On Currency Misalignments

This week's Economist discusses the problem of trying to tell whether or not an exchange rate is "misaligned" - that is, far from some sort of underlying equilibrium exchange rate. As the piece below describes, discerning this is not as easy as it sounds:

Misleading misalignments

“MISALIGNMENT” is all the rage. A new bill introduced into America's Senate proposes to punish countries where the exchange rate is found to be “fundamentally misaligned”... The bill, which is clearly aimed at China, follows a flurry of China-bashing proposals over the past year. But this one is different: it has widespread support and is likely to be passed before the end of this year.

Congress is hoping that it will be much easier to show that a currency is misaligned than manipulated. On June 13th, the day that this legislation was introduced, the Treasury decided yet again not to brand China a currency “manipulator” in its semi-annual report on exchange rates, but confidently declared that the yuan was “undervalued”. And on June 18th the IMF also announced a new framework for monitoring countries' exchange-rate policies. It will track indicators such as heavy foreign-exchange intervention and “fundamental exchange rate misalignment” in order to identify countries that are unfairly manipulating their currencies.

This activity is based on the widespread assumption that the Chinese yuan is hugely undervalued against the dollar. Yet the awkward truth is that it is almost impossible to be sure when a currency is misaligned, let alone by how much.

...There are three main ways of determining the “correct” value for a currency. The oldest is based on the theory of purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise prices across countries (The Economist's Big Mac index is a crude version of this).

...A more popular definition of the fair value of a currency is the exchange rate that corresponds to a trade position considered “sustainable”. Thus China's large and rising current-account surplus is seen as hard evidence that the yuan is severely undervalued.

...Stephen Jen of Morgan Stanley prefers a third method of calculating the fair value of a currency: the so-called behavioural equilibrium exchange rate. This does not attempt to define long-term economic equilibrium. Instead it analyses which economic variables, such as productivity growth, net foreign assets and the terms of trade, seem to have determined an exchange rate in the past, and then uses the current values of those variables to estimate a currency's correct value.

Morgan Stanley uses no fewer than 13 models to value currencies... [According to these models,] the yen might be anything between 18% overvalued and 29% undervalued, depending on which model you trust. But nine of the 13 models signal undervaluation, with the median value suggesting the yen is 15% too cheap—the weakest currency in the chart. What about the yuan? Morgan Stanley uses only four models to estimate the yuan's fair value, of which the median valuation suggests it is only 1% undervalued against the dollar—not the answer Congress wants. Another surprise is that most other emerging Asian currencies now look overvalued.

None of these numbers should be taken as precise, but two conclusions follow. The first is that, in theory at least, there is a stronger case for declaring Japan's currency to be misaligned than China's. It is bizarre that the weakest currency is the yen, when Japan is the world's largest net creditor and had faster GDP growth than either America or the euro area in the first quarter. The problem, says Mr Jen, is that traditional models for estimating the fair value of currencies still focus mainly on the real economy, but increased cross-border investment flows (based partly on nominal interest-rate differentials) are now much more important. The second awkward conclusion is that the highly subjective nature of assessing currency misalignment will make it very hard for America or the IMF to agree on whether a currency is out of line.

The extent of any existing yuan misalignment is indeed open to question, and reasonable people (and models) can disagree substantially. That's why to me it makes more sense to think about whether government intervention in the currency markets are acting to depress or prop up the value of a currency. If the current market value of a currency is only possible with government purchases or sales of the currency, then that is prima facie evidence that the current market exchange rate is somehow different from its free-market equilibrium rate.

That is slightly different from saying that it is different from some sort of "fundamental" or "fair" exchange rate, because market participants may still bid the price of a currency away from that underlying rate, but it's a lot easier to conceptualize and measure.

Rectifying Market Failures

This is interesting. It seems to be a case where government regulation has actually caused the market (in this case, the market in investment advice) to operate more efficiently.

Wall Street Analysts Proving More Bearish Than Ever

June 18 (Bloomberg) -- Never in the history of Wall Street have analysts been so bearish. The good news is they're also getting it right more often, helping make investors richer by betting against corporate America.

Thank the regulatory hammer of former New York Attorney General Eliot Spitzer. In 2003 he forced 10 big firms to separate investment banking from research to avoid the conflicts of interest that tempted analysts to keep their reports upbeat.

"The industry has changed: you're not anathematized if you come out with a negative opinion," said Robert Stovall, whose work on Wall Street the past five decades included stints as a strategist at the securities unit of Newark, New Jersey-based Prudential Financial Inc. and research director at Nuveen Corp. in New York. "It used to be that sell recommendations were frowned upon. I even worked at firms where the CEO said, 'I never want to see a bearish word on my stationery.'"

That transformation has helped investors following analysts' advice to beat the market. Nine of those 10 firms have been accurate the past two years, according to Investars, which tracks analysts' performance.

It's old news that government intervention can help remedy market failures. But the fact that this principle seems to hold true even on Wall Street - the emotional center of the laissez-faire economic world-view - is fascinating, and carries important implications for markets where market-failures are much more obvious.

Oh, and in case you were wondering: Yes, I'm thinking about health care.

New Economic Data

There was a lot of new economic data released today. The two most widely anticipated were the news releases on Consumer Prices and Industrial Production.

The first picture shown below sums up the story as far as consumer prices go. Energy prices have gone up a lot, so the overall CPI looks bad, rising at a 5.5% annualized rate over the past six months - the fastest rate of inflation since the oil-price spike in the fall of 2005, following hurricanes Ivan and Katrina. So far, that inflation has not fed through into faster inflation in non-energy products, but recent history suggests that we should probably expect an uptick in core inflation in coming months.



Industrial production data also tells a somewhat unsettling story, illustrated below.



Real output by US industry stagnated last fall, and has failed to resume regular growth since then. Over the past three months production has been growing at a meager 0.6% annualized rate; as a result, capacity utilization remains only moderate. That's good news for inflation pressures, but bad news for the job market and future business expansion.

More Care, Not Better Care

This article contains nothing that is the slightest bit surprising, but it still provides a nice illustration of some of the problems with the US's health care system:

In Health Care, Cost Isn’t Proof of High Quality

In a Pennsylvania government survey of the state’s 60 hospitals that perform heart bypass surgery, the best-paid hospital received nearly $100,000, on average, for the operation while the least-paid got less than $20,000. At both, patients had comparable lengths of stay and death rates.

But the best part of the article is a single sentence that comes about half-way through the piece. It is the sentence that cleanly and concisely encapsulates the biggest structural flaw in the US health care system:

[S]o hospitals are rewarded for providing more care, not better care.

I can't sum it up any better than that.

Action in Long-Term Interest Rates

Long-term interest rates have been in the news in the US financial world in recent days. For example:

Bond Yields Soar, Driving Shares Down

The cost of borrowing headed higher yesterday and drove the stock market down sharply.

Yields on the 10-year Treasury note — a key benchmark that influences nearly all long-term interest rates, including home mortgages — hit a five-year high, climbing to 5.248 percent yesterday, up from 5.154 percent late Monday as investors sold off notes and bonds.

Treasury yields, which have been rising steadily since the end of April and have started to weigh on the stock market, quashed an early afternoon stock rally. The Standard & Poor’s 500-stock index, a broad gauge of the market, closed down 1.07 percent, or 16.12 points, to 1,493 points; and the Dow Jones industrial average dropped 1 percent, or 129.95, to 13,295.01 points.

