The UK NGDP dog is barking

A James Alexander post

It is always amazing that the UK statistics authority can produce a Real GDP estimate four weeks after the end of the quarter. They do admit that there are often large revisions due to the fact that less than 50% of the data is in the bag, particularly lacking are the third month surveys of business output, ie September for the 3q15 number.

The first Real GDP estimate is based on the first estimate of inflation-adjusted, industry by industry value added, or GVA – and  is always about 90% of RGDP. The statisticians have to add back taxes on production and take off subsidies on production to get to the bigger number.

The Real GVA figure, technically known as the “Chained Volume Measure at Constant Prices” is itself half based on GVA at Current Prices, ie Nominal GVA. This data is a hotpotch, some actual physical output, grossed up to a “Current Prices” value are included as are the actual (ie nominal) turnover numbers from the business surveys, particularly for the service sector where physical output is almost impossible to measure.

Around half of GVA numbers are not from reports of business turnover but physical production numbers (for manufacturing and construction), sales figures (for retailers), imputed rent (for the value of owner-occupied housing) and government expenditure (for bureaucrats, teachers and health workers).

In order to get from the nominal GVA figure to the real GVA and hence to RGDP the statistics people have to use a deflator. The estimate four weeks after period end is clearly not considered good enough to release to the public but it is being used nonetheless. Given that real YoY GDP growth in 3q15 is put at 2.6% and nominal GVA 2.0% then the deflator is around 0.6% YoY. This ultra low figure is not a million miles from the very low YoY (and not very reliable, admittedly) CPI figure of 0% for September released two weeks ago. If you really are targeting inflation things look really grim.

If you are implicitly targeting NGDP, as the Bank of England probably is, then things are equally grim. The nominal GVA figure is very closely followed by the first estimate for Nominal GDP released several weeks later. For the second quarter in a row nominal growth has been horribly low. the last time it was this low was in 3q08 just before Lehman. In 4q08 nominal GVA began to crash and was YoY negative for four quarters. Sure, the Bank of England could wait until the first “proper” NGDP estimate in a month’s time, but in the meantime be very, very careful – remember 4q08. The same goes for the Fed, too.

JA GDP Release

The supposedly strong retail sales figures for September could well be giving us a bad steer. The “strong” number was a quantity figure up by 6.5% YoY. Nominal sales (ie by value) were up just 2.7% YoY as in-store prices collapsed at a record-equalling rate of negative 3.6% YoY. The figures are further messed up by a continuing surge in online sales vs physical sales.

This is a really, really dangerous time for the UK economy. Monetary policy is very tight indeed. Yet what is the Governor of the Bank  of England saying? A barking dog makes more sense. What is the market thinking about UK monetary policy? It has no idea either.

The “Big, Blunt Instrument”!

Yellen Has Over 6 Million Reasons to Take Her Time Raising Rates:

Yellen’s focus on the under-employed is steering monetary policy toward a bold experiment: The Federal Open Market Committee will use the big, blunt instrument of low interest rates to push the jobless level low enough to pull more labor-force quitters and part-timers back into full-time work.

The hope is that it will kick-start a virtuous cycle of investment, higher productivity and better pay that will heal the vestiges of the worst recession since the Great Depression.

It’s a “new view of the reach of monetary policy,” said Laurence Meyer, who served on the Fed’s Board of Governors with Yellen in the 1990s. It “goes against everything I taught at the university for 27 years.”

Most (all) of the people involved in the 1929 and 1937 BIG monetary mistake are dead. But history books, contemporaneous articles and “modern” analysis are still available (a new item, Scott Sumner´s opus on the Great Depression will be available December 1). Therefore, to call low (“zero”) interest rates a “big, blunt instrument” is hilariously shocking!

“Last chance”…to get their act together!

Unfortunately, that´s very unlikely as seen here: “The Fed Strives for a Clear Signal on Interest Rates”:

Federal Reserve officials are widely expected to announce Wednesday that short-term interest rates will remain near zero, leaving mid-December as the central bank’s last chance to raise rates this year.

The timetable poses twin challenges for Fed Chairwoman Janet Yellen: Deciding whether the U.S. economy is ready for an interest-rate increase, and signaling central bank intentions without causing further market confusion.

