Archive for the ‘Theory’ Category

A (Very) Long History of Real Interest Rates

December 23, 2016 2 comments

One of the problems that inflation folks have is that the historical data series for many of the assets we use in our craft are fairly short, low-quality, or difficult to obtain. Anything in real estate is difficult: farmland, timber, commercial real estate. Even many commodities futures only go back to the early 1980s. But the really frustrating absence is the lack of a good history of real interest rates (interest rates on inflation-linked bonds). The UK has had inflation-linked bonds since the early 1980s, but the US didn’t launch TIPS until 1997 and most other issuers of ILBs started well after that.

This isn’t just a problem for asset-allocation studies, although it is that. The lack of a good history of real interest rates is problematic to economists and financial theoreticians as well. These practitioners have been forced to use sub-optimal “solutions” instead. One popular method of creating a past history of “real interest rates” is to use a nominal interest rate and adjust it by current inflation. This is obvious nonsense. A 10-year nominal interest rate consists of 10-year real interest rates and 10-year forward inflation expectations. The assumption – usually explicit in studies of this kind – is that “investors assume the next ten years of inflation will be the same as the most-recent year’s inflation.”

We now have plenty of data to prove that isn’t how expectations work – and, not to mention, a complete curve of real interest rates given by TIPS yields – but it is still a popular way for lazy economists to talk about real rates. Here is what the historical record looks like if you take 10-year Treasury rates and deflate them by trailing 1-year inflation:

dumbrealThis is ridiculously implausible volatility for 10-year real rates, and a range that is unreasonable. Sure, nominal rates were very high in the early 1980s, but 10%? And can it be that real rates – the cost of 10-year money, adjusted for forward inflation expectations – were -4.6% in 1980 and +9.6% in 1984? This hypothetical history is clearly so unlikely as to be useless.

In 2000, Jay Shanken and S.P. Kothari wrote a paper called “Asset Allocation with Conventional and Indexed Bonds.” To make this paper possible, they had to back-fill returns from hypothetical inflation-linked bonds. Their method was better than the method mentioned above, but still produced an unreasonably volatile stream. The chart below shows a series, in red, that is derived from their series of hypothetical annual real returns on 5-year inflation-indexed bonds, and backing into the real yields implied by those returns. I have narrowed the historical range to focus better on the range of dates in the Shanken/Kothari paper.


You can see the volatility of the real yield series is much more reasonable, but still produces a very high spike in the early 1980s.

The key to deriving a smarter real yield series lies in this spike in the early 1980s. We need to understand that what drives very high nominal yields, such as we had at that time in the world, is not real yields. Since the real yield is essentially the real cost of money it should not ever be much higher than real potential economic growth. Very high nominal yields are, rather, driven by high inflation expectations. If we look at the UK experience, we can see from bona fide inflation-linked bonds that in the early 1980s real yields were not 10%, but actually under 5% despite those very high nominal yields. Conversely, very low interest rates tend to be caused by very pessimistic real growth outcomes, while inflation expectations behave as if there is some kind of floor.

We at Enduring Investments developed some time ago a model that describes realistically how real yields evolve given nominal yields. We discovered that this model fits not only the UK experience, but every developed country that has inflation-linked bonds. Moreover, it accurately predicted how real yields would behave when nominal yields fell below 2% as they did in 2012…even though yields like that were entirely out-of-sample when we developed the model. I can’t describe the model in great detail because the method is proprietary and is used in some of our investment approaches. But here is a chart of the Enduring Investments real yield series, with the “classic” series in blue and the “Shanken/Kothari” series in red:


This series has a much more reasonable relationship to the interest rate cycle and to nominal interest rates specifically. Incidentally, when I sat down to write this article I hadn’t ever looked at our series calculated that far back before, and hadn’t noticed that it actually fits a sine curve very well. Here is the same series, with a sine wave overlaid. (The wave has a frequency of 38 years and an amplitude of 2.9% – I mention this for the cycle theorists.)


This briefly excited me, but I stress briefly. It’s interesting but merely coincidental. When we extend this back to 1871 (using Shiller data) there is still a cycle but the amplitude is different.