First, a little perspective. Yes, the rise in long-term interest rates in recent weeks has been fairly impressive. But as the following chart illustrates, this sell-off in the bond market is not much different (so far) from a number of previous short-lived surges in interest rates, and could just as easily be reversed over the coming months. In the grand scheme of things, long-term interest rates in the US are still substantially below where they were during the last economic expansion.



That said, there are a couple of interesting things to note about the current phenomenon. First of all, the recent rise in long-term rates - together with a bit of a fall recently in short-term rates - means that the yield curve has abruptly become "un-inverted". In other words, short-term interest rates are now no longer higher than long-term rates, in contrast to the situation for most of the past year. There are a number of different possible interpretations for this change, including the possibly contradictory beliefs that the Fed is soon going to have to start reducing interest rates to prop up economic growth, or that the economy is poised for a rebound that would increase the demand for loanable funds.

A second point of interest is that the current run-up in long-term interest rates is entirely due to a rise in real interest rates, rather than a rise in inflation expectations. Using the 10-year inflation-indexed bond to serve as an estimate of the real interest rate, we can estimate inflation expectations as the difference between that real interest rate and the nominal bond yield (a procedure that has a few minor problems with it due to liquidity issues in the TIPS market, etc., but one that still conveys the general idea). Doing that reveals that financial market participants still (on average) expect inflation over the next 10 years to be in the neighborhood of 2.3%-2.5% - right where those expectations have been for years. The real interest rate, on the other hand, has jumped by almost three-quarters of a percentage point in the past few weeks, as the following chart shows.



One big question on a lot of people's minds is how big the China factor may be. If this movement in US interest rates is indeed being driven largely by concerns about China's economy, then this could be an important moment in US financial history, i.e. the point in time when we really started seeing China's direct influence on US interest rates. Of course, given how difficult to gauge why financial market participants are doing the things that they're doing, we may never know for sure if that's the case.

Inflation in China

This news story is making headlines in the business press this morning:

China's Inflation Accelerates, Adding Rates Pressure

June 12 (Bloomberg) -- China's inflation accelerated at the fastest pace in more than two years in May as pork prices soared, increasing the likelihood that interest rates will be raised.

Consumer prices rose 3.4 percent from a year earlier, the National Bureau of Statistics said today. That was more than the 3.3 percent expected by economists. April's inflation rate was 3 percent, matching the central bank's 2007 target.

Meat prices surged 26.5 percent, helping to push inflation above the target and adding to concern that the world's fastest- growing major economy may overheat. Inflation is outpacing returns on bank deposits, encouraging households to put money into a stock market that the government is trying to cool.

"Today's number and the stock market for the past few days make a stronger case for a rate hike," said Wang Qing, chief China economist at Morgan Stanley in Hong Kong.

The reason that this news is of such interest to the US is because of the implications it holds for China's monetary policy, which faces increasing pressure to cool down the Chinese economy. The classic ways to do that would be to raise domestic interest rates, and/or to allow the currency to appreciate against the dollar. Either of these steps could cause a reduction in official Chinese purchases of US bonds, thus contributing to a rise in interest rates in the US.

On the other hand, in the past the Chinese authorities have used more quantitative means to control the speed of the economy - i.e. urging (commanding?) more or less lending by the banking sector. That route implies a smaller impact on the US economy (US interest rates would be less directly impacted), which is why observers in the US have been paying close attention to every move by the Chinese monetary authorities.

One thing is for sure, though: month by month, it seems increasingly clear that China's government will need to take bigger steps to cool the economy than they have so far.

Update on Housing Prices

Last week (while I was away on vacation) the OFHEO released their quarterly estimates of housing prices in the US. While it isn't a perfect measure of house prices, I think it's a pretty good one. Since it tries to track what happens to the price of the same house over time as it is bought and sold, it avoids some of the problems of prices measured by the median sales price. Furthermore, it is separately calculated for each Metropolitan Statistical Area (MSA), which provides a lot of texture to our analyses of the housing market.

At any rate, here's a picture of what the most recent data shows for some of the US's largest coastal cities - the ones the enjoyed the biggest price appreciations during the period 2000-05.



In a rather remarkable display of synchronization, all of these cities are showing rapidly falling rates of price appreciation. Boston, San Diego, and San Francisco are now registering negative year-over-year real price changes, and it seems likely that in three months we'll be able to add New York, L.A., and Washington DC to that list. Note that the states that contain these particular MSAs account for about 40% of the population of the US.

On the other hand, there is another 60% of the US that lives in interior states that did not go through the most recent big price appreciation. Unfortunately, it seems that house prices are leveling off - and in some cases, falling - in those places, too.

And as for the longer view: the last picture shows the 2-year price change (to better smooth out some quarterly variability) in major coastal cities of the US over the past twenty years.



Based on past experience, it seems very reasonable to think that we're only in the very early stages of a many-year-long price correction. Don't think about the housing market turning around in 6 months, or even in a year or two; I'd suggest that you think about it gradually falling and leveling off over the course of the next 5-7 years or so. So be patient.

Back Soon...

A quick update for loyal readers of The Street Light: No, I haven't forgotten about the blog, but I've been on vacation for the past week. I plan on returning to blogging next week.

There was a lot of economic news today, including the GDP report and the release of the first quarter 2007 HPI. I'll be able to write about both in a couple of days.

In the mean time, thanks for your patience...

Income Inequality: International Comparisons

The Luxembourg Income Study (LIS) group has put out a new working paper by Andrea Brandolini and Timothy Smeeding that gives us an update on some international comparisons on income inequality, titled "Inequality Patterns in Western-Type Democracies: Cross-Country Differences and Time Changes" (pdf file). The paper compares levels and trends in income inequality using the LIS's unique database on internationally comparable measures of household income in numerous countries.

I found two main results to be of particular interest - though the paper contains lots of valuable tidbits about income inequality in different countries, so please check out the whole thing.

First, it appears that the substantial rise in income inequality in the US over the past several years has not been experienced by other countries. Changes in income inequality since the 1970s seem to be country-specific, and tend to happen in relatively short episodes rather than as decades-long trends. From the Brandolini and Smeeding's conclusion:

National experiences vary during the last four decades and there is no one overarching common story. There was some tendency for the disposable income distribution to narrow until the mid-1970s. Then, income inequality rose sharply in the United Kingdom in the 1980s and in the United States in the 1980s and 1990s (and still continuing), but more moderately in Canada, Sweden, Finland and West Germany in the 1990s. Moreover, the timing and magnitude of the increase differed widely across nations. Inequality did not show any persistent tendency to rise in the Netherlands, France and Italy. Commonality seems to be greater for market income inequality: in five of the six countries for which we have data, we observe an increase in the 1980s and early 1990s and a substantial stability afterwards.

Changing public monetary redistribution appears to be an important determinant of the time pattern of the inequality of disposable incomes. Changes in inequality do not exhibit clear trajectories, but rather irregular movements, with more substantial changes often concentrated in rather short lapses of time. Together with the lack of a common international pattern, this suggests to look at explanations based on the joint working of multiple factors which sometimes balance out, sometimes reinforce each other, rather than to focus on explanations centered on a single cause like deindustrialization, skill-biased technological progress, or globalization. Identifying and characterizing episodes and turning points in the dynamics of inequality may reveal more fruitful than searching for overarching general tendencies.