Mike Belongia and Peter Ireland have just published “The Fed Has Not Become More Transparent”:

We applaud the Fed’s willingness under Bernanke and Janet Yellen to announce publicly its commitment to a 2 percent inflation target and acknowledge the consistency of its statements regarding a balanced approach to stabilizing inflation and unemployment.  This information makes clear what the central bank hopes to achieve with its monetary policies over both intermediate and longer horizons.  At the same time, however, we join others in wondering whether the “lively debate” that continues to be evident in the frequent, but often conflicting statements of Fed officials clarifies or confuses what monetary policy is doing and why.

John Taylor agrees:

“I don’t really understand what is unclear right now,” said William Dudley, president of the Federal Reserve Bank of New York, during an appearance at a panel in Washington this month.

“Are you kidding?” Stanford University economist and Fed critic John Taylor said. “No one knows what you’re doing.”

The root of all-evil: The strong dollar

Reasoning from a price change (RFPC) is one of the most common mistakes made by economists, journalists and pundits.

This take from “Why the Fed won’t raise rates in October” — in five charts” is illustrative:

One of the factors weighing on inflation is the strong U.S. dollar, which is up about 14 percent over the past year against a broad basket of other currencies. A stronger dollar makes American exports less competitive in the global marketplace, and Goldman Sachs estimated that is dragging down U.S. growth by a full percentage point right now.

So it lowers growth and inflation! That should give people the hint that it´s a negative demand shock, coming from? You guessed: tight monetary policy!

How come? Interest rates remain “on the floor”. But a few (including Bernanke) know that´s a very bad indicator of the stance of monetary policy. Better if you take a look at what´s happening to NGDP growth.

Not surprisingly, it´s falling


Bringing down inflation


Strengthening the dollar


And pushing down commodity and oil prices


PS. RFPC is , at least, “consistent”: “How Global Easing Makes the Fed’s Job Harder”:

For the Fed, that is worrisome. Further dollar strength could cut into inflation more and weigh on growth. If(!) the Fed tightens while all other central banks are loosening, the dollar could strengthen even more, intensifying the problem.

The global squall that kept the Fed on hold in September is looking more and more like a storm that is gathering pace.

Front Runner for “the Paragraph Golden Globe”

That comes from this piece by Gavyn Davies in the FT “ECB and Fed reverse their traditional roles“:

…As a result, the ECB seems much more concerned about a slowdown in GDP growth than the Fed. In fact, recent statements by members of the FOMC have explicitly saidthat a slowdown in US growth to around 2 per cent would not only be acceptable, but have hinted it would actually be desirable, because it would reduce the pace of improvement in the labour market.

No comment!

Carney and the Fed are actors and scriptwriters

A James Alexander post

In his recent extended interview with The Daily Mail Mark Carney not only raised the problem of market-deniers, those who deny the validity of rational expectations in the climate change market.

He revealed his own very confused state of mind when it comes to the future path of UK interest rates when he gave this “guidance”:

‘If we think there is a prospect, a possibility – that’s a possibility not a certainty – of rate rises, then that is far, far better to let the British people know so they can prepare,’ he says. ‘If events mean that does not happen and rate rises are not appropriate, then we will do the right thing and we will not adjust rates.’

It reminded me of the famous response from the patrician British Prime Minister Harold Macmillan when asked what could push his government off course: “Events dear boy, events“.

As his government blundered from mistake to mistake he was eventually booted out for his hopeless response to events, but many of the events blowing him off course were caused by his government in the first place.

Central bankers, like Macmillan, seem unable to see themselves as endogenous, only thinking they respond to exogenous impacts. It’s never their fault.

If they are operating with faulty Philips Curve models they will cause a lot of confusion when the economy refuses to move as they expect, as now. They think that they have to raise rates now to keep their predictions of 2% inflation in 2017-18 intact. They’ve modelled it, so it has to be true. First they corral market forecasters to predict rate rises. And then they produce circular reasoning charts like this:

JA Carney_1

As the data comes in worse than they expect they should admit their models are faulty rather than ad hoc blaming new, exogenous, “events”.

In fact, it is the markets’ belief that the UK (and US) central banks are itching to raise rates in line with their faulty inflation scenarios that subdues nominal growth and therefore inflation also. The answer is to target nominal growth, not inflation.

Is Mark Carney a Market-Denier?

A James Alexander post

Mark Carney is feeling a bit under pressure. His entry into various non-monetary policy debates such as “inclusive capitalism”, climate change, and now Brexit has stirred a few feathers, especially amongst Bank of England traditionalists. Progressives and others from the chattering classes seem to be making less fuss as he mostly seems to be one of them.

