(Think of this as a guest post by the Cynic in me. I’m not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began.)
Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.
How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.
Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.
Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks’ Treasury note holdings and an increase in their cost of funds.
Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.
So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC’s policy meetings?
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Thursday, August 26, 2010
Tuesday, August 24, 2010
Do Umbrellas Cause Rain?
In a recent speech Minneapolis Fed President Narayana Kocherlakota argues that low interest rates could ultimately be dangerous in that they could lead to deflation. His argument seems bizarre to me. I’ll go through it piece by piece.
Suppose that the Fed were to keep the funds rate near zero but people began to be dissatisfied with that rate and began anticipating the 1% to 2% long-run real rate. What would happen? People would stop lending short-term money to the government at the near zero rate and instead start lending money elsewhere – for longer terms and to riskier borrowers. The more this continued, the easier it would get to borrow money. The easier it got to borrow, the more people would buy with the borrowed money, and the higher the prices of those purchases would go. And prices would continue going higher until...when?
Prices would continue going higher until they were so high that they were expected to fall. At that point, there would be expected deflation, and we would be at the long run equilibrium. There would be deflation, but it would necessarily be preceded by rising prices – that is, inflation.
However, there is no reason to expect that we would ever get to that long run equilibrium. Instead, if the Fed kept interest rates too low, we would move toward another long-run equilibrium – which Kocherlakota ignores – where money becomes worthless. In that case, the Fed could continue targeting near zero interest rates, but the rates would be meaningless, since nobody would be willing to sell anything, so there would be no reason to borrow money. Now I doubt we would actually get anywhere near that long-run equilibrium, because I think the Fed would raise interest rates long before money became worthless. But the dynamics of market responses will tend to drive toward the worthless-money equilibrium rather than the deflation equilibrium. Why would people ever start to think prices will fall after they start rising rapidly?
The Fed does have a little more information than the public does. For example, it has a better idea of how its own policies will react in the future. And perhaps it has slightly better forecasts than the public. And maybe it has a little bit of inside information about the economy. People may take Fed policies as a signal of its expectations for future inflation, and may react accordingly, but this effect is likely to be far outweighed by the actions of people who disagree with the Fed – or who find the Fed’s expectations irrelevant to their own projects – and want to take advantage of its low interest rate policy.
What does it mean to say that “the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level”? It means there will be opportunities for real investment that have more attractive expected returns. Even if the Fed’s actions lead people to increase slightly their expectations of falling prices, people will also notice these real investment opportunities and will start investing in those rather than in safe short-term investments. Or they’ll take money and spend it on consumer purchases in anticipation of continued employment. Either way, there will be more purchases made, which will tend to drive up prices, and the deflation prophecy will not fulfill itself.
Ultimately, as people notice the economy improving, they will come to expect rising rather than falling prices, no matter what the Fed does. Ultimately, the effect of having the Fed keep interest rates too low for too long will be inflation, not deflation. Of course, the Fed will notice this and then raise interest rates to slow down the economy and stop the inflation rate from rising further, so it shouldn’t be a big problem.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation.OK, so far, so good. This is just the definition of the real return: it’s the return that’s anticipated after accounting for inflation.
Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral.I’ll agree to that, although I shall subsequently quibble with his definition of “neutral.”
This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.Not necessarily true. (The long-run real return on safe short-term investments depends on a lot of things besides what the FOMC does, and we can’t say a priori that it will remain in that range.) But I’ll accept it for the sake of argument.
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition.True, as far as it goes, but in his subsequent statement he’s actually talking about superneutrality – the proposition that the growth rate of the money stock (rather than its absolute size) doesn’t affect real activity – which is not entirely uncontroversial. But let’s grant superneutrality, for the sake of argument.
In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.Here Kocherlakota seems either disingenuous or irrational. It’s true that, in a long run equilibrium where the funds rate remains near zero, it also must be the case that there is negative inflation (provided that money retains any value at all). But how do we get to that long run equilibrium? And would we ever get to that equilibrium?
Suppose that the Fed were to keep the funds rate near zero but people began to be dissatisfied with that rate and began anticipating the 1% to 2% long-run real rate. What would happen? People would stop lending short-term money to the government at the near zero rate and instead start lending money elsewhere – for longer terms and to riskier borrowers. The more this continued, the easier it would get to borrow money. The easier it got to borrow, the more people would buy with the borrowed money, and the higher the prices of those purchases would go. And prices would continue going higher until...when?
Prices would continue going higher until they were so high that they were expected to fall. At that point, there would be expected deflation, and we would be at the long run equilibrium. There would be deflation, but it would necessarily be preceded by rising prices – that is, inflation.
However, there is no reason to expect that we would ever get to that long run equilibrium. Instead, if the Fed kept interest rates too low, we would move toward another long-run equilibrium – which Kocherlakota ignores – where money becomes worthless. In that case, the Fed could continue targeting near zero interest rates, but the rates would be meaningless, since nobody would be willing to sell anything, so there would be no reason to borrow money. Now I doubt we would actually get anywhere near that long-run equilibrium, because I think the Fed would raise interest rates long before money became worthless. But the dynamics of market responses will tend to drive toward the worthless-money equilibrium rather than the deflation equilibrium. Why would people ever start to think prices will fall after they start rising rapidly?
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation.OK, that is (almost) pure nonsense. It’s true that a low fed funds rate can exist, in long run equilibrium, only if people expect deflation (or if money is worthless). But the causation goes in the opposite direction. People lend at a low interest rate because they expect deflation. People carry umbrellas because they expect rain. An equilibrium with umbrellas must include a significant possibility of rain, but we don’t say that carrying umbrellas must “lead to” rain. If we take away people’s umbrellas, it will not prevent rain, and if we require people to carry umbrellas, it will not cause rain.