So what is the implication of this chart? There is nothing predictive here; about all that we can (reasonably) say is what we already knew: real yields are not just low, but historically low. (Current 10-year TIPS yields are higher than our model expects them to be, but not by as much as they were earlier this  year thanks to a furious rally in breakevens.) Money is historically cheap – again, we knew this – in a way it hasn’t been since the War effort when nominal interest rates were fixed by the Fed even though wartime inflation caused expectations to rise. With real yields that low, how did the war effort get funded? Who in the world lent money at negative real interest rates like banks awash in cash do today?

That’s right…patriots.

1986-004-223Frankly, that makes a lot more sense than the reason we have low real interest rates today!

Categories: Good One, Investing, Theory, TIPS

Why Does the Fed Focus on a Flawed PCE?

On Friday, I was on Bloomberg TV’s “What’d You Miss?” program to talk about the PCE inflation report from Friday morning. You can see most of the interview here.

I like the segment – Scarlet Fu, Oliver Renick, and Julie Hyman asked good questions – but we had to compress a fairly technical discussion into only 5 or 6 minutes. As a result, the segment might be a little “wonky” for some people, and I thought it might be helpful to present and expand the discussion here.

The PCE report itself was not surprising. Core PCE came in as-expected, at 1.7%. This is rising, but remains below the Fed’s 2% target for that index. I think it is interesting to look at how PCE differs from CPI to see why PCE remains below 2%. After all, core PCE is the only inflation index that is still below 2% (see chart, source Bloomberg). And, as we will see, this raises other questions about whether PCE is a reasonable target for Fed policy.

fourmeasuresThere are several differences between CPI and PCE, but the main reasons they differ can be summarized simply: the CPI measures what the consumer buys, out-of-pocket; the PCE measures not only household expenditures but also spending on behalf of consumers, including such things as employer-purchased insurance and some important government expenditures. As pointed out by the BEA on this helpful page, “the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.”

This leads to two major types of differences: weight effects and scope effects.

Weight effects occur because the PCE is a broader index covering more economic activity. Consider housing, which is one of the more steady components of CPI. Primary rents and owners’-equivalent rent constitute together some 32% of the CPI and those two components have been rising at a blended rate of about 3.4% recently. However, the weight of rent-of-shelter in PCE is only 15.5%. This difference accounts for roughly half of the difference between core CPI and core PCE, and is persistent at the moment because of the strength in housing inflation.

However, more intriguing are the “scope” differences. These arise because certain products and services aren’t only bought in different quantities compared to what businesses sell (like in the case of housing), but because the two surveys include and exclude different items in the same categories. So, certain items are said to be “in scope” for CPI but “out of scope” for PCE, and vice-versa. One of the places this is most important is in the category of health care.

Most medical care is not paid for out-of-pocket by the consumer, and therefore is excluded from the CPI. For most people, medical care is paid for by insurance, which insurance is usually at least partly paid for by their employer. Also, the Federal government through Medicare and Medicaid provides a large quantity of medical care goods and services that are different from what consumers buy directly – at least, purchased at different prices than those available to consumers!).

This scope difference is enormously important, and over time accounts for much of the systematic difference between core CPI and core PCE. The chart below (source: BEA, BLS) illustrates that Health Care inflation in the PCE essentially always is lower than Medical Care inflation in the CPI.

pceandcpiMoreover, thanks in part to Obamacare the divergence between the medical care that the government buys and the medical care consumers buy directly has been widening. The following chart shows the spread between the two lines above:

pceandcpispreadIt is important to realize that this is not coincidental, but likely causal. It is because Medicare and other ACA control structures are restraining prices in certain areas (and paid by certain parties) that prices to the consumer are rising more rapidly. Thus, while all of these inflation measures are likely to continue higher, the spread between core CPI and core PCE is probably going to stay wider than normal for a while.

Now we get to the most interesting question of all. Why do we care about PCE in the first place? We care because the Fed uses core PCE as a policy target, rather than the CPI (despite the fact that it has ways to measure market CPI expectations, but no way to measure PCE expectations). They do so because the PCE covers a wider swath of the economy. To the Fed, this means the PCE is more useful as a broader measure.

But hang on! The extra parts that PCE covers are, substantially, in parts of the economy which are not competitive. Medicare-bought prices are determined, at least in the medium-term, by government fiat. The free market does not operate where the government treads in this way. The more-poignant implication is that there is no reason to suspect that these prices would respond to monetary policy! Ergo, it seems crazy to focus on PCE, rather than CPI (or one of the many more-useful flavors of CPI), when setting monetary policy. This is one case where I think the Fed isn’t being malicious; they’re just not being thoughtful enough.

