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Velocity and Rates and the Vicious Cycle Possibility

November 1, 2017 3 comments

There was a potentially important development in inflation recently, but one that was generally overlooked.

Perhaps it was mostly overlooked because it is way too early to say that a trend is developed that could cause an adverse inflation occurrence. But I think that the main reason it was overlooked is that monetary velocity is not very well understood. In particular, most people seem to think that money velocity – definitionally, the number of times a unit of money is transacted in a year, on average – is somehow tied to nervousness about the economy. So, when money velocity fell in the global financial crisis, many observers attributed that to savers stuffing dollar bills in the proverbial mattress.

There may be some role for investor/consumer uncertainty in the modeling of velocity, but at best it is a secondary or tertiary cause. The main cause of changes in velocity is simple: when the cost of holding money is high, we work hard to hold less of it, and when the cost of holding money is low, we don’t mind holding more of it. Friedman first noticed this, so it isn’t a new discovery. In monetarist speak, velocity is the “inverse of the demand for real cash balances,” and the demand for such balances depends of course on the relative cost of cash balances relative to other investments.

The chart below shows the power of this relationship. I’m using the 5-year constant maturity treasury rate, but there are obviously other investments that would get thrown into this relationship. But it’s easy to envision the effect here. When interest rates are at 6%, then money does not sit idle for very long or accumulate without limit in your bank account – you will invest those monies in, say, a 5-year CD or Treasury Note, rather than earn basically nothing in a checking account. But when interest rates are at 1%, the urge to do so isn’t as much.

What you can see in the chart is that interest rate moves tend to precede movements in money velocity, which is what we would expect from a causal relationship such as this. So the reason that money velocity plunged in the GFC wasn’t because people were scared; it was mostly because interest rates fell, taking away the incentive to invest longer-term.

Changes in money velocity, of course, tend to cause changes in inflation. MVºPQ, after all, and Q tends to be mostly exogenously determined by aggregate fiscal variables, industrial policy (what’s that?) and the like. Changes in M and changes in V tend to be reflected mainly in P over time.

Also, interest rates are affected by inflation, or more properly by the expectations of inflation. And expectations about inflation tend to follow inflation.

So, the history of the 1980s’ declining inflation can be read like this, without too much of a stretch: declining money growth under Volcker caused declining inflation initially. The decline in inflation tended to cause interest rates to decline. Declining interest rates tended to cause declines in money velocity. Declining money velocity tended to cause declines in inflation…and we were in a virtuous cycle that extended, and extended, and extended, until we were close to zero in interest rates and inflation, and money velocity was as low as it has ever been.

Now, you can see from this chart that interest rates bottomed in 2013, but really have not appreciably risen above the lows, and so money velocity hasn’t reversed its slide although since the beginning of last year the trajectory has been slowing (I suspect some nonlinearity/stickiness of this relationship near zero). But the GDP report from last Friday, combined with recent money growth and increase in the price deflator, implied that money velocity actually rose slightly.

It has nudged higher before, but not by very much. And this is why I am reluctant to make a huge deal about this being the start of something, except that this is the first time since 2008 that there has been a reasonable expectation that interest rates might continue to rise because the central bank wishes it so.

And so I don’t think it’s wrong to consider the “what if” of the next cycle. Normalization of interest rates implies normalization of velocity, and there’s just no way to get appreciably higher velocity without higher inflation. Higher inflation would probably produce higher interest rates, because however much your expectations about inflation are “anchored” they are likely to become unanchored if inflation of 3%-4% starts to print. Higher interest rates could lead to higher velocity, and we have a cocktail for the opposite of the 1980s virtuous interest rate cycle.

This speculation isn’t destiny, and a lot depends on whether interest rates start to move higher and by how much. But there is already starting to be some concern about inflation and the FRBNY’s “Underlying Inflation Gauge” has recently gone to new post-crisis highs (see Chart above, source Bloomberg), so I don’t think it is unreasonable to consider and prepare. Because the best case for the next inflation uptick is that it rises a bit and falls back. But there are elements in place that support a much worse case, and that is a feedback loop through interest rates and velocity. The chances of that outcome are considerably higher than zero.