The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.That is pretty much the same nonsense as above, except for one thing: perhaps people believe that the Fed knows more about the likely inflation rate than outside forecasters do. If so, people could interpret the continued low interest rates as a signal that the Fed expects deflation, and the deflation could become a self-fulfilling prophecy. If that’s what Kocherlakota means, then he isn’t insane – but he’s still wrong.
That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.
The Fed does have a little more information than the public does. For example, it has a better idea of how its own policies will react in the future. And perhaps it has slightly better forecasts than the public. And maybe it has a little bit of inside information about the economy. People may take Fed policies as a signal of its expectations for future inflation, and may react accordingly, but this effect is likely to be far outweighed by the actions of people who disagree with the Fed – or who find the Fed’s expectations irrelevant to their own projects – and want to take advantage of its low interest rate policy.
What does it mean to say that “the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level”? It means there will be opportunities for real investment that have more attractive expected returns. Even if the Fed’s actions lead people to increase slightly their expectations of falling prices, people will also notice these real investment opportunities and will start investing in those rather than in safe short-term investments. Or they’ll take money and spend it on consumer purchases in anticipation of continued employment. Either way, there will be more purchases made, which will tend to drive up prices, and the deflation prophecy will not fulfill itself.
Ultimately, as people notice the economy improving, they will come to expect rising rather than falling prices, no matter what the Fed does. Ultimately, the effect of having the Fed keep interest rates too low for too long will be inflation, not deflation. Of course, the Fed will notice this and then raise interest rates to slow down the economy and stop the inflation rate from rising further, so it shouldn’t be a big problem.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Thursday, August 19, 2010
What Housing Bubble?
How does the world economy adjust when the propensity to save exceeds the propensity to invest? It has to adjust somehow, since total saving has to equal total investment. Broadly speaking, there are two mechanisms by which it can adjust. The first is that incomes can fall, held down by weak demand from firms choosing not to invest or households choosing not to spend. (This leaves less income available for saving and thus forces total saving to fall.) The second is that asset prices can rise, bid up by savers looking for a place to put their savings. (This increases the incentive to invest and decreases the incentive to save.) Over the past decade, the world has consistently faced an environment in which the propensity to save exceeded the propensity to invest, and various nations, at various times, have adjusted by one mechanism or the other. It should be obvious – and used to be obvious, at least to mainstream economists – that the latter mechanism is preferable.
During the recent US housing boom, I was of the school that believed rising house prices were an example of that preferred mechanism taking effect. At the time, I had plenty of company. Today – now that we have transitioned to the less preferred mechanism for equating saving and investment – my cohorts all appear to have deserted. Apparently it is now generally accepted that the rise in house prices was an aberrant bubble, justified only in the minds of irrational buyers who ignored the fundamentals and expected house prices to keep rising simply because they were already rising.
But what were the fundamentals? Certainly, if one had foreseen today’s circumstances, it would have been clear that housing was not a good investment. If one had been able to say, “In a few years, the unemployment rate will rise to 10%, the inflation rate will fall to nearly zero, and policymakers will be too timid to undertake the policies necessary to reverse those trends,” then it would have been clear that 2005 was not a good time to buy a house. But that’s not what most housing bears were saying at the time. And in any case, while investors must of course do their best to anticipate actual policies, it is hardly appropriate for economists to consider the anticipation of future policy timidity as part of the intrinsic fundamentals. It is hardly reasonable to declare an episode a bubble just because investors failed to anticipate the timidity of policymakers.
Less timid policies – which are indeed advocated today by a great many of the erstwhile housing bears – would have two salient features: a commitment (in some form) to higher inflation rates over the medium run and (in pursuit thereof) an aggressive attempt to reduce interest rates across the yield curve. Under those circumstances, houses – a classic inflation hedge that could be purchased with ultra-cheap financing – would seem like a very good thing to own. If such policies were undertaken, and housing prices were to rise once again to their former level, would the bears once again declare the housing market to be a bubble? Perhaps housing prices wouldn’t rise quite so much, but some asset prices would have to rise quite a lot to bring about full employment and moderate inflation. It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude.
It is of course conventional (but wrong, in my opinion) to regard the current malaise as the result of the housing bubble’s collapse, so perhaps it will be argued that such asset-boom-inducing policies are needed now only because that housing boom already took place. That argument makes little sense to me. Back in 2003, as the housing boom was already taking form, the US economy was weak enough to raise deflation concerns at the Fed. The housing boom (along with its collateral effects on things like consumer spending) was precisely what drove the subsequent recovery and alleviated those concerns. And even with the tremendous stimulus of the housing boom, that recovery barely reached full employment and stopped far short of a macroeconomic boom. Surely, without the housing boom, the US economy would have remained weak, and we would have ended up in much the same situation we are in today.
I would challenge those who believe there was a housing bubble (which is, today, nearly everyone) to come up with a coherent and believable scenario in which those supposed bubble prices would have proven unjustified without either (1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us or (2) being replaced by a “bubble” in something else. I submit that the term “bubble” is inappropriate. What we had were the makings of an equilibrium that involved very high asset prices (and low subsequent asset returns), the only equilibrium that would have allowed saving and investment to equate at a level high enough to avoid foregoing potential aggregate income. Perhaps, in 2006, housing prices were a little bit overvalued relative to that equilibrium, while some other asset prices were a little bit undervalued; but in general, very high asset prices were a critical feature.