This is significant. Since income inequality has been roughly stable over the past decade in countries like Canada, the UK, Germany, and France, it's harder to argue that rising income inequality in the US is due to some broad-based global economic evolution. As I've argued before, I think that rising income inequality in the US is more the result of changes in government policy that have cumulatively shifted the balance of power away from workers and toward the owners of capital.

The second important point that the paper makes is the importance of redistributive policies in reducing income inequality, and how the US stands out when compared to other countries. Progressive taxation and social programs tend to redistribute income toward the poor in all rich democracies, but the degree of redistribution varies quite a bit from country to country. The following table provides a snapshot comparison across several countries.


Notes: Real Disposable Personal Income (DPI) for low- and high-income households expressed as a percent of median income in the US. Reduction in inequality measured as the change in the Gini coefficient between market incomes and after-tax (including transfer payments) disposable personal incomes.

To no one's surprise, the ratio between rich (households in the top 10% of the income distribution) and poor (those in the bottom 10%) is considerably larger in the US than in any other rich democracy. Part of the explanation (though only a part, to be sure) is the fact that US government policies do considerably less to redistribute income than policies in other countries.

Why are Americans so much less interested in income distribution than, say, Canadians or Australians? I'm not sure. As we think about ways to improve the US's rather tattered social safety net, that's an issue worth thinking more about.

Difficulties in Reading the Tea Leaves

Caroline Baum tackles some more of the puzzling aspects of the US economy today:

U.S. Economy's Mixed Vital Signs Flummox Experts

May 22 (Bloomberg) -- U.S. economic growth has slowed to a crawl; the stock market is soaring. Housing is in a recession; construction employment has yet to show any effect. Employment growth is decelerating; weekly jobless claims have tumbled in the last month.

That's just a short list of the U.S. economy's conflicting vital signs, serving to keep forecasters off balance and Federal Reserve policy makers at bay.

... Employment has offered up its share of mysteries in this business cycle.

"If real GDP growth has slowed as much as it has, and potential growth doesn't change that quickly, how is it that unemployment has come down and been maintained at a low level?" says Neal Soss, chief economist at Credit Suisse. "Maybe the productivity downshift was structural rather than cyclical."

None of the answers is compelling or satisfying.

...Then there's the mystery of capital spending.

"Usually when you see huge stock buybacks you see good capex," Soss says.

Instead, investment in equipment and software hit a wall late last year, with the year-over-year growth rate slowing to less than 1 percent in the first quarter of 2007 from 9 percent a year earlier.

"Corporations didn't just figure out last October they're supposed to invest in China, did they?" he says. "The answers aren't satisfying."

Stuff worth thinking about. Personally, I think mixed signals are pretty much normal for an economy that is slowing down. My best description of the economy right now is that we're on the fence. In the next six months I think it likely that we will either move toward recession - which I see happening much like the 1990 recession - or toward renewed solid economic growth, perhaps along the lines of the second-wind expansions that happened after non-recessionary economic slow-downs in 1985 or 1994.

Economic Puzzles

Irwin Kellner does a nice job laying out some of the puzzling features of the US economy today:

Conundrum redux: The U.S. economy keeps getting harder to explain

HEMPSTEAD, N.Y. (MarketWatch) -- On January 2 of this year, I opined that this would be the year of the conundrum. I wasn't kidding. Originally used by former Federal Reserve chairman Alan Greenspan to describe the drop in bond yields while the Fed was pushing up its federal funds rate, the word conundrum can also describe a number of anomalies and disconnects that have appeared as the year 2007 has unfolded.

For example, economic growth has slowed markedly since the beginning of 2006... You would expect this kind of performance to push up unemployment while pulling down the rate of inflation. You would be wrong.

During this same period of time, the unemployment rate actually fell while the rate of inflation has picked up. The failure of unemployment to rise as the economy has slowed is a good thing in the short run, since it helps maintain jobs and buying power for the nation's workers. This helps to explain another conundrum: the failure of consumer spending to collapse as the housing bubble has popped.

Over the longer term, however, low unemployment in a slow-growth economy may not be so good, since it appears to reflect a slowdown in productivity. When productivity fails to grow, any increase in workers' pay either hurts companies' bottom lines, or shows up in the form of higher prices. So far, corporate profits are doing just fine -- another conundrum, by the way, but the key reason why the stock market has been on a tear of late.

But what's good for earnings in a period of slower economic growth and declining efficiency is not so good for prices. No matter which index you look at, the rate of inflation has not receded as the central bank has expected, but rather, has remained above the Fed's so-called "comfort zone."

In my view, the Fed has aided and abetted this surge in inflation by pumping up money growth even as it has raised interest rates. As we all know, the basis for inflation is too much money chasing too few goods. Talk about a conundrum: after 17 hikes in the fed funds rate from the middle of 2004 to the middle of 2006, the money supply is actually growing faster, not slower.

I'm not so sure that I agree with Kellner's statement that consumer spending is not showing any signs of slowing... but I do think he's right that there are a couple of stylized facts about the US economy right now that fit together pretty awkwardly.

I suspect that most of them can be explained by lag times, though. For example, inflation generally lags economic growth, and so it's not uncommon for weaker economic growth to take some time before it causes inflation to fall.

The one that is most puzzling to me is the continued apparent rise in profits - or at least in corporate profits as reported. Given declining productivity, and slowing demand, it's very hard for me to see how profit growth can continue as it has. We'll know a lot more about that particular puzzle on May 31, however, when the BEA releases data on corporate profits for the first quarter of 2007. It should be interesting to see how well it matches with profits as reported on Wall Street.

Chinese Investment Abroad

Reuters has some interesting analysis regarding the loosening of China's external investment policy last week:

China gives investors foretaste of liquidity wave

LONDON (Reuters) - China's recent loosening of rules to allow more investment abroad is a reminder to investors and central bankers around the world that a new wave of global liquidity may well buoy future asset prices.

In what Morgan Stanley dubbed a "baby step", China last week announced moves to allow Chinese investors to invest indirectly in foreign equities and derivative products.

The scope, however, was narrow. It applies to investment through qualified Chinese commercial banks and the quota at issue is currently only about $14 billion with just half of what is raised allowed to go to equities instead of fixed income.

...That said, the mere idea of Chinese money coming to overseas stock markets has been enough to stir investor juices. Hong Kong-listed stocks in mainland companies, or H shares, surged more than 5 percent to an all-time high on Monday after the Chinese announcement.

The excitement, of course, is primarily based on potential, the belief that a wall of money will eventually come to world markets from Chinese investors.

To get some idea of the potential, consider that total yuan deposits in China were worth around $4.8 trillion at the end of April, with slightly less than $2 trillion of it in household deposits.

Fitch Ratings estimates China held nearly $500 billion in external assets last year excluding foreign exchange reserves while, in another baby step, China is setting up an agency to invest part of its $1.2 trillion reserves in world markets.

State media suggests it will initially manage some $200 billion.

Great oaks from such little acorns grow.

The notes of caution that the article injects are well-placed; it will take a long time before substantial amounts of non-government Chinese investment money starts flowing out of China.

But I find the piece interesting for two reasons. First, it's a good reminder that a lot of players in the financial world are busily looking for "the next wave of liquidity" to give (another?) boost to asset prices. What that implies, exactly, I'm not quite sure, but as a basis for guaging future asset prices it does seem slightly suspect to me.