Every “core” inflation indicator, including the ones above (and you can throw in wages and the Employment Cost Index as well!), is at or above the Fed’s target even accounting for the typical spread between the CPI and PCE. Not only that, they are above the target and rising. The Fed is most definitely “behind the curve.” Now, as I have noted before in this space I don’t think there’s anything the Fed can do about it, as raising rates without restraining reserves will only serve to accelerate inflation further since it will not entail a slowing of money supply growth. But it seems to me that, for starters, monetary policymakers should focus on indices that are at least in principle (and in normal times) more responsive to monetary policy!


Even With a Crisis, No Deflation Coming

September 28, 2016 2 comments

Recently I’ve been thinking a lot about what might happen in the event of a banking crisis redux. While I’m not very concerned about US banks these days, there is a ‘developing situation’ in China that could well eventually lead to crisis (although the state might prevent outright collapses), and of course ongoing gnashing of teeth over Deutsche Bank’s capital situation if it is fined as heavily as some have suggested they will be.

I am not yet really worried about the banking side of things. But there are plenty of sovereign issuers who are clearly heading down unsustainable paths (not least of these is the US, especially if either of the leading Presidential candidates really implements the high-cost programs they are declaring they will), and when sovereigns tremble it is often banks that bear the direct brunt. After all, you can’t form a line outside of the sovereign to withdraw your money.

But, in a spirit of looking forward to anticipate potential crises, let us pretend we are confronting another banking crisis. The question I often hear next is, “how deflationary would it be to have another crisis when inflation is already low?”

Unpeeling the onion, there are several reasons this doesn’t concern me much. First, inflation is stable or rising in most developed nations. Yes, headline inflation is still sagging due to energy prices, but median inflation is 2.6% in the US and core inflation is 0.8% in Europe and 1.3% in the UK. To be sure, all of those are lower than they were in mid-2008. But remember that in 2009 and 2010, median (or core) inflation never got below 0.5% in the US, 0.8% in Europe, and 2.7% in the UK. Japan of course experienced deflation, but that wasn’t the fault of the crisis – as I’ve pointed out before, Japan has been in long-running deflation due to the BOJ’s inability or unwillingness to grow the money supply.

So, if the worst crisis in 100 years didn’t take core inflation negative – a major, major failure of Keynesian predictions – then I’m not aflutter about it happening this time. Heck, in 2009 and 2010 core inflation wouldn’t even have been as low as it was, had the cause of the crisis not been the bursting of the housing bubble. The chart below (source: Bloomberg) shows the Atlanta Fed’s “sticky” CPI (another way to measure the underlying inflation trend) ex-shelter. Note that in 2010, the low in this measure was about 1.25%…it was actually lower in 2014 and 2015.


But we can go further than that. One reason that inflation decelerated in 2009 and 2010 was because money velocity dropped sharply. As I’ve shown before, and argued in my book, the decline in money velocity was not particularly unusual given the decline in interest rates. That is, if you had known what was going to happen to interest rates, you would have had a very good forecast of money velocity and, hence, core inflation.

Back in 2008, I never dreamed that interest rates would go so low, or stay so low for so long. Few of us did! But the outcome, in the event, was consistent with the monetarist model while being completely inconsistent with the Keynesian model. And here’s the point, when thinking about the next crisis: interest rates are already at incredibly low levels, lower even than the 36-year downtrend channel would have them (see chart, source Bloomberg).


With the wisdom of experience, I would never be so cavalier as to say that interest rates cannot go lower from here! But in 2008, 10-year rates were around 3.80% and they’re 1.60% now (in the US, and lower elsewhere). Real rates were around 2% at the 10-year point; they are at 0% now. It is difficult to imagine how rates can have another dramatic move as they did in 2008-09.