In any case we are far away from that equilibrium today. Asset prices are far too low to bring us anywhere near full employment. Relative to that “classical” equilibrium, asset prices are far below where they should be, and prospective asset returns are far above where they should be. That’s not to say that prospective returns are necessarily high in historical terms: in the classical equilibrium, when a lot of people (and nations and institutions) are trying to save, they bid down the returns that can be earned on those savings. And that’s just the thing: we need to get to the point where houses (and stocks and bonds and everything else that people hold for the future) are very expensive, not because prices are expected to keep rising forever but because people realize that low returns are the best deal they’re going to get. Along the way to that equilibrium, though, asset prices will have to rise. Unfortunately, current policies do not appear to be moving us in that direction – at least not very quickly.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
During the recent US housing boom, I was of the school that believed rising house prices were an example of that preferred mechanism taking effect. At the time, I had plenty of company. Today – now that we have transitioned to the less preferred mechanism for equating saving and investment – my cohorts all appear to have deserted. Apparently it is now generally accepted that the rise in house prices was an aberrant bubble, justified only in the minds of irrational buyers who ignored the fundamentals and expected house prices to keep rising simply because they were already rising.
But what were the fundamentals? Certainly, if one had foreseen today’s circumstances, it would have been clear that housing was not a good investment. If one had been able to say, “In a few years, the unemployment rate will rise to 10%, the inflation rate will fall to nearly zero, and policymakers will be too timid to undertake the policies necessary to reverse those trends,” then it would have been clear that 2005 was not a good time to buy a house. But that’s not what most housing bears were saying at the time. And in any case, while investors must of course do their best to anticipate actual policies, it is hardly appropriate for economists to consider the anticipation of future policy timidity as part of the intrinsic fundamentals. It is hardly reasonable to declare an episode a bubble just because investors failed to anticipate the timidity of policymakers.
Less timid policies – which are indeed advocated today by a great many of the erstwhile housing bears – would have two salient features: a commitment (in some form) to higher inflation rates over the medium run and (in pursuit thereof) an aggressive attempt to reduce interest rates across the yield curve. Under those circumstances, houses – a classic inflation hedge that could be purchased with ultra-cheap financing – would seem like a very good thing to own. If such policies were undertaken, and housing prices were to rise once again to their former level, would the bears once again declare the housing market to be a bubble? Perhaps housing prices wouldn’t rise quite so much, but some asset prices would have to rise quite a lot to bring about full employment and moderate inflation. It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude.
It is of course conventional (but wrong, in my opinion) to regard the current malaise as the result of the housing bubble’s collapse, so perhaps it will be argued that such asset-boom-inducing policies are needed now only because that housing boom already took place. That argument makes little sense to me. Back in 2003, as the housing boom was already taking form, the US economy was weak enough to raise deflation concerns at the Fed. The housing boom (along with its collateral effects on things like consumer spending) was precisely what drove the subsequent recovery and alleviated those concerns. And even with the tremendous stimulus of the housing boom, that recovery barely reached full employment and stopped far short of a macroeconomic boom. Surely, without the housing boom, the US economy would have remained weak, and we would have ended up in much the same situation we are in today.
I would challenge those who believe there was a housing bubble (which is, today, nearly everyone) to come up with a coherent and believable scenario in which those supposed bubble prices would have proven unjustified without either (1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us or (2) being replaced by a “bubble” in something else. I submit that the term “bubble” is inappropriate. What we had were the makings of an equilibrium that involved very high asset prices (and low subsequent asset returns), the only equilibrium that would have allowed saving and investment to equate at a level high enough to avoid foregoing potential aggregate income. Perhaps, in 2006, housing prices were a little bit overvalued relative to that equilibrium, while some other asset prices were a little bit undervalued; but in general, very high asset prices were a critical feature.
In any case we are far away from that equilibrium today. Asset prices are far too low to bring us anywhere near full employment. Relative to that “classical” equilibrium, asset prices are far below where they should be, and prospective asset returns are far above where they should be. That’s not to say that prospective returns are necessarily high in historical terms: in the classical equilibrium, when a lot of people (and nations and institutions) are trying to save, they bid down the returns that can be earned on those savings. And that’s just the thing: we need to get to the point where houses (and stocks and bonds and everything else that people hold for the future) are very expensive, not because prices are expected to keep rising forever but because people realize that low returns are the best deal they’re going to get. Along the way to that equilibrium, though, asset prices will have to rise. Unfortunately, current policies do not appear to be moving us in that direction – at least not very quickly.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Monday, August 9, 2010
What Will Happen If the Fed Stops Paying Interest on Reserves?
- Banks will try, ultimately unsuccessfully, to get rid of their reserves by exchanging them for T-bills and other safe, liquid, short-maturity assets. Collectively, they will be unsuccessful because the previous owners of those assets will deposit the proceeds back in banks, leaving them with the same level of reserves. Some of the reserves that were previously excess reserves will now be required reserves, given the higher level of deposits. Most, however, will probably still be excess reserves, as banks will continue this process only until it has driven down the yields on T-bills and similar assets to the point where those assets are no more attractive than zero-interest reserves.
- As a result, the yield on short-term T-bills (currently about 14 basis points for the 3-month bill) will go down to zero (approximately), and returns on similar assets (longer-term T-bills, top-grade commercial paper, repos, etc.) will go down to near zero. But no yields will drop by as much as 25 basis points (because none of those assets are perfect substitutes for reserves), and most will drop by considerably less.