But secondly, it's also a good reminder about exactly how much investment money the Chinese governmental authorities have to dispose of. Whether we're talking about $500 billion of non-forex assets held by Chinese official entities, or the well over $1 trillion dollars in foreign exchange assets they hold, it's impossible to overstate exactly how big a player China is in the world's financial markets today.

China's influence on the world's finances has generally received less attention than its influence on world trade, simply because Chinese overseas investment behavior (unlike Chinese export growth) has generally not had any dramatic side-effects on the rest of the world. But in another decade that could well change.

Core Inflation Still Tame

Our monthly inflation picture was fleshed out a bit more this morning with new CPI data from the BLS.

Higher energy prices pushed the overall rate of consumer price inflation higher in April. But it still seems that higher energy prices are not spilling over to other types of goods and services.

However, it's worth injecting a note of caution here: in general, it's not a stretch to think that higher energy prices may eventually spill over into other prices, so it is worth keeping a sharp eye on non-energy prices over the next several months. As the following picture shows, when the overall consumer price index rises at a rate faster than the core rate, we often (though not always, to be sure) find the core rate beginning to rise after a few months.



So there is good reason for careful vigilance of measures of inflation in the US. However, so far, core inflation does not show any significant signs of rising, as the following graph illustrates.



I'm not worried about inflation; I think the US economy has much bigger problems than an inflation rate between 2-2.5%. And furthermore, I think that the non-energy inflation rate will probably continue to gradually subside over the rest of the year. But with energy prices as we've seen them lately, one never knows for sure...

And the Good Times Keep On Rolling...

...For the owners of large US corporations, anyway. Bloomberg reports:

Profit Growth in U.S Tops 10 Percent Again, Surprising Analysts

Profits at U.S. companies rose by more than 10 percent for the 19th straight quarter in the period ended March 31 as MasterCard Inc., Hewlett-Packard Co. and Prudential Financial Inc. surprised analysts with better-than- estimated earnings.

Companies in the Standard & Poor's 500 Index through May 11 reported an average earnings gain of 13 percent in the quarter, according to data compiled by Bloomberg. The last time growth was less than 10 percent was the second quarter of 2002.

International sales helped by a weaker U.S. dollar and continued spending by U.S. consumers fueled the earnings advance. Concerns that the U.S. housing slump and rising delinquencies by subprime mortgage holders would damp profits have eased, analysts said.

The results are "an upside surprise anyway you slice it," said Alec Young, an equity market strategist at Standard & Poor's in New York. Worries about housing and mortgages were "wrong-headed," he said.

First-quarter earnings advanced four times faster than analysts had projected as of April 13, as 76 percent of the 444 companies in the S&P 500 that reported through May 11 met or topped projections. Twenty-seven percent beat estimates by at least 10 percent.

...The unexpected surge in profits helped push the Dow Jones Industrial Average to a record 13,369.2 on May 9, while the S&P 500 closed that day within 1 percent of its 2000 record. The Dow finished at 13326.2 on May 11, up 6.9 percent for the year. The S&P 500 was at 1505.8, up 6.2 percent this year.

I'm on record as suggesting that such profit growth can't continue forever. It will be interesting to see whether the official national income statistics (NIPA) measurements of profits agree that there was such continued growth in profits in the first quarter of 2007. If you recall, toward the end of the last business cycle expansion, profit growth as announced on Wall Street far exceeded actual (real) profit growth, as measured by the NIPA. To some, this was an early indication that trouble was brewing...

Economists' Growth Forecasts

The Wall Street Journal (hat tip: CR) reports that economists are guessing that the worst is over regarding economic growth in the US this year:

Economy Is Clawing Back, but Not Much

The worst of the economic slowdown has passed, private economists said in the latest WSJ.com forecasting survey. But they don't see any reason to expect a significant acceleration.

By a more than 5-to-1 margin, the economists said they believe the first quarter's 1.3% growth -- the weakest in four years -- marked the low point in the slowdown that gripped the economy much of last year. However, they expect growth to stay below 3% into early 2008, leaving 2007 on track to have the slowest economic growth since 2002.

...On the whole, the 60 economists predict gross domestic product, the broadest measure of economic output, will grow at a 2.2% annual rate this quarter.

As a bit of context, here's what a similar survey of economic forecasts predicted two months ago:

The world's largest economy may expand at a 2.4 percent annual rate this quarter, and accelerate to 3 percent by year's end, according to the median estimate of 75 economists surveyed by Bloomberg News from March 1 to March 7. The economy grew at a 2.2 percent pace in the last three months of 2006.

It's almost not worth mentioning (but I'll do it anyway) that actual GDP growth during the 1st quarter of 2007 was not even close to the prediction of 2.4 percent growth. Let's hope that these economists somehow managed to get closer to the mark this time.

A Productivity Story

This week the Economist covers a paper by Rob Jensen that nicely illustrates how technological advances can translate into unexpected productivity improvements, and win-win economic gains.

How do mobile phones promote economic growth? A new paper provides a vivid example

YOU are a fisherman off the coast of northern Kerala, a region in the south of India. Visiting your usual fishing ground, you bring in an unusually good catch of sardines. That means other fishermen in the area will probably have done well too, so there will be plenty of supply at the local beach market: prices will be low, and you may not even be able to sell your catch. Should you head for the usual market anyway, or should you go down the coast in the hope that fishermen in that area will not have done so well and your fish will fetch a better price? If you make the wrong choice you cannot visit another market because fuel is costly and each market is open for only a couple of hours before dawn—and it takes that long for your boat to putter from one to the next. Since fish are perishable, any that cannot be sold will have to be dumped into the sea.

This, in a nutshell, was the situation facing Kerala's fishermen until 1997... On average, 5-8% of the total catch was wasted, says Robert Jensen, a development economist at Harvard University who has surveyed the price of sardines at 15 beach markets along Kerala's coast.

...But starting in 1997 mobile phones were introduced in Kerala... As phone coverage spread between 1997 and 2000, fishermen started to buy phones and use them to call coastal markets while still at sea. (The area of coverage reaches 20-25km off the coast.) Instead of selling their fish at beach auctions, the fishermen would call around to find the best price. Dividing the coast into three regions, Mr Jensen found that the proportion of fishermen who ventured beyond their home markets to sell their catches jumped from zero to around 35% as soon as coverage became available in each region. At that point, no fish were wasted and the variation in prices fell dramatically. By the end of the study coverage was available in all three regions. Waste had been eliminated and the “law of one price”—the idea that in an efficient market identical goods should cost the same—had come into effect, in the form of a single rate for sardines along the coast.

...Furthermore, says Mr Jensen, phones do this without the need for government intervention. Mobile-phone networks are built by private companies, not governments or charities, and are economically self-sustaining. Mobile operators build and run them because they make a profit doing so, and fishermen, carpenters and porters are willing to pay for the service because it increases their profits. The resulting welfare gains are indicated by the profitability of both the operators and their customers, he suggests. All governments have to do is issue licences to operators, establish a clear and transparent regulatory framework and then wait for the phones to work their economic magic.

It's a neat story about how technological progress sometimes results in economic gains that are almost completely "loser-free". The only note of caution that I would interject is that one shouldn't extrapolate from this example that technological progress always produces winners without producing losers. Most types of technological change that I can think of create both winners and losers.

That doesn't mean that one should be any less enthusiastic about technological-based productivity improvements. But it does mean that we have to try hard to remember that there are losers from nearly all types of economic change. What, if anything, we should do about that fact is then a matter of personal opinion.