His spin doctors evidently decided that he needed to try and get back on-side with the more conservative majority in the UK and so allowed a journalist from the right-wing Daily Mail to follow him around for a day and record some of his more informal thoughts.

Climate change denial vs market-denial

On the big question for the Bank of England, climate change, he was giving no quarter.

‘I was in Lima with the International Monetary Fund and G20 last week and the second most talked about issue was climate change. Is it a bad thing that the Bank of England is not only doing its job but leading the way?’ he asks. Crucially, he argues, it is not outside his remit. London is one of the world’s biggest insurance markets. Insurers are having to take account of climate change fears and risk. It is affecting their capital levels and the premiums they levy.

Carney pulls the debate back to his core job – regulating and monitoring the UK’s financial system, saying: ‘If you want to deny climate change, OK. But you can’t deny the market. If you want to deny the market, then I can’t talk to you.’

Unlike Scott Sumner I feel somewhat sceptical about man-made climate change. The physicists I talk to seem unsure. Who knows? Anyway, the far more revealing point to me was when he drew an analogy between climate change deniers and market-deniers.

It is a paradox. Carney is most certainly not a climate change denier. But is he a market-denier? He appears to have no interest in creating an efficient market in UK inflation futures or Nominal GDP. He denies the market a leading role, or at least doesn’t trust it when it comes to monetary policy, instead preferring the models of the PhD’s in the engine room of the Bank of England. Most mainstream economists are like this, all treating rational expectations as too random, and therefore are all more or less market-deniers. It is arrogant beyond belief, but there you have it, and it causes huge market and economic dislocations as a result.

To be somewhat fair, Carney is not like the Fed in denying the market implied US inflation rate. But this is probably because the UK implied inflation curve is frankly unbelievable because of various technical failures.

  • Firstly, it measures an index called RPI that is no longer an “official” UK National Statistic, just calculated as an afterthought because so many index-linked gilts and other long-term contracts rely on it.
  • Secondly, CPI is what the BoE now targets and it runs anywhere between 0.5 and 1.5% below the officially under-resourced RPI measurement  .
  • Lastly, it is widely known that the UK pensions and annuity industry, that provides long-term RPI-indexation guarantees, is starved of supply for index-linked gilts causing an artificial shortage. The lack of supply drives up the price and drives down the inflation adjusted return, causing implied inflation to be shown as much higher than it really is.

JA Carney

(4% implied inflation! must be something screwy, and there is, massive artificial shortage of longer dated index linked gilts)

What a mess! Come on Mark, get a grip, help sort it out and stop denying markets a proper role.

UK inflation expectations are rather unreliable as a result of these technical issues and public confusion. The BoE’s modelled inflation seems very much to underestimate medium term “inflation” versus surveys and market implied RPI numbers given in the BoE’s Inflation Reports.


“Looking for Wally when there are many Wallies”

That well describes the challenges faced by monetary policymakers according to this piece from Bloomberg Business “Are we tight yet? The Fed´s problem in finding the neutral rate”:

Federal Reserve officials just aren’t sure how much stimulus their zero-interest-rate policy is providing.

At issue is the level of the so-called natural, neutral or equilibrium rate of interest, which is the borrowing cost — adjusted for inflation — that keeps the economy at full employment with stable prices.

Economists from the academic world and even within the central bank are vigorously airing differing views on where the rate lies in the aftermath of the worst recession since the Great Depression. The uncertainty is yet another reason for Fed officials to go slowly as they begin raising interest rates for the first time since 2006.

According to this older piece from Brueguel:

What’s at stake: The natural rate of interest is a key ingredient in the recent discussion of secular stagnation, and more generally in New-Keynesian models of the Great Recession. But the concept is often poorly understood, in part because the term refers to different things for different people.

A couple of examples:

Richard Anderson writes that the Swedish economist Knut Wicksell based his theory on a comparison of the marginal product of capital with the cost of borrowing money. If the money rate of interest was below the natural rate of return on capital, entrepreneurs would borrow at the money rate to purchase capital (equipment and buildings), thereby increasing demand for all types of resources and their prices; the converse would be true if the money rate was greater than the natural rate of return on capital.

Axel Leijonhufvud writes that Erik Lindahl (1939) and Gunnar Myrdal (1939) refined the conceptual apparatus, in particular by introducing the distinction between ex ante plans and ex post realizations and thereby clarifying the relationship between Wicksellian theory and national income analysis.