- As a further result, yields on nearly all assets will drop very slightly, depending on how closely they substitute for reserves and how long the zero interest rate on reserves is expected to be in effect (and to what extent it was already anticipated as a possibility).
- Banks will make a few more loans. Loans are a high-return, high-risk asset, while reserves are a low-risk, low-return asset. They are not close substitutes at all, but they aren’t completely irrelevant, so banks will slightly lower the interest rates on loans (by less than 25 basis points) and probably slightly ease their credit standards and pursue lending business slightly more aggressively. Banks may also be willing to make more loans because they have more assets (due to deposits by those who sold them the T-bills and such), but this effect is also not likely to be large, since Banks’ primary constraint today is capital rather than liquidity.
- Banks will stop borrowing from GSE’s in the federal funds market, since they will no longer be able to arbitrage with the interest on reserves.
- As a result, the federal funds market will essentially disappear. Since banks are seldom, if ever, short of reserves in today’s environment, there will not be any reason for them to borrow.
- Also, GSE’s will instead purchase T-bills and similar assets, thereby contributing to the already noted small declines in yields.
- Because yields will now be far too low to cover their expenses, most money market funds will go out of business, and the few remaining will need to be subsidized heavily by their management companies (essentially operating the funds either as a courtesy to customers who use their other products or for the purpose of keeping the infrastructure and/or reputation alive so that it will be available at some future date when the funds are once again able to generate enough income to pay expenses). As implied by the first point in this list, banks will have taken over the role of money market funds. (Technically, this will amount to an increase in M-1, with little change in M-2. If there are still any M-1 fixated monetarists out there, they’ll get very excited.)
- With a much larger deposit base than they need, banks will stop encouraging customers to make deposits. Fees will go up. New fees will be introduced. The quality of customer service will go down. Nonessential features will be eliminated. Banks will no longer try to make it easy to open an account. Large depositors will no longer receive any special treatment.
- As a result, customers will, on average, hold a bit more of their cash in the form of currency rather than bank deposits. Marginal bank customers won’t bother to open accounts; customers who do have accounts will do fewer transactions; etc. (This implies an increase in the monetary base, assuming that the Fed accommodates the additional demand for currency. But note that this is not an economic stimulus, because it is demand-driven. The Fed will increase the supply of currency only enough to meet the increased demand, so there will be no change in the “value” of currency.)
- Bank customers will also participate in the declines in yields described in the third point on this list. As bank accounts will be less convenient and more costly, while money market funds will be largely gone, customers will branch out into using other assets (such as short-term bond funds) for transactions.
- Any number of other things will happen, which I haven’t thought of yet, and many of which nobody has thought of. Some will be good; some will be bad; many will be disruptive.
- The Fed’s profits will go up slightly (and therefore the federal deficit will go down slightly), since it will no longer be paying the interest on reserves.
All in all, we get a mild economic stimulus at the price of some substantial disruptions to the financial system. On my list of priorities, when the two are in conflict, the convenience of a smoothly functioning financial system comes far below the need to create jobs and resist deflation, so if eliminating interest on reserves were the only monetary stimulus option on the table, I would support it. But it’s not the only option. Perhaps if the money the Fed saves from not paying interest on reserves were to be devoted to a well-targeted fiscal stimulus, this option would be more attractive. But that isn’t likely to happen. I won’t say I’m against eliminating interest on reserves, but I’m not particularly in favor of it. Better to do more asset purchases. Much better (in conjunction with asset purchases as necessary) to announce retroactively extrapolated nominal GDP or price level targets. But is any of this going to happen?
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Inflation Targeting When the Natural Interest Rate is Negative
Over a century ago, in a theory that is still influential today, Swedish economist Knut Wicksell argued that, at any particular time, there is a certain “natural rate of interest” that is consistent with price stability. If the actual rate of interest falls below the natural rate, there is an incentive for entrepreneurs to borrow aggressively and demand more goods and more labor, driving prices up. If the actual rate rises above the natural rate, the incentive to borrow disappears, leading entrepreneurs to demand less goods and labor, driving prices down. Since the opportunities available to entrepreneurs are always changing, the natural rate is always changing, sometimes rising dramatically and at other times falling dramatically. Thus Wicksell argued that, relative to the natural rate, “the interest on money is, in reality, very often low when it seems to be high, and high when it seems to be low.”
As applied to the world we live in today, Wicksell’s original theory has several shortcomings, all widely recognized now. First, it doesn’t account for stickiness in wages and prices: as we observe, the short-run effect of a drop in demand is not so much a fall in wages and prices as a fall in employment. Second, it doesn’t account for the role of expectations in determining the price level and thus, the possibility of “inertial” inflation: it is now generally understood that (under a fiat money regime) a steadily rising price level, rather than a necessarily constant price level, is consistent with the equilibrium “natural” interest rate that Wicksell hypothesized. Third, it doesn’t fully account for the role of inflation expectations in defining the “real” interest rate: for example, a 2% nominal interest rate when prices are expected to be constant is equivalent to a 4% nominal interest rate when prices are expected to rise at a 2% rate. Finally, as I discuss below, it doesn’t account for the role of risk aversion in determining the behavior of entrepreneurs and those who finance them.
Wicksell argued that the natural interest rate was determined by the rate of return on capital. But in practice, the rate of return on capital is never known exactly in advance. Entrepreneurs require a compensation for the risk involved, and lenders (and buyers of stock and other forms of financing) require a compensation for the risk involved in financing them. As a result, particularly in times which are uncertain and when people are particularly risk-averse, there can be a very large wedge between the natural “risk-free” rate of interest and the rate of return on capital. One consequence of having such a large wedge is that, even if the return on capital is necessarily expected to be positive, the natural interest rate can be negative.
