This post is an elaboration on this important post by David Beckworth (who has returned to blogging at ‘full blast’ after a long sojourn (one month away from blogging must be the equivalent to 1 year sabbatical)). David writes:
The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.
But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the ‘Great Moderation’ period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happen. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.
David has updated his post to accommodate a comment by Nick Rowe, showing that income growth expectations precede nominal (NGDP) spending growth.
I show an alternative chart that I hope better describes the income growth expectations and NGDP outcomes. To reduce ‘noise level’ in the household income expectations data I used a six-month moving average. The expectations series is also aligned to the NGDP ‘gap’ series (where the ‘gap’ is the difference between NGDP and the trend level). The NGDP series is a monthly series from Macroeconomic Advisors.
Note how the ‘zero gap’ aligns with the 5% long-term average nominal income growth that David emphasizes. And by the time Lehman ‘happened’ both NGDP and income growth expectations were well below their ‘normal’ levels, an indication that Lehman may not have been the ‘cause’ of the financial crisis but the ‘consequence’ of the Fed mistakes.
PS There´s a new Chicago Fed paper: “Expected Income Growth and the Great Recession”
Back at David´s comment section there has been a hot debate on ‘causality’. According to Nick Rowe:
Mark and Alex: this sounds interesting. But we might want to distinguish between:
1. Which caused which over the whole time period?
2. Which caused which in one particular episode (like the recent recession)? (Harder to test of course, except by the eyeball method?)
The theory that changes is ENGDP *always* cause changes in NGDP wouldn’t make sense, unless expectations were totally irrational, or totally self-fulfilling in a world of multiple equilibria?
I think there´s a simple story. Something happens (maybe house prices stop rising and then began to drop) and people turn slightly less optimistic, retrenching a little. This retrenching shows up in lower aggregate spending, so people retrench some more. This goes on while the Fed is showing it´s worried about inflation (from oil prices) and signaling that there´s a growing chance of policy being tightened. People ‘retrench’ some more and spending drops a bit more and so on and so forth. House prices continue to fall and delinquencies grow. The financial system starts to feel the heat. The first to go under are the mortgage houses, but there are linkages in the ‘financial chain’… all the way to Lehman, which was big in real estate.
Since the Fed´s major (only?) concern is inflation and feels ‘threatened’, it does not offset the fall in velocity that´s been going on under its nose. Suddenly, there´s a ‘tipping point’ and ‘all hell breaks loose’.
“Dereliction of duty” refers to the Fed not offsetting the fall in velocity, in other words, it allowed, by its inaction, the shock to propagate. I strongly believe that the “Great Moderation” came about because, even if implicitly, the Fed was concerned with nominal stability. That, and not an inflation target, should be the overriding concern of the monetary authority.