Note: these articles are now first released on my private Twitter feed, which you can subscribe to for only $10 per month here. Subscribers also get my real-time tweet analysis on the monthly CPI report, which are not on my public feed, and I am working on adding a free chart package to the mix as well.

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Summary of My Post-CPI Tweets (Oct 2017)

October 13, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • Friday the 13th and a heavy data day. What could go wrong?
  • 10y breakevens at local highs of 1.90% – but that’s the biggest spread over core CPI in several years.
  • …yet we still have 10y TIPS 50bps to fair at this level of interest rates.
  • Economist expectations are for 0.21% on core and 1.78% y/y. Interesting given how low it has been recently.
  • I don’t usually look at headline but the y/y number is forecast to jump to 2.3% from 1.9%. That will get some attention.
  • I think the market forecasts are about right for core, but there’s a wide range of upside risks. Autos are due to catch up, e.g.
  • But that’s why the forecasts make sense. 0.15% for trend plus 0.05% for expected value of risks.
  • …in turn, that means the point forecasts are not the most likely prints. They’re in between the most likely prints.
  • Core +0.13%, 1.69% y/y.
  • Breakdown will be interesting. Housing broad category went to 2.79% y/y from 2.91%. Medical Care fell to 1.56% from 1.81%.
  • Used cars/trucks went to -3.7% vs -3.8% y/y, so that rebound is still ahead of us. Surveys of car prices are up a lot, just not in BLS yet.
  • pulling in the breakdown now…core services 2.6% from 2.5%, but core goods deflation deepens to -1.0% from -0.9%.
  • Core goods deflation, however, ought soon to be rising again after the lagged effect of the dollar’s decline passes in.
  • In Housing, Primary Rents plunged to 3.78% from 3.88%. That’s huge. OER dropped to 3.18% from 3.27%. Also huge. There’s your story.
  • Core ex-housing rose to 0.58% vs 0.52% y/y, so there’s more going on here but the housing. Wow.
  • A few months ago we had y/y OER fall by more, but that was when OER was overextended.
  • Here is primary rents y/y. I guess this isn’t DRAMATIC – just quite contrary to my own expectations for a continuation of the rebound.

  • In Medical Care, Medicinal Drugs fell to 1.01% from 2.51%. Wow! But Professional Services and Hospital Services accelerated slightly.
  • Here’s CPI for pharma. Think we’ve discussed this before – likely compositional in nature, more generics thanks to worse insurance.

  • Professional services (doctors) bounced;not significant. Also somewhat compositional as old doctors quit rather than take ins. headaches.

  • College Tuition 2.08% vs 1.89%. Have I mentioned the new S&P Target Tuition Inflation Index recently? 🙂
  • Just b/c …who can get enough of wireless telecom services? Bounced, mostly base effect of course. Bottom line was that dip was a 1-off.

  • New cars also still deflating, BTW. -1.0% vs -0.68%. Obviously this will change with Houston buying loads of new cars.
  • Speaking of Houston: core CPI in Houston y/y ended June: 1.31%. For y/y ended Aug: 1.90%. But that’s actually before Harvey.
  • In Miami, 2.01% vs. 2.26% (June vs August). Have to wait a bit to get October numbers – they’ll come out in Dec.
  • Bottom line on the storms is that we haven’t seen the impact yet on CPI. Still to come.
  • My early estimate of Median CPI is 0.20%, bringing y/y up to 2.17% from 2.15%.
  • Housing and Medical Care still keeping pressure on core.

  • Interestingly, these other categories, including Food, and Energy too, all saw acceleration this month (except for other).

  • distribution of changes getting more spread out…

  • Percentage of basket over 3% hasn’t changed much, ergo median didn’t change much.

  • Does this change the Fed’s calculus? I don’t think so, especially with wages accelerating. Still waiting for one-offs to unwind.
  • The doves will argue that the unwind of a one-off is itself a one-off and we should therefore look thru and see 0.12-0.14 as the trend.
  • They’re unlikely to carry the day in Dec, even if the data don’t bounce higher. But if core stays weak the mkt will unwind the 3 in 2018.
  • 10y breakevens -3bps since the number. Market had seemed a little long but this is still too low for breakevens.
  • Four pieces. Piece 1: Food & Energy

  • Piece 2: core goods. Won’t go down forever with the dollar well off its highs.

