fiscal management.."
- An extension of funds-supplying operations to support financial institutions in disaster areas. This is why the Loan Support Program has an expected annual percentage expansion of almost 300% followed by 40% over the next two years.
- On the economy, you see your conventional terms of "signs of picking up" and "a moderate recovery path". While the change in CPI still hovers in negative territory, there might be indicators suggesting a change in inflationary expectations which I believe still remain relatively anchored.
The last statement on this, which reads "conditions in financial markets have turned favorable due to the abatement of global investors' risk aversion and expectations for domestic policies" could be another way of saying, "The Nikkei has been booming with all this talk" but we'll leave that for another time...
I don't quite understand how this happens but the more you try and ignore something, the more it finds ways to show up. Case in point, what the what the WSJ ed-page spews. As a political portal that blatantly attempts to act as a mouthpiece for ridiculously stupid policy, I'm not surprised by this latest piece from Arthur Laffer and Stephen Moore titled "Laffer and Moore: The Red-State Path to Prosperity".
I could take, as Ritholtz pointed out, a variable such as weather and spin a brilliant tale with it - namely that colder climates are losing jobs faster. To sound even more ridiculous, I could proceed to say that we need a bit more global warming to buck this trend.
I may be on to something but the point is that I have zero evidence to back it up! Not one bit conclusive, not one bit truthful and not one bit sensible. And while this doesn't make me wrong, it does make me evil in a way - for pushing through with my global warming agenda based on...wait for it...a correlation that I turned into causation for my own convenience.
Here are some highlights of the inconsistencies:
"Among the 10 fastest-growing metro areas last year were Raleigh, Austin, Las Vegas, Orlando, Charlotte, Phoenix, Houston, San Antonio and Dallas. All of these are in low-tax, business-friendly red states. Blue-state areas such as Cleveland, Detroit, Buffalo, Providence and Rochester were among the biggest population losers.
This migration isn't accidental. Workers and business owners are responding to clear economic incentives. Red states in the Southeast and Sunbelt are following the Reagan model by reducing tax rates and easing regulations. They also offer right-to-work laws as an enticement for businesses to come and set up shop. Meanwhile, the blue states of the Northeast, joined by California, Minnesota and Illinois, are implementing the Obama model of raising taxes on businesses and the wealthy to fund government "investments" and union power.
But it isn't just higher taxes that make these so-called progressive states less attractive to business. Red states Texas, Oklahoma, Wyoming, West Virginia, Montana and North Dakota (and a few blue states like Ohio and Pennsylvania) are getting rich from oil and gas drilling. Meanwhile, bluer-than-blue New York has extended its moratorium on the technological advance behind the boom, hydraulic fracturing, citing overblown environmental hazards, and Vermont has outlawed it altogether. California's regulations prohibit nearly all new drilling of any kind.
All the empirical evidence shows that raising a state's tax burden weakens its tax base. Still, too many blue-state lawmakers believe that a primary purpose of government is to redistribute income from rich to poor, even if those policies make everyone, including the poor, less well off. The obsession with "fairness" puts growth secondary.
In short, red states of the South and other areas of the country are moving forward with pro-growth tax reform, while California and the blue states of the Northeast are doubling down on Obamanomics and European progressivism. Who will come out on top? Our money is on the red states and those wisely following their lead."
Yes, it's true. Laffer and Moore have claimed the right of empirical evidence! Scratch your head some more, it's the only thing that'll help.