When the natural interest rate is negative, since it’s impossible to cut nominal interest rates much below zero, the only way to get back to normal is to create an expectation of inflation. If the nominal interest rate is zero and the inflation rate is positive, then the real interest rate is negative; thus it is possible, with a sufficient amount of expected inflation, to set the real interest rate down to the negative natural rate. But how can that inflation be achieved? Wicksell argues that prices rise when the actual interest rate falls below the natural rate, but in order for that to happen, prices must already be expected to rise. Can a central bank pull itself up by its own bootstraps?
The answer is almost certainly yes, since nearly everyone agrees that a sufficiently reckless central bank will always be able to produce a high inflation rate. (Imagine the Fed buying up the entire national debt, along with all the private sector’s offerings of commercial paper, mortgages, corporate bonds, and so on. Eventually, there will be inflation.) The problem is that it is hard to estimate in advance how aggressive monetary policy needs to be in order to produce the needed expectation of inflation. Not only doesn’t the central bank know what actions would produce a given “happy medium” target between too-low and too-high inflation expectations; it never really even knows what the natural interest rate is, so it doesn’t know how much inflation would be enough to get the real rate down to the natural rate.
If the central bank estimates wrong and overshoots, it risks a period of very high, and unnecessarily high, inflation. If (as seems infinitely more likely to me) it estimates wrong and undershoots, it risks reducing its credibility, so that it becomes more difficult, subsequently, to achieve the necessary inflation rate. (Note BTW that if you take the Mankiw Rule as an estimate of the natural interest rate, then the Fed’s current 2% inflation target is not high enough: the Fed is on a course to fail and thereby reduce its subsequent credibility.)
The solution is to aim not for an inflation rate but for a price level (or, as I suggested in my previous post, a level of nominal GDP). A series of price level targets that rises over time, but that does not get revised when the central bank undershoots or overshoots, allows for policy that automatically becomes more aggressive (or less aggressive) as necessary. If the central bank undershoots the first price level target, the second target is still in place, and this means it must aim for a higher inflation rate. If it undershoots the second target, the third is still in place, and it must aim for yet a higher inflation rate. And so on. Eventually, it will (automatically) find the inflation rate that works.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
As applied to the world we live in today, Wicksell’s original theory has several shortcomings, all widely recognized now. First, it doesn’t account for stickiness in wages and prices: as we observe, the short-run effect of a drop in demand is not so much a fall in wages and prices as a fall in employment. Second, it doesn’t account for the role of expectations in determining the price level and thus, the possibility of “inertial” inflation: it is now generally understood that (under a fiat money regime) a steadily rising price level, rather than a necessarily constant price level, is consistent with the equilibrium “natural” interest rate that Wicksell hypothesized. Third, it doesn’t fully account for the role of inflation expectations in defining the “real” interest rate: for example, a 2% nominal interest rate when prices are expected to be constant is equivalent to a 4% nominal interest rate when prices are expected to rise at a 2% rate. Finally, as I discuss below, it doesn’t account for the role of risk aversion in determining the behavior of entrepreneurs and those who finance them.
Wicksell argued that the natural interest rate was determined by the rate of return on capital. But in practice, the rate of return on capital is never known exactly in advance. Entrepreneurs require a compensation for the risk involved, and lenders (and buyers of stock and other forms of financing) require a compensation for the risk involved in financing them. As a result, particularly in times which are uncertain and when people are particularly risk-averse, there can be a very large wedge between the natural “risk-free” rate of interest and the rate of return on capital. One consequence of having such a large wedge is that, even if the return on capital is necessarily expected to be positive, the natural interest rate can be negative.
When the natural interest rate is negative, since it’s impossible to cut nominal interest rates much below zero, the only way to get back to normal is to create an expectation of inflation. If the nominal interest rate is zero and the inflation rate is positive, then the real interest rate is negative; thus it is possible, with a sufficient amount of expected inflation, to set the real interest rate down to the negative natural rate. But how can that inflation be achieved? Wicksell argues that prices rise when the actual interest rate falls below the natural rate, but in order for that to happen, prices must already be expected to rise. Can a central bank pull itself up by its own bootstraps?
The answer is almost certainly yes, since nearly everyone agrees that a sufficiently reckless central bank will always be able to produce a high inflation rate. (Imagine the Fed buying up the entire national debt, along with all the private sector’s offerings of commercial paper, mortgages, corporate bonds, and so on. Eventually, there will be inflation.) The problem is that it is hard to estimate in advance how aggressive monetary policy needs to be in order to produce the needed expectation of inflation. Not only doesn’t the central bank know what actions would produce a given “happy medium” target between too-low and too-high inflation expectations; it never really even knows what the natural interest rate is, so it doesn’t know how much inflation would be enough to get the real rate down to the natural rate.
If the central bank estimates wrong and overshoots, it risks a period of very high, and unnecessarily high, inflation. If (as seems infinitely more likely to me) it estimates wrong and undershoots, it risks reducing its credibility, so that it becomes more difficult, subsequently, to achieve the necessary inflation rate. (Note BTW that if you take the Mankiw Rule as an estimate of the natural interest rate, then the Fed’s current 2% inflation target is not high enough: the Fed is on a course to fail and thereby reduce its subsequent credibility.)