  • Core services less ROS. A bounce. Sustainable? We’ll have to see.

  • Piece 4, Rent of Shelter. Seemingly ignoring continued rise in home prices. Back to model but weaker than I expected.

  • Last chart. here is the argument: do we cheer the weak consumer inflation or worry about higher wages?

  • Yes, wages follow inflation rather than lead…but the Fed doesn’t believe that.

Thanks to everyone who followed my new “premium” (but cheap) channel. I wrote on Wednesday about the reason for changing my Tweet storm; in a nutshell, it’s because research is starting to be priced a la carte at the major dealers and hopefully this means that quality but off-Street analysis might finally be competing on an even footing rather than competing with “free.” If you think there’s value in what I do, I’d appreciate a follow. If not…well, if the market tells me that what I’m producing isn’t worth anything, then I’ll stop producing it of course!

But in the meantime, here is the story of CPI this month. A continuing regression of rents and OER to model levels held core down to recent-trend levels. But there are many one-off and temporary effects that are due to be reversed, and relationships that suggest certain components are due to catch up to underlying realities. For example, here is the picture of Used Cars and Trucks CPI, compared to the Manheim Used Vehicle Value Index 4 months prior.

According to the relationship between these series over the last decade, CPI for Used Cars and Trucks should be growing about 5% faster than it is presently, and rise another 3-4% in the next few months. New and Used Motor Vehicles inflation is about 8% of core CPI, so this effect alone could add 0.7% to core CPI! Or, put another way, right now core CPI is about 0.4% lower than it would be if the CPI was measuring the actual price of vehicles the same way that Manheim does it. That’s a big number when the entire core CPI is only 1.7%.

The continued, and actually extended weakness in core goods is also due to reverse. I don’t mean that core goods inflation will go from -1% to +3% but only to 0.5%. But that 150bp acceleration, in one-quarter of the core CPI, would also raise core CPI by 40bps or so. To be sure, there is some double-counting since a third of core commodities is new and used vehicles, but that merely reinforces the message.

So, too, are the effects in medical. Volatility in those series should persist, which means that since they are at a low ebb there’s a better bet that the next volatile swing is to higher prices.

All of which is to say that the hawks on the Federal Reserve Board actually have it right, in a sense. Prices are headed higher, and inflation is accelerating. It would be a truly shocking development if core inflation one year from now was unchanged from the current level. Indeed, I think there is a better chance that core inflation is above 2.7% than below 1.7%. On another level, the hawks aren’t quite right though. By hiking rates before draining excess reserves, the Fed risks kicking off the vicious cycle I have mentioned before: higher rates cause higher money velocity, which causes higher inflation, which causes higher rates etc. Without control of reserves at the margin, the Fed cannot control money supply growth and so the normal offset to rising monetary velocity in a tightening cycle, slowing money growth, comes down to chance. Either way, the Fed is very likely to tighten in December, but beyond that it probably matters more who ends up in the Chairman’s seat than anything economic data.

The Mystery of Why There’s A Mystery

October 10, 2017 Leave a comment

We have an interesting week ahead, at least for an inflation guy.

Of course, the CPI statistics (released this Friday) are always interesting but with all of the chatter about the “mystery” of inflation, it should draw more than the usual level of attention. That’s especially true since the mystery will cease to be a mystery fairly soon as even flawed indicators of inflation’s central tendency, such as the core CPI, turn back higher. This is not particularly good news for many pundits, who have declared the mystery to be solved with some explanation that implies inflation will stay low.

  • “Amazon effect”
  • Globalization
  • “competition”
  • Etc

The first of these I have addressed previously back in June (“The Internet Has Not Killed, and Will Not Kill, Inflation”). The second is a real effect, but it is a real effect whose effect peaked in the early 1990s and has been waning since then. I wrote something in our quarterly in Q4 last year, which is partly summarized here.

The “competition” objection is a weird one. It seems to posit that competition was pretty lame until recently, which is pretty strange. One argument along these lines is in this article by Steve Wunsch, who considers the increase in airline fees “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition.” This is odd, since airlines were deregulated in 1978 and have in recent years become less competitive if anything with the mergers of Delta/Northwest in 2009, United/Continental in 2010, Southwest/AirTran in 2011, and US Airways/American Airlines in 2013. A flaccid antitrust response from the Justice Department has allowed quasi-monopolies to develop in some travel hubs, which has tended to push fares higher rather than lower. The chart below shows the relationship between Jet Fuel prices and the CPI for airfares (both seasonally adjusted) for the 20 years ended in 2014, along with the most-recent point from last month.