And there are several others.

In short, the Fed is faced with an “estimation” problem. To make that clear, think of a Taylor-Rule for setting the Fed Fund (FF) rate:

Looking for Wally_1

The circles around the level of “potential output” (y*) and the level of the natural rate (NR) represent the “uncertainty” about their estimated values.

For example, San Francisco Fed senior economist Vasco Cúrdia argued in a paper published earlier this month that the equilibrium rate may have dropped so much that “monetary conditions remain relatively tight despite the near-zero federal funds rate.” He provides a chart which indicates that at present the “natural rate” could be anywhere from -3% to 6%!

Looking for Wally_2

Similar uncertainty surrounds the value of “potential” output.

In essence, facing the “estimation” problem, the situation of monetary policy makers is well captured by this picture!

Looking for Wally_3

An alternative, to try to overcome the “estimation” problem would be for the Fed to try some “experimentation”.

That has happened before. In March 1933, in the depths of the Great Depression, President Roosevelt decided to “innovate” and free the economy from the “gold standard shackles”, delinking from gold. The effect was immediate as illustrated below.

More recently, in the heights of the Great Inflation, Paul Volcker also decided to innovate:

On Oct. 6, 1979, the Federal Open Market Committee—under the leadership of Paul Volcker—made a decision that would come to be known as a key moment in U.S. economic policymaking, a turning point in the history of the Federal Reserve that would forever alter central banking. And those are the understatements.

A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation’s economic history.(A Greenspan)

So, what did the FOMC do? It made a short-term change in the method used to conduct monetary policy, from making adjustments in the federal funds rate to containing growth in the monetary aggregates. (Yes, the Fed now targets the funds rate again—the 1979 change was reversed in 1982—but more on that in a minute.) This meant the Fed would focus on controlling the amount of reserves provided to the banking system, which would ultimately limit the supply of money.

By many, that “experiment” was seen as a failure. Nevertheless, judging by the results it worked, in that inflation was permanently brought down.

In what follows I´ll give a “liberal” interpretation of the experimentation, based on NGDP. The interpretation is not so farfetched because the NGDP targeting concept was extensively discussed both by the Volcker Fed in 1982 and by the Greenspan Fed in 1992.

The first charts show how rising core inflation was the outcome of a rising NGDP growth. The follow up shows that by “downsizing” NGDP growth inflation was brought down.

Looking for Wally_4

This was followed by Greenspan´s “consolidation” in 1987-92 and almost “smooth sailing” from then to the end of his mandate in January 2006. These last two periods came to be known as the “Great Moderation”.

Looking for Wally_5

I interpret the “experiment” as trying to find first the level and then the stable growth path for NGDP. As the next chart shows, by 1987 the Fed had “hit” on the NGDP level and from then onwards NGDP growth rate was stabilized, i.e. kept close to the trend path.

Looking for Wally_6

There were “mistakes” along the way, notably in 1998-03, when NGDP first rose above trend and then fell below, but by the end of 2005, NGDP was back on trend.

Looking for Wally_7

Soon after taking the Fed´s helm, Bernanke allowed NGDP to begin once more to fall below trend. This was magnified in 2008, probably because of the Fed´s exclusive focus on headline inflation, which was being propelled by an oil and commodity price shock. In an environment where the financial system was “wounded”, allowing NGDP to crumble is mortal!

Looking for Wally_8

At present we have the opposite situation of the 1970s. Instead of high/rising inflation due to rising NGDP growth, we have low/falling inflation due to low/falling NGDP growth. So this time around it may be fruitful to devise an NGDP based experiment in reverse. Try to establish a higher level of NGDP that when attained is “consolidated” through a stable NGDP growth rate.

This “experimentation” would be much more helpful than spending time on “estimation” of the “natural rate of interest” or the “potential level of output”.

PS In the comments, bill writes:

“I need to go see the correlation between corporate spreads and NGDP growth. I think those spreads have been widening which I take as a good sign that the market expects less than optimal choices by the Fed in the near future.”

