Saturday, March 14, 2015

In which I look strangely at Paul Krugman

 - by New Deal democrat

Prof. Paul Krugman writes today: "When I tell people that macroeconomic analysis has been triumphantly successful in recent years, I tend to get strange looks."
Consider me looking strangely. Yesterday Krugman acknowledged that few macroeconomists saw the Panic of 2008 coming, but once it happened many (like him) immediately saw how it needed to be addressed:
"Well, very few [macroeconomists] saw the crisis coming — mainly, I’d say, for two reasons. First, most economists (me too) failed to understand how the growth of shadow banking, which lacked a deposit-insurance safety net, had recreated the possibility of old-fashioned financial panics. Second, we didn’t pay nearly enough attention to household debt. So the crisis came as a surprise. 
"But these were failures of observation, not fundamental conceptual problems, and the sensible half of the profession quickly took them on board — basically realized that we were seeing old issues in new bottles. Or as I tend to think of it, we collectively went “Aha! Diamond-Dybvig-Irving Fisher yowza!” and all was clear."
This is rather like an air traffic controller who allows two jumbo-jets to crash in midair, but afterward is really good at directing to which hospital to send the mangled living among the smoldering carnage.  You know, "sorry about that midair collision, but please have 30 ambulances on runway 15W to take the survivors to Metro Hospital STAT!"

Krugman excuses macroeconomists for failing to see the crash coming due to "failures in observation."  Well, this is me on November 30, 2007, describing the coming "Panic of 2008:"
 This is NOT the Great Depression II.  Nor is this the stagflationary 1970s.  It is going to unfold as some other Beast.  Only the broad outlines of this Beast appear discernable now:  it will likely feature (1) increasing import prices; (2) wage stagnation (that does not keep up with price inflation; (3) real asset deflation; and (4) possibly a Japan-style "liquidity trap."  In fact, while I believe we are already in a recession, I suspect there will be a business upturn late next year. 

Furthermore, I believe there will be NOT any "runs" on FDIC-insured bank deposits.  Period.  In fact, I suspect they will turn out to be the best havens in the storm.  But this slow motion bust, this Panic of 2008 (and thereafter), will be painful, and it will unfold.  I do not think it can be avoided any more."

I followed that up on January 7, 2008 with this description of a "slow motion bust."
"I constantly describe the era we are in as a "Slow Motion Bust."  A few days ago economist/blogger Prof. Brad DeLong published an excellent article that describes just what I have been trying to convey by that term."Whoever inherits the White House on January 20, 2009 is likely to confront serious and urgent economic conditions unlike any we have seen in our lifetimes.  For the mortgage crisis is only part of a bigger insolvency crisis that has already taken longer to unfold than most economic downturns in our history."...

"[T]he problem has slowly worsened over the last year -- in other words, it has become "a slow motion bust."  Let's first note that housing prices probably peaked nationwide by early 2006.  By February 2007, as noted by Calculated Risk, there were serious problems with subprime mortgage- backed investment paper.  By August, the problems had spread far beyond subprime mortgages, and banks and hedge funds were facing liquidity problems.
"Prof. DeLong's article describes perfectly why I have been calling this a "slow motion bust".  Very much unlike its 19th and 20th century predecessors, instead of going from boom to deflationary spiral suddenly, in a matter of mere months, this bust began to implode a year ago, and bit by bit financial assets (what blogger Russ Winter calls "fictitious capital") are being written down or written off entirely.  Only now are serious financial thinkers beginning to worry about the "third mode" of a deflationary spiral."
If not all the data was out there publicly, enough of it was to get an idea about the risks of what was coming.  Not just a point or two off of GDP, not just a little recession, but a modern variation on an old-fashioned bust, due to too much debt and leverage in the system.  If yours truly could see it - and could see how it was likely to play out - why couldn't, by Krugman's own admission, macroeconomists?
So consider this me giving Paul Krugman a strange look.

Weekly Indicators for March 9 - 13 at

 - by New Deal democrat

My Weekly Indicators post is up at

The effects of the West Coast port strike are abating.  Meanwhile, the question is, just how much outright deflation is the US importing?

Friday, March 13, 2015

The 3 dimensional Phillips curve as a forecasting tool

 - by New Deal democrat

Why do I continue to harp on the Phillips curve being best viewed as 3 dimensional, with the third dimension being basic commodity prices?  Because it helps forecast where the traditional, 2 dimensional Phillips curve is likely to be in a year or so. And since the Fed is focused on the "non-inflationary rate of unemployment," we at very least want to maximize employment and wages without causing self-defeating inflation.  Which means we don't want the Fed to apply the brakes too early.