The highly-explanatory R-squared of 0.81 suggests that there is not much wiggle room in airline pricing. Airfares are, as you would expect under a competitive industry, roughly cost-plus with the main source of variance being jet fuel prices. This is true even though we would expect that spread to vary over time. As Mr. Wunsch would argue, the highly competitive nature of the industry is holding down the non-commodity price pressures in airfares.

The only problem is that if you extend this graph to include the last three years, the R-squared drops about 10 points:

In case it isn’t clear from that chart, the last three years have seen airfares increasingly above what we would expect from the level of jet fuel prices. The next chart makes that clear I hope by plotting the residual (and 12-month moving average to smooth out seasonal issues such as one that evidently happened last month) between the actual CPI-airfare and the level that would be predicted from the 1994-2014 relationship. As you can see, prices have been higher, and increasingly so, than we would have thought, until this last month or two – and I wouldn’t grab a lot of comfort from that yet.

Not only is this not “stark evidence of a deflationary spiral in those ticket prices caused by antitrust-induced competition,” it seems to be stark evidence of inflation in ticket prices caused by a reduction in competition thanks to airline mergers.

In reading these many articles, it always is somewhat striking to me: everybody thinks their answer is “the” answer to the mystery. But most of these authors really don’t sufficiently understand how inflation works, and what the data is showing. This is apparent to those who do understand these nuances, as an author might discuss (as the one mentioned above did) an “aberration” in cell phone inflation as if the experts are stupid for expecting inflation when cell phone services only go down. The author clearly misunderstands what the “aberration” referred to even is; in this case the aberration was an enormous one-month collapse in prices that had never been seen and has not been repeated since. (For those who are curious about the aberration, and why it occurred, and why it is likely a methodology issue rather than sign of spiraling deflation in wireless services you can see my discussion of it here.)

The mystery is simple – the Fed’s models don’t work, and don’t take into account the fact that lower interest rates cause lower money velocity. They rely on a Phillips Curve effect that they think is broken because they don’t understand that the Phillips Curve relates wages and unemployment, not consumer prices and unemployment. They focus on a flawed measure like PCE rather than on something like Median CPI which, coincidentally, is a lot higher and suggests more price pressures. The mystery isn’t why inflation isn’t rising yet – the mystery is why they think there’s a mystery.

Money and Credit Growth Update

September 19, 2017 Leave a comment

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It has been a challenging few years to be a monetarist. That isn’t because monetarist predictions have failed, but rather because monetarists have had to spend a lot of time explaining why money velocity has been declining (the answer is: low interest rates) and why “printing money” hasn’t led to runaway inflation (the answer is: inert reserves don’t count, but M2 money growth has been growing between 5%-8% for the last 5 years and that would be too fast for stable prices if velocity was stable).

Money velocity declines when interest rates decline because the demand for real cash balances increases when the opportunity cost of those cash balances is low. That is, if interest rates are at 10%, then you won’t leave cash sitting around idle; it becomes a hot-potato and either gets reinvested in term loans or other assets, or spent. On the other hand if term interest rates are at 0%, then what’s the hurry? The chart below (source: Bloomberg) shows the simple relationship since the early 1990s between 5-year Treasury rates and M2 velocity. This is not a mystery – it has been a critical part of monetarist theory since the 1970s.

You can see that there is a modest conundrum, since interest rates bottomed a couple of years ago but money velocity has continued to sag. I don’t see this as a major mystery; it makes sense to me that there could be some nonlinearities in this relationship near and below the 0% level that we just don’t have enough data to resolve. These nonlinearities have certainly made forecasting more difficult and led generally to forecasts that were modestly too high compared with actual inflation outturns. Again, there’s no mystery about why the forecast misses – the mystery is why money velocity has remained low while interest rates have bounced (we believe economic policy uncertainty has led people to hold somewhat higher real cash balances than they otherwise would, but that’s just a hypothesis). At some point, higher interest rates will snap money velocity back as it gets too ‘expensive’ to leave cash balances sitting around. But this hasn’t happened yet.