Economic News of the Day

A couple of interesting tidbits today. First, indications about April retail sales, as reported by Marketwatch:

Easter egged April sales; most retailers miss

April was largely a sales disaster for most of the nation's biggest retail-chain operators, as consumers pulled in their purse strings after March's spending spree and as they faced rising prices at the gas pump, as well as a slumping housing market.

...With 51 retailers reporting to Thomson Financial, 85% of them missed expectations for same-store sales, the industry's benchmark for growth measured by receipts rung up at stores open longer than a year. Overall, the data showed a 1.8% decrease.

The International Council of Shopping Centers weighs its results differently and tallied an overall same-store sales drop of 2.3% to set the largest decline on record, which dates back to November 1970. For the combined period, same-store sales were up an anemic 1.8%, below the 2.8% expectation.

"It's an ugly picture," said Michael Niemira, ICSC's chief economist. "The 2.3% decline is a wake-up call that something fundamental is going on."

Second, there was new trade data released today. Menzie Chinn:

Trade Deficit Stabilization Deferred

The March trade figures are in at BEA, and many are surprised. Bloomberg reports:

U.S. Economy: Trade Deficit Widens More Than Forecast (Update3)

May 10 (Bloomberg) -- The U.S. trade deficit widened more than forecast in March as higher oil shipments drove the biggest increase in imports in more than four years.

The deficit rose 10.4 percent to $63.9 billion, the Commerce Department said today in Washington. Imports and exports were the second highest on record. Climbing fuel costs also pushed the price of foreign goods higher for a third month in April, the Labor Department reported separately.

...I might observe that the trade balance is one of the wild cards in the expected revision of the GDP numbers going from the advance to the preliminary 07Q1 release. At the time, some analysts argued that the GDP numbers would be revised upward because of strong GDP growth abroad would suggest a surge in exports. As it was, nominal exports of goods and services did grow 21% on a annualized m/m basis (log terms). But nominal imports ex. oil grew by 33% (the total grew by 53%). Things look better on a 3 month change basis. Then it's nominal exports by 3%, non-oil imports by 4.9%, and nominal total imports by 7.2%. Still, over the first quarter of 2007, imports by any measure are increasing faster in nominal terms than exports.

In a sense, these two reports send conflicting signals. The first tells us that consumer spending may be slowing. But the rise in non-oil imports indicated in the trade data suggests strong spending by American businesses and consumers. I'm not quite sure how to square this circle...

Fed Holds Interest Rates Steady

The press release is available here. For early analysis, a good place to start is with Mark Thoma:

No surprise, the Fed left the target rate at 5.25%. The statement is essentially unchanged and Inflation is highlighted. The statement says:

1. The statement on economic growth has changed from "Recent indicators have been mixed" to "Economic growth has slowed in the first part of the year" indicating that uncertainty over slowing has been resolved by new data.

2. The statement about inflation changed slightly, with the opening sentence changed from "Recent readings on core inflation have been somewhat elevated" to "Core inflation remains somewhat elevated," and they continue to expect moderation of inflation in the future. However, the statement notes the potential for high levels of resource utilization to sustain inflation pressures.

3. The balance of risks is still tilted toward inflation. There is no signal that a rate cut is contemplated anytime soon.

4. There was no dissent.

I agree that there was nothing at all surprising in the Fed's statement. However, it is interesting that the Board is not more confident that inflation will trend downward. Capacity utilization levels are not that high, after all.

Why Does Rove Ignore Income Distribution?

I think I have to agree with Brad DeLong about something, despite a good defense by Mark Thoma. I'm not going to take on the question of whether Stanley Fish is the Most Mendacious Man Alive, but I agree with Brad that Karl Rove does include in his conception of good economic performance some measure of how people other than corporate executives and owners are doing. The fact that Rove systematically neglects to discuss how average Americans have done economically over the past several years is therefore, I think, a lie by omission.

Lots of the statements in the speech by Karl Rove that Mark excerpts indicates that Rove knows that "economic health" includes some measure of how average people are doing. Examples:

• "[I]n the three months following 9/11, the American economy shed 1 million jobs." The fact that he mentions aggregate job losses at all is an indication that Rove understands that what happens to average workers is an important part of the economic picture. He's not discussing the income losses to corporate executives and owners here - he's discussing a million average workers who lost their jobs, and making the point that that was a bad thing.
  
  
• "The Bush tax cuts have shifted more of the burden onto the wealthy and those lower on the economic ladder have been relieved of a larger share of their tax burden... And the tax burden of the top 5 percent of those in America, those with incomes of lower than $141,000 a year, is up almost 3 percentage points." The fact that Rove includes statements like these seem to indicate that he knows that it matters what happens to the disposable income earned by people who are not among the very richest in the economy.
  
  
• "The American economy has created more jobs than all the countries in the Euro zone and Japan combined... Employment is at near all-time high. Claims for unemployment insurance are at a five-year low. The unemployment rate is 4.7 percent; well below the average for each of the last three decades." Again, these aggregate labor market statistics would only be included in the speech if Rove believed (or believed that his listeners believed, at any rate) that the condition of the labor market for average workers is an important indicator of the health of the economy.
  
  
• "President Bush believes trade is an important source of good jobs for our workers, higher growth for our economy, and bigger earnings for our farmers and our factories. For example, exports accounting for roughly one-quarter of all U.S. economic growth in the '90s, and jobs in exporting plants pay wages that are up to an average of 18 percent higher than jobs in nonexporting plants." Here's another example of Rove citing how economic progress (in this case due to trade, in Rove's argumentation) can be measured by creating jobs and higher wages for average workers.

Yes, I do believe that Rove thinks about how the economy is performing for average Americans. If he doesn't care about it personally (and I'm perfectly open to that possibility), then he certainly is smart enough to know that most people do think that economic progress has to include some measure of the well-being of average people.

The most convincing thought experiment for me is simply this, however: if median income was up a bunch in the last few years, don't you think that Rove would be advertising that fact as loudly as possible?

So why does Rove seem to ignore issues of income distribution? Simply because the results have not been good.

Questioning ECB Independence

The EU's finance ministers have started pushing back against some of the relatively anti-ECB (European Central Bank) rhetoric that Nicholas Sarkozy has used recently. The Financial Times has the story:

Ministers warn Sarkozy on Central Bank

European finance ministers on Tuesday issued a concerted warning to Nicolas Sarkozy to stop undermining the European Central Bank by blaming it for France’s economic problems, in a determined defence of the bank’s independence.

The incoming French president was warned there was no enthusiasm for his election calls for the ECB’s mandate to be amended to focus it on creating jobs and growth as well as fighting inflation.

...Mr Sarkozy, a former French finance minister, has blamed the ECB’s obsession with fighting “inflation that doesn’t exist” for forcing up interest rates and the value of the euro against the dollar and other world currencies. He has echoed concerns from French exporters, including Airbus and Air Liquide, that they are being priced out of world markets. “Independence doesn’t mean indifference,” Mr Sarkozy said last December.

On Tuesday, a number of Mr Sarkozy’s former Ecofin colleagues rejected his ideas. Wouter Bos, Dutch finance minister, said the new French president could “increase the pressure but it is not a good idea”. Wilhelm Molterer, Austria’s finance minister, said: “No politician should put pressure on the ECB. The ECB is an independent bank.”

...Daniel Gros, director of the Centre for European Policy Studies, said he expected Mr Sarkozy to lay off the ECB for a while but that it was a convenient “scapegoat” if France’s economy does not take off.