I can actually show you this very neatly in traditional, two-dimensional graphs.  Some might object that I am "double-counting" inflation, since one axis is commodity prices, the other consumer prices. But commodity prices do not move in sync with consumer prices. In the graph below, both commodity and headline consumer prices are normed to 100 in 1982:

You can see that over the long term, commodity prices have gone up at less of a rate than consumer prices, but with significant exceptions in the early 1970s and the 2000s.

Now let's take ratio of commodity prices to consumer prices, and compare it with the "misery index" which is the addition of the two components of the Phillips curve, the unemployment rate + the YoY consumer inflation rate:

With just a few exceptions, (the late 1960s and 1989-90), for the last half a century the two have moved in tandem.  This is strong evidence that the relative strength of commodity vs. consumer prices does indeed move the Phillips curve along a third axis.  Furthermore, note that the "misery index" lags the ratio of commodity to consumer prices. By knowing the relative YoY% changes in commodities vs. consumer prices, we can forecast where the Phillips curve will be about 12 months later.

And to be clear, here is the YoY% change in commodity prices (blue) vs. core inflation (red, first graph) and the unemployment rate (red, second graph):

Commodity prices (the Z axis on the 3 dimensional Phillips curve) lead both core inflation and the unemployment rate.

Finally, here is a scatterplot of commodity prices and the unemployment rate over the last 5 years:

The values have been consistently shifting to the lower left, with the last two months at the extreme bottom left. This tells us that the 2-dimensional Phillips curve has also been shifting downward and to the left.

In short, treating the Phillips curve as 3 dimensional gives us the ability to forecast the values of the traditional two dimensional Phillips curve 1 year out. In 2015 this means the traditional Phillips curve should shift to downward and to the left of where it has been in the last few years. Since the values of the last several years already indicated an overshoot of the Fed's inflation target of less than 1%, the 3 dimensional Phillips curve forecasts that unemployment can fall well below the Fed's range of 5.2%-5.5% without triggering core inflation in excess of 2%.

International Economic Week in Review: Causes of Global Deflation, Edition

This is over at

February Retail sales: how big of an 'Ouch!'?

 - by New Deal democrat

I have a new post up at, discussing yesterday's retail sales report.

Hold your fire until you see what the inflation adjustment is.

The Phillips curve in 3 dimensions, animated

 - by New Deal democrat

Yesterday I wrote that the Phillips curve might best be considered as three-dimensional, where the third axis was commodity prices, and in particular Oil.  A shock to underlying commodity prices would also "shock" the unemployment vs. inflation trade-off, moving the curve along the third dimension.

Thanks to the help of a reader, I am able to show you this animated gif of the Phillips curve.  The X axis is the unemployment rate, the Y axis is YoY headline CPI, and the Z axis is YoY PPI commodity prices.

Since there are many points with the same UNEMPxCPI (x,y) value, the mean PPI for those values was used.  As you can appreciate, the distribution is noisy, so as my correspondent noted, the "data does not suggest a smooth function."

With that introduction, here is the Phillips curve in 3 dimensions as an animated gif;

Thursday, March 12, 2015

The Phillips curve in the 21st century (or, The Phillips curve as a 3 dimensional foil)

 - by New Deal democrat

This is my third post about the possibility of the Fed raising rates as early as June.

In the first post, I pointed out that both wage growth and inflation are at historic, half-century lows. Further, the heightened number of involuntary part-time employees and those who want a job now, but have completely given up looking, suggest additional slack as compared with other instances of 5.5% unemployment, There is not the slightest pressure on inflation from wages at present.

In the second post, I showed that since the turn of the Millennium that CPI inflation, ex-Oil, has never exceeded 3%, even with 4% unemployment or 4% YoY wage growth.  Further, it is likely that core inflation in the next 12 months will actually decrease somewhat as the collapse in oil prices feeds through the economy.

Now let's look at the 21st century Phillips curve, i.e., the tradeoff between inflation and unemployment.

To begin with, the Phillips curve is regaining respectability as some economists (pdf) consider it is not a 2-dimensional curve, but a 3-dimensional foil, similar to this graph, which was the best visualization of the concept I could find:

The insight is that labor is one of many commodity inputs.  A significant change in the cost of other commodities changes how much labor can be profitably employed. Thus the third dimension is  the cost of non-labor commodities, and in particular Oil.   An exogenous shock such as the 1974 Oil embargo, which suddenly and dramatically increased the price of a basic good, will shift the 2 dimensional Phillips curve along the third axis.

[Note:  I apologize for the non-uniformity of the graphs below. Some were prepared quite some time ago, under the "old" FRED. The new and allegedly "improved" FRED is considerably less functional. I traded uniformity for clarity of presentation.]