Meanwhile, money growth has been slowing. It is still rising faster than 5% per annum, which means that if money velocity was stable and potential GDP growth is 2.5% then we would see the GDP Deflator rising at 2.5%. So money growth is still a bit too fast, unless money velocity is going to decline forever. But it is better at 5% than at 8%, to be sure.

Credit growth has also been slowing, as the chart below (source: Federal Reserve) shows.

Now, regardless of what you read credit growth has essentially no relation to money velocity. Obviously, credit growth has been fairly rapid – as money velocity continued to sag – and is now slowing – as money velocity has continued to sag. It is moderately better connected to M2 growth, so it tends to reinforce the notion that money growth is slowing somewhat, but people who are saying that velocity will continue to slow because banks are slowing loan growth need to explain why rapid growth didn’t lead to velocity acceleration. One-way relationships in economics are pretty rare.

I doubt very seriously that M2 growth is about to drop off a cliff. The Fed’s rate hikes and any balance sheet reduction is not going to affect money supply growth while bank reserves are still “abundant,” to use the Fed’s phrase. Banks are neither capital nor reserve-constrained at the moment, so a decline in credit growth is either coming from the supply side as banks voluntarily reduce loan growth perhaps because credit quality is diminishing, or it is demand side as borrowers are not seeing the growth opportunities that require financing. Money growth is still, and always, something to keep an eye on. But, just as changes in velocity dominated changes in money growth when velocity was falling, velocity changes will dominate changes in money growth when (if?) money velocity starts to rise. As the first chart above shows, velocity when interest rates were “normal” was around 1.8 or higher. I invite you to go to the calculator on the Enduring Investments website and play around using a starting money velocity of 1.43 to see what sort of money supply contraction is required to keep inflation low, if velocity returns to 1.80 over some period of time.

And then, realize that M2 has not declined on a y/y basis as far back as the Fed has records on FRED (about 1960). It seems unlikely to do so now. This leaves few low-inflation exit paths as long as money velocity isn’t permanently dead.

I think the decline in credit growth has implications, but they are mainly implications for growth and not for inflation. Along with the weakness that is starting to be seen in some other areas of the economy (e.g. autos, until the hurricanes caused some “forced replacement”), I think this could be seen as a harbinger of a potential recession in 2018.

Categories: Causes of Inflation Tags: ,

Some Effects on Inflation from Harvey and Irma

September 11, 2017 3 comments

It has been a rough few weeks. First, Hurricane Harvey drenched Houston and south Texas with feet of rain, turning millions into temporary refugees and tens of thousands of them into longer-term refugees as 40,000 homes were destroyed along with a million automobiles. Then, Hurricane Irma battered Miami and Tampa Bay, which is a rare feat, and seems likely to make it the fourth most-damaging hurricane in nominal dollar terms in US history (behind Katrina, Sandy, and Harvey).

And of course, there’s the memorial of September 11th. I once thought that this day would someday become less raw, but remarkably the passage of time has not applied the usual salve in this case. I don’t know why. But the terrorist attacks of that day no longer affect the markets, so we nod and somberly reflect, and move on.

But those other two events will have an impact on markets and on data. Interestingly, the initial response to Irma was a strong rally in equity markets, as the damage was not as great as originally feared – perhaps $50bln, rather than $250bln, in damages. Aside from the human toll, whose value is beyond accounting, this is potentially a large figure for insurance companies and owners of catastrophe bonds (or what is left of them) but a mere scratch on the GDP of the nation as a whole. The total cost of the two hurricanes will be something in the neighborhood of 1% of GDP – although very unevenly distributed.

It is de rigeur in times like these to point out that GDP will increase over time with the expenditure of rebuilding, but of course the nation is not better off and so this is not good for the economy. More thoughtful models note that the national accounts gain that 1% back over the next few years, but local production from the affected areas is at least temporarily reduced so that the net effect is actually somewhat negative over the next several years. The net effect overall is small…but very unevenly distributed.