“If he does it for domestic consumption it doesn’t really matter, but if he really wants to make an impact and links ECB reform to his support for a new treaty, it does start to matter.”

While I think most macroeconomists would agree that a highly independent central bank is probably a great thing to have to keep inflation-expectations down, I must confess that I am a bit sympathetic to Sarkozy's complaints. The ECB has seemed rather stingy in setting interest rate policy over the past few years, particularly given that inflation in Europe has been extremely low - generally a solid percentage point below inflation in the US.

But on the other hand, there is some plausible logic that suggests that perhaps it made sense for the ECB to be tougher on inflation than the Fed would have been under similar circumstances. Since the ECB is new, it has had to establish and solidify its inflation-fighting credentials. Furthermore, it may be the case that (in many parts of the Euro-area, at least) inflation expectations are more prone to rising than they are in the US, due to a consistent history of sustained bouts of moderate inflation in several euro countries.

It seems clear that Sarkozy would not be able to initiate any major changes to the ECB's charter, even if he really wanted to. But the fact that his rhetoric was so successful serves as another good reminder that huge swathes of the public - even in France, which has been right at the heart of the formation of the EU ever since its inception in the 1950s - are skeptical, nervous, and often downright grumpy at the compromises that they've been forced to make in order to forge the European Union.

Time for the Credit Card?

Herb Greenberg relates a funny, yet chilling story in his most recent column:

SAN DIEGO (MarketWatch) -- You may have seen that LendingTree commercial with a happy-go-lucky guy named Stanley Johnson, who brags about his big house, his new car and how, "I even belong to the local golf club. How do I do it?" he continues with a big, dumb smile, "I'm in debt up to my eyeballs." Lowering his voice, but still smiling, he adds, "I can barely pay my finance charges." The smile doesn't leave his face as he drives a riding lawn mower, saying, "Somebody help me."

Thanks to easy credit, many Americans have been living well beyond their means. But that credit picture is beginning to change. And when you think about where the U.S. economy might be a quarter or two from now, you have to wonder how many Stanley Johnsons are out there. This isn't the stereotypical subprime borrower, with a spotty credit history and low credit score, but instead people perceived by friends and neighbors to be living the good life, some even sporting good credit scores.

I'm not sure what hard evidence there is for the notion that people with good credit are starting to run into problems with their loans (though Greenberg does related a couple of pretty compelling anecdotes). But I do know that there is plenty of statistical evidence that Americans have recently begun relying on their credit cards more than they had.

Yesterday we had a little-noticed Federal Reserve news release on consumer credit, which noted that consumer borrowing was up substantially in March. But this was only the latest report in what has clearly become a trend. The following picture illustrates.



Consumers typically start borrowing when their income starts falling (as happened in the recession of 2001). So this may be an early indicator that income growth has been slowing.

Alteratively, this new borrowing might simply be covering the long-standing gap between the growth rates of personal income and spending that I highlighted a little while ago. Until recently, it seems many households were covering that gap with mortgage equity withdrawals. Now that house prices are no longer rising, are households simply turning to their credit cards? The story is rather compelling...

Supernova News

Included for no other reason than that I think it's fascinating, I give you today's edition of Supernova News:

Astronomers spot exploding faraway star

WASHINGTON - A massive exploding faraway star — the brightest supernova astronomers have ever seen — has scientists wondering whether a similar celestial fireworks show may light up the sky much closer to Earth sometime soon.

The discovery, announced Monday by NASA, drew oohs and aahs for months from the handful of astronomers who peered through telescopes to see the fuzzy remnants of the spectacular explosion after it was first spotted last fall.

Using a variety of Earth and space telescopes, astronomers found a giant exploding star (see artist's illustration at right) that they figure has shined about five times brighter than any of the hundreds of supernovae ever seen before, said discovery team leader Nathan Smith of the University of California at Berkeley. The discovery was first made last September by a graduate student in Texas.

...Unlike other exploding stars, which peak at brightness for a couple of weeks at most, this supernova, peaked for 70 days, according to NASA. And it has been shining at levels brighter than other supernovae for several months, Smith said.

And even at 240 million light years away, this star in a distant galaxy does suggest that a similar and relatively nearby star — one 44 quadrillion miles away — might blow in similar fashion any day now or 50,000 years from now, Smith said. It wouldn't threaten Earth, but it would be so bright that people could read by it at night, said University of California at Berkeley astronomer David Pooley. However, it would only be visible to people in the Southern Hemisphere, he said.

Economics and the NFL Draft

Kevin Hasset argues that economists will do a better than sports-writers in assessing the success of teams in the NFL draft:

May 7 (Bloomberg) -- U.S. sportswriters analyzed the National Football League draft during the past week and quickly reached a consensus: The Cleveland Browns were the champs.

The Browns wowed the football establishment by choosing both highly regarded offensive lineman Joe Thomas from the University of Wisconsin and quarterback Brady Quinn from the University of Notre Dame on the first round. Yet while both players may well turn out to be outstanding, the opinionated rankings aren't worth the paper they are printed on.

Why rely on opinion when there is scientific evidence? The best available model of the football draft tells a very different story: It suggests that the Browns' draft was only the 17th best out of 32 teams. The big winner: The Oakland Raiders.

To come to this conclusion, I relied again upon a model developed by economists Richard Thaler of the University of Chicago and Cade Massey of Yale University. A year ago, I used their study to evaluate the NFL draft, and the results were amazingly on target.

On average, the teams that the model indicated had succeeded most in last year's draft won 2.25 more games in the 2006-2007 season than they had in the previous year. And the draft's losers on average lost 3.5 more games than they had the year before.

So if you really want to know which club is going to improve the most next year and which ones will fall back, you should tune out the sports geeks and tune in to the economics of football.

This logic will seem very familiar to those of you who have read Moneyball, by Michael Lewis. A lot of this type of analysis does seem to suggest that there are, to use a phrase from a saying in economics, $100 bills lying on the sidewalk. In other words, people do really have blindspots in some situations, and make less than fully-rational decisions, opening up chances for others to come in profit at their expense.

I've long thought that the implications of this reasoning for the financial markets are interesting. If people also have blindspots when they deal on the financial markets, that would imply that markets are indeed not completely efficient in all cases. That in turn suggests the possibility that there may be publicly available information that could allow one to profit in a systematic way on the financial markets, like the Oakland A's did in Moneyball.

But of course, the question of whether or not the financial markets are efficient is an age-old one, which I'm certainly not going to be able to answer. But it's tantalizing to think about...

Offshore Wind Energy

An excellent idea, in my opinion. From today's Washington Post:

Delaware Energy Debate Could Turn on the Wind

REHOBOTH BEACH, Del. -- Two hundred towering windmills, each so tall that its blades would loom over the U.S. Capitol Dome, could be built in the Atlantic Ocean near one of Washingtonians' favorite beach retreats, under a plan being considered in Delaware.

The plan, which could create the first wind "farm" in waters along the East Coast, envisions a thicket of turbines offshore of either Rehoboth Beach or Bethany Beach, Del. As the blades are spun by ocean winds, designers say, the wind farm could provide enough power every year for 130,000 homes.

The wind farm is one competitor in an unusual kind of power-plant bake-off: Delaware officials are also considering plants that would burn coal or natural gas as they seek ways to generate more electricity. A preliminary decision could be made tomorrow.