The chart shows how the recent fall in NGDP growth has been accompanied by a rise in less than stellar bond spreads over 10yr treasuries:

Looking for Wally_9

Wow! ECB Vice-President reads The Riot Act

A James Alexander post
The ECB has just put out a full transcript of Thursday’s press conference in Malta. No wonder the market responded well, in real time, as it listened to this splendid take-down of a serial inflation hawk questioner:

Question: You talked about the inflation picture being less sanguine. Can you just explain a little bit more to the public why you think you have to fight so hard against low inflation? Especially for lower and middle-income people, spending less at the gas station, spending less at the grocery store is helping their purchasing power. You’ve said before, people buy more stuff when inflation is low. Why spend all this money on government bonds to fight something that a lot of people would say is a good thing for them and for their budgets?My second question is, is there a risk that the ECB will just kind of fall into a trap of QE without end? That you keep doing it, that you keep buying government bonds? We see it from the Federal Reserve’s experience, whether or not they start raising interest rates. Is there a danger that this stimulus keeps going on and on and the markets just come to expect it and that you won’t be able to get out?

Draghi: Let me respond first to your second question. The projections of recovery both in output and inflation are based, are conditional on the full implementation of the QE programme as announced in January and the full implementation of all the credit-easing measures that have been announced in the course of 2014. So we have to continue on that. On the other hand, they were also based on a set of technical assumptions concerning exchange rates, oil prices, external demand, growth in output and so on. And to the extent that these conditions change and possibly worsen, we will have to adjust our QE programme or in general our monetary policy stance. That’s the sense of our discussion about downside risks.

On why to fight low inflation: I’ve discussed this many times. Low inflation on one hand has a supporting power for real disposable income. On the other hand, it increases the real value of debt. As we’ve seen, low interest rates promote consumption and it’s essential for the recovery of growth and economic activity. That’s why we’re fighting. But to fight low inflation doesn’t mean that we want high inflation. We just want to be compliant with our mandate, which is to drive inflation back to below but close to 2% in the medium term. I understand the Vice-President may want to add something on the first question.

Constâncio: Yes, I would like to add something. Because it’s the second or third time that you asked that question, so let me add something. First, let me remind you that some years ago in the US there was a commission headed by an economist called Boskin to examine the measurement of inflation. And the conclusion of the Boskin Commission was that the way inflation is measured, in particular the type of indexes that are used, Laspeyres indexes, tend to exaggerate the measurement of inflation, in the case of the US by 1.5 percentage points. So, if the target would be zero, very likely we would be targeting a negative inflation rate. So there is a measurement problem with inflation which justifies that the target for inflation should be above zero.

Second point is the point that the President just reminded you about debt deflation, and when there is a situation of high indebtedness, when inflation is very low, the burden of servicing the debt increases and that is very detrimental to the economy. The third point is that with very low inflation or negative inflation, the real interest rate increases, and when the nominal rate cannot go below zero it means that the interest rate in real terms may be above the equilibrium real interest rates that would equal savings to investment at the level of full employment. So that’s another reason why negative inflation rates can be detrimental.

Then there are the deflation risks – real deflation, not what you implied in your question, because to have negative inflation for a few months is not a deflation situation. A deflation situation is a situation of prolonged period, meaning more than one year, of negative inflation. And in that case you have two phenomena: you have an increase in real wages, because there is rigidity in nominal wage growth to not go negative, so you will constrain supply, profits of firms, and you hit growth. And second, there is also then in such a situation a problem of consumers postponing their expenditure, if deflation lasts long enough; when we are talking about real deflation, not just a few months of negative inflation.

So there are a host of reasons why central banks fight deflation, why they spend money, as you implied – and by the way, just reminding you, there is not just one way of central banks to spend money to fight low inflation. We and other central banks purchase securities. The Swiss central bank purchases foreign exchange in order to defend the level of the exchange rate that they want, and they have a balance sheet which is higher than ours in relation to the respective GDP.”

The ECB expects another year of failure

A James Alexander post

The ECB released its Quarterly Survey of Professional Forecasters today. It shows a major drop in inflation expectations for the EuroZone for 2016.

JA Japan_1

On the good old principle that next year will be much like the last year, as 2016 approaches professional economists (and the ECB’s) own teams have ‘fessed up’. They got 2015 horribly wrong. Having shot for 1.2% in 2015 this time last year the actual result is now coming in at 0.1%!

The ECB publishes their interpretation of EZ breakeven inflation rates once a month. These market-based measures appear to have been better forecasters. Around this time last year the “one-year rate two years ahead” was implying less than 1% inflation in the short term. They have been weak again so the economists are now following them down. All except one (red line) show the ECB missing even its own self-defeating target of “close to, but below, 2%”.

JA Japan_2