Some of the upward inflation pressure from the hurricanes comes from the additional pressure in commodities markets. Demand for steel and wood are likely to be elevated as these areas rebuild. For a short time, there will be higher prices for these things locally, and for gasoline, due to the difficulty of delivery to the affected communities. The additional demand might even cause some marginal pressure in commodities markets for industrial metals (e.g.). But in the longer-term there will be no shortage of these items because these goods are bought and sold on international markets and are easily delivered to ports in Houston, Miami, and Tampa Bay. It just takes some time to get the logistics train running. But the uneven distribution of the damage will matter in other ways. For example, there is no way to take a surplus of shelter in one area of the country and move it to another area (mobile homes excepted). Those 40,000 homes in Texas and thousands of others in Florida will need to be rebuilt in situ. Many others will need significant repairs to be nominally habitable. This will not happen overnight, which means that there is an abrupt shelter shortage in Houston and in Florida, and this can be expected to affect inflation.

It is very hard to assess just how much shelter inflation can be expected to follow from these storms. There aren’t many major hurricanes, and for each data point there are lots of other effects that get entangled so that my thoughts here are clearly speculative. But consider the chart below (Source: BLS), which shows Houston-area Shelter CPI (year/year) and compares it to the national Shelter CPI.

In September 2008, when Hurricane Ike hit Texas, housing prices nationally were already decelerating. They had remained elevated in Houston up to that point – thanks in part to $120/bbl oil – but probably would have rolled over almost immediately when the global financial crisis smashed energy markets along with housing markets. Yet, in Houston home prices actually accelerated over the next year before finally declining in late 2009. This is likely to be a side-effect of Ike, and I think we will see similar effects in the cost of shelter in Houston, Miami, and Tampa Bay this time too. This will likely provide a small upward lift to national Shelter prices and hence core CPI over the next year.

The other way that the hurricanes will help push core CPI higher is by helping to alleviate the recent pressure on motor vehicle prices. As the chart below (Source: BLS) shows, new and used vehicle inflation has not been a significant contributor to inflation since early 2012, thanks partly to years of channel-stuffing by manufacturers offering 0% financing along with great lease terms for those who don’t want to buy.

But consider late 2009. The “Cash for Clunkers” program, which took effect in mid-2009, provided cash rebates for consumers to swap used cars for new cars. While largely considered a failure as a stimulus plan, it did produce a sharp increase in motor vehicle prices overall. Prior to C4C, motor vehicle prices were stagnant; by the program’s end prices were rising and they kept rising for some time, at a rate of about 5% per annum between late 2009 and late 2010 – about 4% faster than core inflation at the time. Cash-for-Clunkers took about 700,000 cars off the road. Harvey is taking out about a million. Though those are all in Texas cars, unlike houses, are mobile and surplus inventories will surely be shipped southward with alacrity.

I don’t know why this is a bullish thing for the equity market. But I understand why inflation swaps are at three-month highs and headed higher.

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Some Further (Minor) Thoughts on the Phillips Curve

September 6, 2017 3 comments

Before I begin, let me say that if you haven’t read yesterday’s article, please do because it represents the important argument: the Phillips Curve doesn’t need rehabilitating, because it is working fine. In fact, I would argue that the Phillips Curve – relating wages to unemployment – is a remarkably accurate economic model prediction. The key chart from that article I reproduce here, but the article (which is brief) is worth reading.

Following my publication of that article, I had a few more thoughts that are worth discussing on this topic.

The first is historical. It’s incredibly frustrating to read article after article incorrectly stating what the Phillips Curve is supposed to relate. Of course one writer learns from another writer until what is incorrect becomes ‘common knowledge.’ I was fortunate in that, 30 years ago, I had excellent Economics professors at Trinity University in San Antonio, and I was reflecting on that fact when I said to myself “I wonder if Samuelson had it right?”

So I dug out my copy of Economics by Samuelson and Nordhaus (the best-selling textbook of all time, I believe, and the de rigeur Intro to Economics textbook for generations of economists). My copy is the 12th Edition, so perhaps they have corrected this since then…but on page 247, there it is – the Phillips Curve illustrated as a “tradeoff between inflation and unemployment.” Maybe that is where this error really propagated – with a Nobel Prize-winning economist making an error in his incredibly widely-read text! Interestingly, the authors don’t reference the original Phillips work, but refer to “writers in the 1960s” who made that connection, so to be fair to Samuelson and Nordhaus they were possibly already repeating an error that had been made even earlier.