I've thought for a while that offshore wind turbines are one excellent solution to the renewable energy problem. Every time I fly in and out of Copenhagen, Denmark (which I do quite a bit since I have family there) I love seeing the offshore wind turbines in the sea near the airport (pictured at right). I find them beautiful aesthetically, but more importantly, beautiful because it's one of the only ways that one can actually watch the generation of pollution-free electricity.

Offshore wind farms have been in the news in the US recently because of the ongoing battle over the creation of such a farm in Nantucket Sound - an idea which is being bitterly resisted by many wealthy homeowners in the area. (See the picture at left for an offshore wind farm near Yarmouth, England.) It seems to be a development that can generate (pun intended) breathtaking levels of personal hypocrisy, with people who otherwise claim to care about the environment fighting the installation of efficient, carbon-emission-free wind turbines. For the most recent development in that particular saga, see this story.

That's a pity. Because really, the creation of a wind farm needs to be considered in the context of what would be built if the wind farm is not built. That's why I like the approach being taken by Delaware so much. It establishes right up front that if a wind farm is not going to be built, then a hydrocarbon-using power plant will be built. It's good that everyone be reminded of that fact.

Thoughts on Raising Japanese Interest Rates

This week's Economist has an interesting piece about the possibility that higher interest rates could cause consumer spending to rise. At least in Japan.

Saving grace

EVERY economics student learns that higher interest rates depress growth by curbing borrowing and spending. That, according to the conventional wisdom, is why the Bank of Japan (BoJ) must continue to hold interest rates at historically low levels; a rise in rates would risk tipping the economy back into recession and deflation. Yet a few brave economists believe, to the contrary, that higher interest rates would actually encourage households to spend more, not less.

...The problem is that ultra-low interest rates risk creating economic distortions, such as the excessively weak yen, asset-price bubbles, or inefficient investment. Worse, low interest rates may themselves be discouraging consumers from opening up their wallets. Debtors gain from low interest rates but savers lose, and Japanese households have the biggest stash of savings (relative to their income) among developed economies. Their net financial assets, excluding equities, amount to 3.2 times personal disposable income, compared with a ratio of only 1.9 in America and 1.1 in Germany (see left-hand chart).



...[I]n recent years, savers have earned peanuts on their assets, whereas debtors have gained relatively little from low rates, because most of their debts are at fixed rates (see right-hand chart). Tadashi Nakamae, a Japanese economist, estimates that, using 1992 as a benchmark (when interest rates were over 5%), households have suffered a cumulative net loss of interest income of over ¥200 trillion ($1.8 trillion) as a result of near-zero interest rates, equal to fully 65% of annual income. It is hardly surprising that household spending has been depressed.

There's no single, correct theoretical answer to the question of whether higher interest rates cause consumers to spend more or less; theory tells us either outcome could happen. So it really is an empirical question. And empirically, there's lots of evidence - at least for the US - to suggest that higher interest rates typically cause consumers to spend less.

But Japan is indeed a very special case, so it's worth considering the possibility that the typical empirical results might not hold there. As the Economist piece acknowledges, however, there's little chance that the BoJ will actually raise interest rates to test out this theory, if for no other reason than (thanks to the size-unknown "carry trade") it could have sharp and hard-to-predict effects on the yen/dollar exchange rate. And sudden, uncertain movements in the dollar are not something that any Asian government wants to risk right now.

April Employment Report

This morning the BLS released new employment estimates for April. The average forecast was for net nonfarm job creation of about 100,000. It turns out that that forecast was a tad optimistic, but not too far off:

Nonfarm payroll employment edged up (+88,000) in April, and the unemployment rate was essentially unchanged at 4.5 percent, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Job gains continued in several service-providing industries, including health care and food services, while employment declined in retail trade and manufacturing.

Here is a picture that shows a few key measures of the health of the overall labor market, including net new jobs and the hours per week each worker is being asked to work.



Job growth has been sluggish for several months now, and hours worked per week has shown little sign of increased labor demand.

But one of the most interesting questions for me regarding the labor market right now is the degree to which sectors of the US economy other than housing are starting to soften. To get at this question, I've put together the following picture, which shows employment growth in several of the biggest sectors of the economy (other than the government).



It's still a bit early to definitively declare that we now have clear trends (other than that construction and manufacturing employment continue to be weak - surprise surprise)... but it's certainly starting to look a bit like some of the other sectors of the economy - particularly professional and business (p&b) services and leisure/hospitality (l&h), and perhaps even retail trade - may be softening a bit.

Note that p&b services and l&h services are two of the largest sectors of employment in the economy, accounting for almost half of all private-sector job growth over the past two years. Yet recently, job creation in those sectors has fallen to levels not seen since this recovery took hold in 2003 (with the exception of the bite that Katrina took out of l&h employment in late 2005).

Early signs of contagion? Could be.

Investment and Productivity

This morning the BLS released new data on productivity growth in the first quarter of 2007. The numbers were somewhat better than expected, as Marketwatch reports:

WASHINGTON (MarketWatch) -- The productivity of the American workplace remained healthy in the first quarter, while wage costs were tame, the Labor Department estimated Thursday.

Productivity of the U.S. non-farm business sector rose at a 1.7% annual rate in the first quarter. Unit labor costs -- a key gauge of wage-push inflationary pressures -- rose 0.6% annualized, well short of expectations.

The stronger productivity and weaker labor costs that expected left economists puzzled. The quarterly productivity number was much better that the 0.8% gain expected. And economists had expected unit labor costs to jump 2.1%.

To be perfectly honest, however, quarterly productivity numbers don't do much for me. They're very volatile, and productivity is mostly important because it is the driver of long-run improvements in living standards. So I far prefer to take a much longer view at productivity than what happens in any one quarter.

Unfortunately, when you look at the trend, productivity growth has clearly slowed in the US in recent years. Over the past 2 years productivity growth has averaged about 1.7% per year. By contrast, during the first five years of the decade, productivity grew at an average annual rate of about 3%.

Could this have anything to do with the surprisingly weak business investment in new equipment and software that we've seen in recent years? The issue of weak investment was highlighted recently by Paul Krugman; for a thorough discussion of the problem see Menzie Chinn.

Take a look at the following picture. The blue line shows annualized productivity growth in the US, measured over 24 months to smooth out quarterly volatility. The red line shows the level of investment in equipment and software as a percent of GDP three years earlier. So for example, the right-hand end-points of the series indicate that productivity grew by about 1.7% over the period 2005:Q1 - 2007:Q1, and that E&S investment was about 7.3% of GDP during the four quarters leading up to 2004:Q1.



The obvious correlation between the two series is driven primarily by the large boost in investment during the period 1995-2001, and the subsequent boost in productivity growth from 1998-2004. But other periods seem to show substantial correlation as well.

What might this imply about the future? As the last picture shows, we already know what investment spending was during the period 2004-06. This may suggest something about productivity growth over the next couple of years.



If the correlation between investment spending and productivity remains consistent with experience, perhaps it would be wise to start getting used to relatively modest productivity growth numbers like the ones we received today.

Time to Propose Higher Gas Taxes?

It seems that the Congress may be starting to move toward setting higher Corporate Average Fuel Economy (CAFE) standards in the US:

Strict fuel economy rules to be argued

Michigan's two U.S. senators will defend the U.S. auto industry against a rising tide of support for tougher fuel economy rules in a Senate committee hearing today, warning that such proposals threaten jobs.