It is important to understand, that is, just why inflation tends to fall in recessions. It is not, as the Keynesians would have it, that a growing “output gap” reduces the pressure on resources and relieves price increases. It is because slack demand for credit causes interest rates to decline, which leads to lower money velocity and hence, lower inflation. If the central bank responds in a timely manner to increase money supply growth by increasing reserves, then inflation doesn’t fall very far. In the last crisis, the Fed and other central banks added enough liquidity to ramp up M2 growth, and that kept the decline in money velocity from causing outright deflation (then, they kept adding reserves for a few more years, which led to the situation we are in now – too many reserves in the system, so that central banks no longer control the marginal dollar that goes into the money supply).

So, in the next crisis I expect central banks will add still more reserves to the pile of excess reserves, which will be meaningless but will make them feel better. Interest rates will decline, but not by as much as they did in the last crisis, and money velocity will fall. So, in a real serious crisis, inflation will decline – however, it will not decline very much.

That is the world we are now living in: higher highs to inflation on each subsequent peak, and higher lows in each subsequent trough. The vicious cycle counterpart to the virtuous cycle we have enjoyed for 35 years. This is true, I think, whether or not we get a crisis or just a garden-variety recession.

I should be clear that I think that such a crisis would be horrible for growth. That is, our current weak growth in global GDP would turn negative again, and possibly even more painful. And times would be truly bad in the stock market. But inflation will not follow, just as it didn’t follow in 2009-2010, and turn into deflation.

Japan Is Doomed. Again.

September 21, 2016 1 comment

Japan is doomed. Again.

A couple of years ago, the Bank of Japan began to pursue QE, with the intention of doubling its money supply. While this is a bad plan for almost every country, it was exactly the right plan for Japan, whose economy had been mired in deflation from 1999 until this policy began (see chart, source Bloomberg).


To a monetarist, it was no surprise that Japan was experiencing deflation. Since the early 1990s, annual money supply growth in Japan has been below 4% (see chart, source Bloomberg). It averaged 2.4% from 1992-2012. (The new policy pushed M2 growth above 4% for the first time since the 1990s, albeit briefly as it turned out).


Remember, the monetarist equation says MV≡PQ. With unchanged money velocity and an economy with, say, a 3% potential growth rate in GDP, a 2.4% growth in M2 should result in deflation. And, in fact, just as in the US lower interest rates in Japan produced lower monetary velocity.

Quantitative easing does nothing to help economic growth, and so QE was the wrong prescription for most of the world after 2010. But if deflation is your disease, QE is your cure and that is Japan’s situation. When the BOJ decided to start QE, money supply growth moved above 4% for the first time in years, and “miraculously” core inflation moved above zero as the first chart above illustrates. (Abstract from the spike over 2%, which was due to a one-time consumption tax effect; but core inflation in Japan was over 1% even excluding that spike). When that happened, I wrote in our Quarterly Inflation Outlook that Japan was no longer the poster child for inept central banking; that award had been moved to the European Central Bank.

Unfortunately, even though QE did exactly what it was supposed to do, to Japanese policymakers it seemed to have failed because their intention had been to raise real growth. So, since the hammer they were using did not function very well as a saw, they discarded the tool.

Japan’s problems with growth are structural. There’s not a lot that can be done, and nothing that can be done in the short run and with monetary policy, about the demographic train wreck they are experiencing. But the problem with inflation was, and is, fixable. But only if the Bank of Japan does QE, and a lot of it, and keeps doing it. As they shifted from straight QE to targeting negative interest rates, money supply growth began to ebb (now back to 3.3% y/y) and inflation began to roll over (now 0.3% ex-food-and-energy). Indeed, with lower rates the BOJ is making it worse by helping to push money velocity even lower.

There had been hope that the BOJ might abandon the NIRP experiment, which was clearly not working by every metric you can use to measure it, and go back to the policy that had been working at least with respect to the fixable problem. But instead, last night the Bank of Japan “shifted the policy framework” to targeting the yield curve. According to the Bloomberg story, the Bank is moving away from a “rigid target for expanding the money supply, while seeking to control bond yields across different maturities.”

So money? The heck with that. We just want to make sure that prices are at the “right” levels. Clearly, the BOJ thinks the market is totally failing when it comes to setting the interest rate correctly (to be fair, all central banks seem to now view interest rates as a tool rather than an indicator, as they used to), and so it is assuming control of that job. Clearly, only the wise policymakers at the BOJ can divine the right level for interest rates: the one which leads to great growth and moderate inflation for the country. Sure.