The solution is to aim not for an inflation rate but for a price level (or, as I suggested in my previous post, a level of nominal GDP). A series of price level targets that rises over time, but that does not get revised when the central bank undershoots or overshoots, allows for policy that automatically becomes more aggressive (or less aggressive) as necessary. If the central bank undershoots the first price level target, the second target is still in place, and this means it must aim for a higher inflation rate. If it undershoots the second target, the third is still in place, and it must aim for yet a higher inflation rate. And so on. Eventually, it will (automatically) find the inflation rate that works.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Wednesday, August 4, 2010
Nominal GDP Targeting: the 24-7 Solution
Though I’m skeptical of some of his specific proposals, Scott Sumner has convinced me that nominal GDP targeting is the way to go. I’d like to propose the following law:
I choose 2017 because it’s 10 years after the end of the last growth cycle, and I choose $24 trillion based on an approximate extrapolation of the growth rate from 1997 to 2007. (You get why I like the numbers 7 and 24, right?) This is essentially a retroactive 10-year plan for monetary policy, but it leaves all the details up to the Fed.
I’m proposing this as a law to be passed by Congress, because it’s a little bit easier for me to imagine Congress passing such a law than the Fed making such a radical change on its own. Moreover, it would have more credibility if it were written into law rather than merely an announced policy of the Fed. It does take away a little bit of the Fed’s independence, but, as Dr. Phil might say, “How’s that independent central bank thing workin’ out for ya?” It fully retains the Fed’s operational independence, and it mandates an objective based on what the Fed was already achieving over the 10 years up to 2007 (and very roughly for the prior 10 years as well).
The law would need some sort of enforcement provisions, too, but these need not constrain any specific Fed actions. The Chairman would simply have to explain to Congress, on a regular basis, how the Fed plans to get from here to there. If the plan misses in the early years, it obviously has to become more aggressive in the later years – which is the whole point: the worse things get, the more dangerous it should become for banks, businesses, and individuals to keep sitting on cash instead of investing it. (If you want to give the Fed governors a bonus based on how close they come to the target, I’m down with that, too.)
After 2017, the Fed would be free to go back to its discretion in setting long-range policy goals. But it will have an incentive to continue nominal GDP targeting. It may even ask Congress to pass another law. What incentive? To make up for the abysmal performance of 2008-2010, the 2017 goal will almost certainly require the Fed to allow an inflation rate greater than 2% – possibly much greater than 2% – as 2017 approaches. The Fed will then need a credible way to bring the inflation rate back down. What could be more credible than a promise to continue the nominal GDP pattern of the past 20 years? (Remember, the $24 trillion goal for 2017 was based on an extrapolation of the 1997-2007 trend..)
I would hope that the Fed would then elect to continue with nominal GDP targeting. In the longer run, it’s a policy that solves the problem I discussed when I wrote about inflation targets and financial crises. A financial crisis will (if history is any guide) reduce expectations of real growth. If the Fed is targeting nominal GDP, then inflation expectations should automatically increase when real growth expectations decline. This automatically gives the Fed more room to cut the real interest rate so as to clean up the economic fallout from the financial crisis. And nominal GDP targets should also help prevent such crises by reining in real growth that is driven by speculation rather than actual improvements in productivity. In such cases, inflation may not accelerate, but nominal GDP will, and this will automatically lead to an expectation of Fed tightening. Aside from the arbitrary connection with the numbers 24 and 7, nominal GDP targeting is a 24-7 solution in the sense that it reliably provides help in a variety of circumstances.
I’m hoping my law will receive bipartisan – or even tetrapartisan – support. Progressives can see it as a way to make up for the inadequacy of fiscal policy initiatives. Mainstream Democrats can see it as way to consolidate the gains of fiscal policy. Republicans can see it as an acknowledgment that Democratic fiscal policy initiatives were the wrong solution in the first place. And Tea Partiers can see it as a way to get the Fed out of the business of micromanaging the economy. I don’t really care how you sell it; it’s just a good idea. And since all but about 535 of the members of Congress read my blog...
Yes, I’m hoping that Congress will pick up ideas like this from people like Scott Sumner and me, but I’m not expecting it. I’m still long the bond market in my personal accounts. For the sake of the country, though, I’m begging Congress and the Fed. Take my capital gains. Please.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
The Board of Governors of the Federal Reserve System shall conduct monetary policy in such a way as to increase the nominal gross domestic product to approximately $24 trillion in the year 2017.
I choose 2017 because it’s 10 years after the end of the last growth cycle, and I choose $24 trillion based on an approximate extrapolation of the growth rate from 1997 to 2007. (You get why I like the numbers 7 and 24, right?) This is essentially a retroactive 10-year plan for monetary policy, but it leaves all the details up to the Fed.
I’m proposing this as a law to be passed by Congress, because it’s a little bit easier for me to imagine Congress passing such a law than the Fed making such a radical change on its own. Moreover, it would have more credibility if it were written into law rather than merely an announced policy of the Fed. It does take away a little bit of the Fed’s independence, but, as Dr. Phil might say, “How’s that independent central bank thing workin’ out for ya?” It fully retains the Fed’s operational independence, and it mandates an objective based on what the Fed was already achieving over the 10 years up to 2007 (and very roughly for the prior 10 years as well).
The law would need some sort of enforcement provisions, too, but these need not constrain any specific Fed actions. The Chairman would simply have to explain to Congress, on a regular basis, how the Fed plans to get from here to there. If the plan misses in the early years, it obviously has to become more aggressive in the later years – which is the whole point: the worse things get, the more dangerous it should become for banks, businesses, and individuals to keep sitting on cash instead of investing it. (If you want to give the Fed governors a bonus based on how close they come to the target, I’m down with that, too.)