The hearing in front of the Senate's Science, Commerce and Transportation Committee will consider four competing proposals aimed at forcing automakers to improve the mileage of new cars and trucks, with targets as high as 40 m.p.g. for cars by 2017. The committee may pass one such bill as soon as next Tuesday, making it the first fuel economy proposal to hit the floor of the House or Senate in the new Democratic-controlled Congress.

Many economists - even economists who feel strongly that the government needs to take active steps to help reduce energy use in the US - are not fans of CAFE standards. But the alternative that most such economists would prefer is a higher tax on gasoline, which is generally seen as less politically palatable. Various different economists seem to agree that a good level of gasoline taxation in the US (i.e. the level of taxes that would properly account for gas consumption's social costs) would be in the neighborhood of $1 to $1.50 per gallon, compared to a national average of about 40 cents per gallon today (about half of which are federal taxes).

Interestingly, the Civil Society Institute has just published the results of a survey they took on attitudes toward gas consumption in the US. Most of the survey's results are not particularly interesting to me, since they revolve around how people might change their behavior if gas prices reach $x, and I think that people are not very good at accurately predicting their behavioral changes to such hypothetical situations. But part of the survey caught my eye. From the executive summary (pdf file):

Over half of Americans (54 percent) would support raising the taxes on gasoline sales if that revenue would be used for research into alternative fuels. This idea is more popular with women (58 percent) than it is with men (50 percent). The idea of earmarking a portion of existing federal income taxes for research into alternative fuels is a wildly popular idea among those age 18-24 (74 percent).

Could it be that American attitudes toward higher gas taxes are changing? This survey doesn't give any time trends, so it's hard to know, but these results indicate that there may be surprisingly (to me, anyway) strong support for higher gas taxes. Could the time for higher gas taxes have finally come?

The Dollar and Import Prices

Irwin Keller of Marketwatch is worried about the inflation that the falling dollar might cause:

Commentary: Why the Fed may need to raise key rate above 5.5%

The case for an increase in the federal funds rate has just been bolstered by a jump in British inflation, which has pushed the pound above $2 for the first time since 1992.

...If the Fed does not raise rates, the dollar will continue its fall against the pound as well as compared with the currencies of many other countries. Already down some 30% versus the pound since 2001, the greenback has also dropped about 15% against the Japanese yen and is down close to 40% against the euro, just to name a few.

While this may be helping economic growth by boosting our exports, it is also adding to inflation by boosting prices of imported goods. In turn, this is providing a cover for domestic firms to raise their selling prices, especially since tight labor markets and slowing productivity are increasing business costs and pressuring margins.

...As we all know, inflation here in the U.S. is well above the Fed's comfort zone of 2%. The Fed maintains that housing's woes will not spread to the rest of the economy, and thus drag it into a recession. If that's the case, then a quarter of a point hike to 5.5% may not be enough to bring our inflation to heel.

I disagree. First of all, I don't think the overall inflation rate is a growing problem right now, and (more importantly, I acknowledge!) I don't think that the Fed sees it as a growing problem. Why would they, when the growth of just about every ex-oil price index has been stable or falling for several months now?

Secondly, there's considerable evidence that degree to which exchange rate movements have translated into changes in inflation in the US (the "exchange rate pass-through" rate) has been diminishing. In other words, the falling dollar probably won't make inflation rise in the US like it once might have.

Finally, in case you're curious, here's a picture showing import prices (with and without oil) and the US exchange rate (measured by the Fed's broad trade-weighted index). Feel free to tell whatever story you like about the picture, because I don't see much of a consistent story in it. Yes, there's a little bit of a correlation (particularly during the period 2001-02), but the significant fall in the dollar over the past few years has not led to any noticeable surge in import prices.



The dollar is weakening, and may well weaken further. But I just can't get seriously worried about the prospect of this sparking any significant inflation in the US any time soon.

An Incredible Success Story

I think this picture from last week's Economist is amazing:



It's a simple little graph, a few squiggles and shapes... and yet it signifies important economic progress - real improvements in the quality of life, and real reductions in material misery - for hundreds of millions of people. Hundreds of millions of people.

I think a good argument could be made that there's nothing that we do in economics that is more important.

Speaking of Declining Consumer Spending...

Auto sales - the biggest single chunk of consumer spending - look to be faring quite poorly this spring. The Incredible Shrinking Car Company is selling still fewer cars in the US... but so is everyone else, it seems.

May 1 (Bloomberg) -- Ford Motor Co. said U.S. auto sales fell for the sixth straight month in April as the industry likely declined and gasoline prices rose.

Sales dropped 13 percent to 228,623, the Dearborn, Michigan-based company said today in a statement. Ford's truck sales slipped 5.8 percent, and its car sales were down 24 percent.

General Motors Corp. and DaimlerChrysler AG also are expected to post sales declines in April as rising gasoline prices sapped demand for new cars, according to analysts surveyed by Bloomberg.

..."April is shaping up as a particularly weak month for automotive sales," said Chicago-based Lehman Brothers analyst Brian Johnson in an April 27 report. "Lower consumer confidence, associated in part with the slowdown in the housing market, appears to be taking its toll."

So April seems to have been a bust, at least for one important part of consumer spending. There are still two months left to go in the second quarter of 2007, so anything could still happen to overall consumer spending in the next GDP report. But based on what I wrote this morning about personal income and spending, you can guess how I would bet...


UPDATE: The other major automakers have now reported their April results... and they were pretty grim. The slowdown in consumer purchases of motor vehicles was not brand-specific. Even Toyota was down. And when Toyota sales are down, it's worth taking notice.

Personal Income and Spending

Yesterday the BEA gave us some new data about personal income and spending for March of 2007. You can find the news release here, but what I want to focus on today are the reasons why I am worried about the prospects for consumption growth in the coming months.

Actually, my concerns can be summarized in a picture. The following graph shows the annual growth in consumption and in labor compensation, with both series adjusted for inflation using the PCE deflator. The red line then shows the savings rate for US households.



As I've discussed before, income growth for households that get their income through their labor has been sluggish during this economic recovery. Profits have been strong, and the income of people who get a lot of their income from their ownership of US corporations has done well... but labor income has generally struggled along at 2-3% real growth for the past several years.

Consumption growth, on the other hand, has been considerably and consistently stronger. How is that possible? There are three ways. First, households have spent an ever-growing portion of their income... so much so that by 2005 the savings rate actually turned consistently negative for the very first time. Second, some American households have enjoyed strong income growth from non-labor sources. I'm referring mostly to those profits that I mentioned above. Third, many households have used mortgage equity withdrawals to finance their consumption.

These various sources of money for households to spend have propped up consumption growth at a solid level despite relatively weak growth in labor income. But there are good reasons to guess that all three of these supports for consumption are running out.

The end of the housing boom and concomitant MEW phenomenon has been well documented by others (yes, I'm talking about Calculated Risk), so that source of money is drying up. Corporate profits have grown amazingly well in recent years, but probably can't continue that pace for much longer.

That leaves changes in the savings rate. But if anything, it is starting to seem like we are entering a phase where households will be more interested in moving their savings rate back toward zero, rather than allow it to become more negative. However, to bring the savings rate back toward zero (not to mention positive) households will have to allow several period elapse with rates of consumption growth below the rate of income growth.

Put it all together, and it seems quite likely to me that we're in for a period of slower consumption growth. And given the importance of consumption in the US's economic growth right now, that does not spell good news for the economy as a whole.