My second point is artistic. In yesterday’s article, I said “The Phillips Curve…simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand,…” But students of economics will note that the Phillips Curve seems to obfuscate this relationship, because it is sloping the wrong way for a supply curve – which should slope up and to the right rather than down and to the right. This can be remedied by expressing the x-axis of the Phillips Curve differently – making it the quantity of labor demanded rather than the quantity of labor not demanded…which is what the unemployment rate is. So the plot of wage inflation as a function of the Employment Rate (as opposed to the Unemployment Rate) has the expected shape of a supply curve. More labor is supplied when the prices rise.

Again, this is nuance and not a really important point unless you want your economics to be pretty.

My third point, though, is important. One member of the bow-tied fraternity of Ph.D. economists told me through a friend that “the Phillips Curve has evolved to the relationship between Unemployment and general prices, not simply wages.” I am skeptical of any “evolution” that causes the offspring to be worse-adapted to the environment, but moreover I would argue that whoever led this “evolution” (and as I said above, it looks like it happened in the 1960s) didn’t really understand the way the economy (and in particular, business) works.

There is every reason to think that wages should be tied to available labor supply because one is the price of the other. That’s Microeconomics 101. But if unemployment is going to be a good indicator of generalized price inflation too, then it means that prices in the economy are essentially set as the price of the labor input plus a spread for profit. That is not at all how prices are set. Picture the businessperson deciding how to set prices. According to the “evolved Phillips Curve” understanding, this business owner looks at the wages he/she is paying and then sets the price of the product. But that’s crazy. A business owner considers labor as one input, as well as all of the other inputs, improvements in productivity in producing this good or service in question, competitive pressures, and the general state of the national and local economy. It would be incredible if all of these factors canceled out except for wage inflation, wouldn’t it? So in short, while I would expect that unemployment might have some explanatory power for inflation, I wouldn’t expect that explanatory power to be very strong. And, in fact, it isn’t. (But this isn’t new – it never has had any power.)

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The Phillips Curve is Working Just Fine, Thanks

September 5, 2017 2 comments

I must say that it is discouraging how often I have to write about the Phillips Curve.

The Phillips Curve is a very simple idea and a very powerful model. It simply says that when labor is in short supply, its price goes up. In other words: labor, like everything else, is traded in the context of supply and demand, and the price is sensitive to the balance of supply and demand.

Somewhere along the line, people decided that what Phillips really meant was that low unemployment caused consumer price inflation. It turns out that doesn’t really work (see chart, source BLS, showing unemployment versus CPI since 1997).

Accordingly, since the Phillips Curve is “broken,” lots of work has been done to resurrect it by “augmenting” it with expectations. This also does not work, although if you add enough variables to any model you will eventually get a decent fit.

And so here we are, with Federal Reserve officials and blue-chip economists alike bemoaning that the Fed has “only one model, and it’s broken,” when it never really worked in the first place. (Incidentally, the monetary model that relates money and velocity (via interest rates) to the price level works quite well, but apparently they haven’t gotten around to rediscovering monetarism at the Fed).

But the problem is not in our stars, but in ourselves. There is nothing wrong with the Phillips Curve. The title of William Phillips’ original paper is “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” Note that there is nothing in that title about consumer inflation! Here is the actual Phillips Curve in the US over the last 20 years, relating the Unemployment Rate to wages 9 months later.

The trendline here is a simple power function and actually resembles the shape of Phillips’ original curve. The R-squared of 0.91, I think, sufficiently rehabilitates Phillips. Don’t you?

I haven’t done anything tricky here. The Atlanta Fed Wage Growth Tracker is a relevant measure of wages which tracks the change in the wages of continuously-employed persons, and so avoids composition effects such as the fact that when unemployment drops, lower-quality workers (who earn lower wages) are the last to be hired. The 9-month lag is a reasonable response time for employers to respond to labor conditions when they are changing rapidly such as in 2009…but even with no lag, the R-squared is still 0.73 or so, despite the rapid changes in the Unemployment Rate in 2008-09.

So let Phillips rest in peace with his considerable contribution in place. Blame the lack of inflation on someone else.

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