After 2017, the Fed would be free to go back to its discretion in setting long-range policy goals. But it will have an incentive to continue nominal GDP targeting. It may even ask Congress to pass another law. What incentive? To make up for the abysmal performance of 2008-2010, the 2017 goal will almost certainly require the Fed to allow an inflation rate greater than 2% – possibly much greater than 2% – as 2017 approaches. The Fed will then need a credible way to bring the inflation rate back down. What could be more credible than a promise to continue the nominal GDP pattern of the past 20 years? (Remember, the $24 trillion goal for 2017 was based on an extrapolation of the 1997-2007 trend..)
I would hope that the Fed would then elect to continue with nominal GDP targeting. In the longer run, it’s a policy that solves the problem I discussed when I wrote about inflation targets and financial crises. A financial crisis will (if history is any guide) reduce expectations of real growth. If the Fed is targeting nominal GDP, then inflation expectations should automatically increase when real growth expectations decline. This automatically gives the Fed more room to cut the real interest rate so as to clean up the economic fallout from the financial crisis. And nominal GDP targets should also help prevent such crises by reining in real growth that is driven by speculation rather than actual improvements in productivity. In such cases, inflation may not accelerate, but nominal GDP will, and this will automatically lead to an expectation of Fed tightening. Aside from the arbitrary connection with the numbers 24 and 7, nominal GDP targeting is a 24-7 solution in the sense that it reliably provides help in a variety of circumstances.
I’m hoping my law will receive bipartisan – or even tetrapartisan – support. Progressives can see it as a way to make up for the inadequacy of fiscal policy initiatives. Mainstream Democrats can see it as way to consolidate the gains of fiscal policy. Republicans can see it as an acknowledgment that Democratic fiscal policy initiatives were the wrong solution in the first place. And Tea Partiers can see it as a way to get the Fed out of the business of micromanaging the economy. I don’t really care how you sell it; it’s just a good idea. And since all but about 535 of the members of Congress read my blog...
Yes, I’m hoping that Congress will pick up ideas like this from people like Scott Sumner and me, but I’m not expecting it. I’m still long the bond market in my personal accounts. For the sake of the country, though, I’m begging Congress and the Fed. Take my capital gains. Please.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Monday, August 2, 2010
Stop Worrying About Structural Unemployment
The economic blogosphere has suddenly become very concerned about the possibility that structural unemployment – resulting from a mismatch between the needs of employers and the capabilities of available job-seekers – has increased in the US. Paul Krugman is worried; Brad Delong is convinced; it’s obvious to Tyler Cowen; The Economist presents a variety of opinions; and any number of other bloggers and fora have been discussing the topic.
One major source of this newfound concern is a post by Dave Altig of the Atlanta Fed, who has detected a shift in the relationship between job openings and unemployment – the Beveridge curve. While the shift is unmistakable in his chart (see below), I have looked more closely at the data, and I have come to the conclusion that it does not represent a major increase in structural unemployment. Rather, I believe it represents the normal dynamics of the business cycle in the context of an incipient recovery from a historically severe recession that, in some ways, has not quite ended.
First, let’s get a clear idea of what’s going on in the chart:
Consistent with a common practice by people (including me) who plot economic data, Dave Altig has drawn a linear regression line to represent the general relationship between job openings and unemployment. But we should not therefore assume that the true relationship is a linear one. If you ignore the regression line, you can see a distinctly curved pattern to the points. We should expect a curved pattern: a strictly linear relationship wouldn’t make sense, because it would mean that, if there were enough job openings, unemployment could go below zero, and if there were enough unemployment, job openings could go below zero. In practice, when one of the series gets very low, it becomes less responsive to the other series. Thus the pattern in 2009, where the unemployment rate keeps rising while job openings become nearly flat at a very low level, is exactly what one might expect. It’s certainly what I expected, having plotted curves like this before.
But the point labeled “2010 Q2” breaks the pattern. It appears that we’ve suddenly moved off the old Beveridge curve onto a new one that has yet to be traced and that promises to associate a significantly greater amount of unemployment with any given number of job openings. But have we, really?
To answer this question, we need to think about how job openings (as well as other factors) affect the number of unemployed workers. Take a look at the actual numbers: in 2010 Q2 there were about 15 million unemployed workers and just over 3 million job openings. If all 3 million job openings were filled, it would (other things equal) reduce unemployment to about 12 million. But if you were to plot that hypothetical point on the chart, it would still be above the old Beveridge curve. So even with what seems a rather optimistic assumption about the matching process, it was inevitable, given the appearance of a comparatively large number of job openings in Q2, that they produced a point that was off the old curve. That result has nothing to do with structural unemployment; it’s just because there are many more available workers than openings.
My assumption is not really as optimistic as it seems, though, because in fact job openings fill very quickly. The May (most recent) JOLTS report, for example, shows 3.2 million job openings but 4.5 million new hires – which implies that the average job opening gets filled in less than a month. What about all those employers complaining that they can’t find people with the right qualifications? Apparently they are a minority – or else they end up settling.