So let's generally divide time periods into low and high priced oil.  I'll start by showing the inflation-adjusted price of Oil:

The regimes are: (1) low prices from 1948-73; (2) high prices from 1974-85; (3) low prices from 1986-2000; and (4) high prices from 2001-14.

Here's the Phillips curve datapoints for each (The y axis is the unemployment rate. The x axis is the YoY% change in headline inflation):

1. Low prices from 1948-73:

2.  High prices from 1976 through 1985:

3. Low prices from 1986 through 2000:

4. High prices from 2001 to the present::

Notice that high unemployment in excess of about 7.5%, only occurs in the eras of high priced oil.  Contrarily, low unemployment below 4.5%, only occurs in eras of high priced oil.  Here's a quick comparison of approximate unemployment rates common to all eras:

2.5% Unemployment:
Era // Inflation
1948-73 // 7%
1974-85 // 10%
1986-2000 // 7%, 4%
2001-14 // 10%

5.5% Unemployment:
Era // Inflation
1948-73 // 4%
1974-85 // 7.5%
1986-2000 // 4.5%
2001-14 // 5.5%

The Phillips curve has shifted upward and outward on the 3-dimensional foil during periods of high oil prices.

For the rest of this piece, I'm going to focus on the era of 2001-present.

As you can see from the final graph above, headline inflation has almost always exceeded the Fed's 2% target in times of 5.5% unemployment or less.

But as I showed yesterday, ex-Oil inflation since 2001 has never gotten above 3%.  Here's the Phillips curve for unemployment vs. CPI less energy:

It's still true that at 5.5% unemployment or less, CPI inflation ex-Oil is over 2%.  But at the absolute worst it is no more than 3%.

Finally, here is the Phillips curve of unemployment vs. core inflation. Craig Eyermann of Political Calculations graciously calculated a regression.  Note that the axes are reversed compared with previous graphs):

Similarly, the worst inflation is less than 3%, even at 4% unemployment.

Granted that under all 3 inflation calculations, since the year 2000 an unemployment rate under 5.5% has almost always correlated with an inflation rate in excess of 2%.  But even so, even if the unemployment rate should fall as low as 4%, the risk is that we overshoot 2% YoY CPI by less than 1%.

Further, if we have at least temporarily entered a period of low oil prices, then the Phillips curve should once again shift downward and to the left on the 3-dimensional foil, and there is evidence that it is already doing so, as shown in this graph zooming in on the last 5 years:

As Oil prices rose by 40% YoY in 2011-12, the inflation rate hit  3% even with high unemployment, but since then the Phillips curve has shifted downward and to the left as gas prices stabilized.  Further, note the two overlapping dots at 5.6-7% unemployment and 1.88% CPI less energy.  The Phillips curve is now shifting even further downward and to the left in response to the collapse in gas prices.  Thus, consistent with the late 1990s and the post WW-2 period, we could have as low as 4% unemployment without inflation exceeding 2%.

Considering we have just endured 5 of 6 years with inflation under the Fed's target with subpar wages and high unemployment, the risk of a 1% overshoot -- or possibly no overshoot at all! -- hardly justifies tamping down on improvements to laborers.

A Two Year Comparison of the Yen, Australian Dollar, Loonie, US Dollar, Pound and Euro

This is at

Wednesday, March 11, 2015

Inflation in the 21st century: Oil, not wage growth or unemployment, is the issue

 - by New Deal democrat

This post follows up on my last piece, in which I argued that there are historically non-existent wage or inflationary pressures in the economy, so the notion that the Fed should raise short term rates now to contain such pressures doesn't pass muster.

I'm going to show you that by looking at the Phillips Curve (the tradeoff between the unemployment rate and inflation) in my next piece.

But I can cut to the chase with just one graph.  Here is the CPI for all items (green) compared with core CPI (blue), and CPI less energy (red):

Focus on two things.

First, the red line.  While consumer inflation for all items have gone as high as 5.5%, once we subtract Oil, inflation has only been as high as 3%, and has only exceeded the Fed's target range of 2% once (2012) in the last 6 years, and that only by +0.6%.

Second, as I pointed out in my first piece, the relationship between core and headline inflation is a two way street. Think of the earth-moon system. The center of gravity is not the center of the earth.  The moon doesn't just revolve around the earth, to a limited extent the earth "revolves"  too, wobbling in its orbit in the direction of the moon.  Similarly, just as headline inflation rate tends to revert in the direction of the core inflation over the ensuing 24 - 36 months, so headline inflation accurately forecasts the direction of core inflation over the next 12 months.