If we’re looking for evidence of an increase in structural unemployment, we need to compare the rate at which openings fill today to the rate at which they filled in the past. When was the last time that there were this many job openings? In November 2008, there were 3.2 million openings but only 4.1 million hires. So job openings are filling faster now than then. You might expect them to fill faster, since there are more unemployed people with whom to fill them (15 million vs. 11 million). Indeed, the fact that they fill only a little bit faster could be taken as evidence that some of the additional unemployment is structural. But these data don’t support the idea that there has been a dramatic shift, that the pool of the unemployed is a significantly worse match for the available job opportunities than it was a few years ago. To find a point where actual hiring was happening as quickly as it is today, you have to go back to August 2008, before the fall of Lehman, when there were 3.7 million job openings.
So if 4.5 million people (equivalent to 30% of the unemployed) find jobs in a given month, how come so many people are still unemployed? Because people are losing jobs almost as quickly. That’s what I meant when I said that the recession, in some ways, has not quite ended. While the average rate of job losses during the recent recession was not particularly severe, those job losses continued for a long time (as it was a long recession) and pushed more and more people into unemployment, while there was an unusual lack of new jobs to get them out of unemployment. The new jobs are finally starting to appear, but the job losses are continuing. When I declared last year that “job losses are not the problem,” it hadn’t occurred to me how long the job losses might last. By the standards of a recovery, job losses are the problem today.
Well, part of the problem. Notice that even after the recent jump, there are fewer job openings than there were at any time during the 2001 recession, and only about as many as there were at the depth of the 2003 “job recession” that lingered after the official recession had ended. Whether you measure in terms of job losses or job openings, the job market is still depressed. There’s plenty of reason to expect persistent cyclical unemployment. Structural unemployment, not so much.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
One major source of this newfound concern is a post by Dave Altig of the Atlanta Fed, who has detected a shift in the relationship between job openings and unemployment – the Beveridge curve. While the shift is unmistakable in his chart (see below), I have looked more closely at the data, and I have come to the conclusion that it does not represent a major increase in structural unemployment. Rather, I believe it represents the normal dynamics of the business cycle in the context of an incipient recovery from a historically severe recession that, in some ways, has not quite ended.
First, let’s get a clear idea of what’s going on in the chart:
Consistent with a common practice by people (including me) who plot economic data, Dave Altig has drawn a linear regression line to represent the general relationship between job openings and unemployment. But we should not therefore assume that the true relationship is a linear one. If you ignore the regression line, you can see a distinctly curved pattern to the points. We should expect a curved pattern: a strictly linear relationship wouldn’t make sense, because it would mean that, if there were enough job openings, unemployment could go below zero, and if there were enough unemployment, job openings could go below zero. In practice, when one of the series gets very low, it becomes less responsive to the other series. Thus the pattern in 2009, where the unemployment rate keeps rising while job openings become nearly flat at a very low level, is exactly what one might expect. It’s certainly what I expected, having plotted curves like this before.
But the point labeled “2010 Q2” breaks the pattern. It appears that we’ve suddenly moved off the old Beveridge curve onto a new one that has yet to be traced and that promises to associate a significantly greater amount of unemployment with any given number of job openings. But have we, really?
To answer this question, we need to think about how job openings (as well as other factors) affect the number of unemployed workers. Take a look at the actual numbers: in 2010 Q2 there were about 15 million unemployed workers and just over 3 million job openings. If all 3 million job openings were filled, it would (other things equal) reduce unemployment to about 12 million. But if you were to plot that hypothetical point on the chart, it would still be above the old Beveridge curve. So even with what seems a rather optimistic assumption about the matching process, it was inevitable, given the appearance of a comparatively large number of job openings in Q2, that they produced a point that was off the old curve. That result has nothing to do with structural unemployment; it’s just because there are many more available workers than openings.
My assumption is not really as optimistic as it seems, though, because in fact job openings fill very quickly. The May (most recent) JOLTS report, for example, shows 3.2 million job openings but 4.5 million new hires – which implies that the average job opening gets filled in less than a month. What about all those employers complaining that they can’t find people with the right qualifications? Apparently they are a minority – or else they end up settling.
If we’re looking for evidence of an increase in structural unemployment, we need to compare the rate at which openings fill today to the rate at which they filled in the past. When was the last time that there were this many job openings? In November 2008, there were 3.2 million openings but only 4.1 million hires. So job openings are filling faster now than then. You might expect them to fill faster, since there are more unemployed people with whom to fill them (15 million vs. 11 million). Indeed, the fact that they fill only a little bit faster could be taken as evidence that some of the additional unemployment is structural. But these data don’t support the idea that there has been a dramatic shift, that the pool of the unemployed is a significantly worse match for the available job opportunities than it was a few years ago. To find a point where actual hiring was happening as quickly as it is today, you have to go back to August 2008, before the fall of Lehman, when there were 3.7 million job openings.
So if 4.5 million people (equivalent to 30% of the unemployed) find jobs in a given month, how come so many people are still unemployed? Because people are losing jobs almost as quickly. That’s what I meant when I said that the recession, in some ways, has not quite ended. While the average rate of job losses during the recent recession was not particularly severe, those job losses continued for a long time (as it was a long recession) and pushed more and more people into unemployment, while there was an unusual lack of new jobs to get them out of unemployment. The new jobs are finally starting to appear, but the job losses are continuing. When I declared last year that “job losses are not the problem,” it hadn’t occurred to me how long the job losses might last. By the standards of a recovery, job losses are the problem today.
Well, part of the problem. Notice that even after the recent jump, there are fewer job openings than there were at any time during the 2001 recession, and only about as many as there were at the depth of the 2003 “job recession” that lingered after the official recession had ended. Whether you measure in terms of job losses or job openings, the job market is still depressed. There’s plenty of reason to expect persistent cyclical unemployment. Structural unemployment, not so much.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
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