Let me delete CPI less energy, and zoom in on that relationship:

Since 2000, there have been 4 peaks and 3 troughs in headline and core inflation.  Here's the record:

Headline // Core
3/00 // 2/01 (11 month lag)
9/05 // 9/06 (12 month lag)
7/08 // 7/08 (simultaneous)
9/11 // 4/12 (7 month lag)

Headline // Core
6/02 // 12/03 (18 month lag)
11/06 // 9/07 (10 month lag)
9/09 // 10/10 (13 month lag)

So to summarize:
  1. core inflation has been below the Fed's target with 1 exception for the last 6 years.
  2. core inflation is likely to decline further below 2% in the next 12 months.
  3. most importantly, inflation ex-oil has been no higher than 3% in the last 15 years, (i.e., irrespective of the unemployment rate or wage growth during that period).
Literally the ONLY thing driving inflation above 3% in the last 15 years has been the secular rise in the price of Oil.  Even at the high point for wage growth and the low point for unemployment.

Raising interest rates in the face of this data would mean that the Fed is treating 2% inflation as a ceiling rather than a target, that it is subordinating its goal of full employment to that ceiling, and that it is beginning to apply the brakes on the economy - and depress wage and job growth - solely because of a possible 1% overshoot, or the possible impact of unrelated higher oil prices in the future.

I'll flesh this out further by showing you the actual Phillips curves in my next post.

Monday, March 9, 2015

Dear Federal Reserve: *Now* is the time to raise interest rates? RLY?? SRSLY?!?

 - by New Deal democrat

I am at a complete loss as to why the Federal Reserve might think that now is the moment to begin raising  interest rates.  I cannot see a scintilla of hard evidence in support, and potent evidence against.

The theory is that the Federal Reserve must start to "normalize" interest rates in order to stave off inflationary pressures, particularly inflationary pressures from wages.

Here is the last 65 years of consumer inflation YoY:

In that entire time, the only occasions on which there was less inflationary pressure than there is now is immediately after the 1950, 1952, and Great Recessions.

The situation is even more compelling when we look at the rolling 3 month average of average hourly earnings:

(h/t Doug Short for preparing this graph)
In the last half a century, there have only been 2 three-month periods, from November 2011 through February 2012, when there was less inflation than there is now.

In other words, of the last 600 measurements, only 2 of them have been less than now. That's 1 in 300. In other words, we are in the bottom 0.05% of all measurements.  99.5% of the measurements have shown more inflationary pressure than now.

And it's not likely, based on your own core measure, that  we will see much inflationary pressure in the next 12 months. Because as you well know, just as core inflation tends to predict the direction of all prices in the next 24 to 36 months, so it takes 12 months or so for current gas prices to feed through into the rest of the economy:

In other words, it is likely that the core inflation reading is going to move lower for the rest of 2015.

Now let's look at wage "growth." Here is nominal YoY wage growth for the last 50 years:

Wages now are putting less pressure on prices than at any time in the last 50 years with the exception of 8 months in 2012.  This is wage pressure??? Again, of the last 600 measurement periods,  only 9 of them have shown less pressure than at present. That puts us in the bottom 1.5% of all time periods in the last 50 years for wage pressure.

I realize that the unemployment rate just fell to 5.5%, and you think that inflationary pressures might start to build as unemployment falls to 5%.

But your own staff has just published a paper indicating that the percentage of long-term unemployed (i.e., people unemployed 27 months or more) is an independent factor in calculating when wage pressure might begin to build.  And here's what that looks like now:

Higher than at any point in the last half century with the exception of the last few years, and coming out of the 1981-82 recession.

And 5.5% unemployment now is not the same as 5.5% unemployment 10 or 20 years ago.  Here is the percentage of the labor force consisting of full-time employees (blue) compared with inflation (red):

In 1998 and 2002 when inflation started to increase off the bottom, the  full time employees were 78.3% and 77.6% of the labor force.  Now they are only 77.0% of the labor force.

And that's not all.  Here is that same information (red) compared with full time employees as a percentage of the labor force plus those who want a job now, but are so discouraged they have dropped out of the labor force (blue):

In 1998 and 2002 respectively, those not in the labor force who wanted a job were 2.7% and 2.5% of the total.  Right now they are 3.1% of the total.

So, to summarize, inflation is in the lowest 1% of all times in the last half century, wage growth is in the lowest 1.5% of the last half century, we still have extraordinarily high long-term unemployment, and a unusually high percentage of part-time employees and discouraged workers even taking into account the current unemployment rate.

Finally, just consider the historical record, limited as it is, of when the Federal Reserve has raised interest rates in the present of out-and-out deflation.

This has happened only once since World War 2:

and three times before - in 1928, 1930, and 1937:

Correlation is not causation and all that, but that's 3 out of 4 times with disastrous results.  Do you like those odds?

In short, you know that raising rates will put additional pressure on wages and employment. So you think NOW of all times is the appropriate time to raise interest rates.  Really?? Seriously?!?