Japan had a chance. Whether by design or pure chance, they had stumbled on the policy that was able to banish the deflation that had plagued them, and perverted decision-making, for two decades. But because they are pursuing a pot of gold at the end of the rainbow – growth springing from monetary policy in the same way that you can plant olive trees and harvest carrots – they abandoned the working policy to pursue one that has no chance of success.

Japan is back in its comfort zone: the developed world’s basket case. Congratulations to the Bank of Japan.

Need a Jedi to Blow Up the R-Star

September 6, 2016 Leave a comment

I haven’t written an article for a couple of weeks. This is not entirely unusual: I have written this commentary, in some form, since about 1996 and there are occasional breaks in the series. It happens for several reasons. Sometimes it is simple ennui, as writing an analysis/opinion article for twenty years can occasionally get boring especially when markets are listless as they frequently are in August. Other times, it is because work – the real work, the stuff we get paid for – is too consuming and I have not time or energy left to write  a few hundred words of readable prose. Maybe that’s part of the reason here, since the number of inflation-investing-related inquiries has definitely increased recently, along with some new client flows (and not to mention that we are raising capital for Enduring Investments through a 506(c) offering – you can find details on Crowdfunder or contact me through our website). Finally, in recent years as the ability to track the number of clicks/eyeballs on my writing has improved, I’ve simply written less during those times…such as August…when I know that not many people will read the writing.

But this time is a little different. While some of those excuses apply in some measure, I’ve actually skipped writing over the last two weeks because there is too much to say. (Fortunately, I said some of it on two Bloomberg TV appearances, which you can see here and here.)

Well, my list of notes is not going to go away on its own so I am going to have to tackle some of them or throw them away. Unfortunately, a lot of them have to do with the inane nattering coming out of Federal Reserve mouthpieces. Let’s start today with the publication that gathered a lot of ink a couple of weeks ago: San Francisco Fed President John Williams’ FRBSF Economic Letter called “Monetary Policy in a Low R-star World.”

The conclusion that Williams reached was sensational, especially since it resonates with the “low return world” meme. Williams concluded that “The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest.” This article was grating from the first paragraph, where Williams casts the Federal Reserve as the explorer/hero:

“As nature abhors a vacuum, so monetary policy abhors stasis. Instead of being a rigid set of precepts, it follows the adage, that which survives is that which is most adaptive to change… In the wake of the global financial crisis, monetary policy has continued to evolve… As we move forward, economic conditions require that central banks and governments throughout the world carefully reexamine their policy frameworks and consider further adjustments in terms of monetary policy strategy—both in its own right and as it relates to other policy arenas—to successfully navigate these new seas.”

One might give the Federal Reserve more credit if subsequent evolutions of policy prescriptions were not getting progressively worse rather than better. Constructive change first requires critical evaluation of the shortcomings of current policy, doesn’t it?

Williams carries on to argue that the natural rate of interest (R-star) is lower now than it has been in the past. Now, Fed watchers should note that if true, this implies that current monetary policy is not as loose as has been believed. This is a useful conclusion for the Fed, since it would explain – within their existing model framework – why exceptionally low rates have not triggered better growth; it also would allow the Fed to raise rates more slowly than otherwise. I’ve pointed out before the frustrating tendency of groupthinking economists to attribute persistent poor model predictions to calibration issues rather than specification issues. This is exactly what Williams is doing. He’s saying “there’s nothing wrong with our model! If we had simply known that the natural rate was lower, we would have understood that we weren’t as stimulative as we thought.” Possible, but it might also be that the whole model sucks, and that the monetarists are right when they say that monetary policy doesn’t move real variables very well. That’s a hypothesis that at least bears examining, but I haven’t seen any fancy Fed papers on it.

What is really remarkable is that the rest of the paper is largely circular, and yet no one seems to mind. Williams attributes the current low r-star to several factors, including “a more general global savings glut.” Note that his estimates of r-star take a sharp turn lower in 2008-9 (see chart below, source FRBSF Economic Letter, figure 1).


Wow, I wonder what could have caused an increase in the global savings glut starting in 2008? Could it be because the world’s central banks persistently added far more liquidity than was needed for the proper functioning of the economy, leading to huge excess reserves – aka a savings glut?

So, according to Williams, the neutral interest rate is lower at least in part because…central banks added a lot of liquidity. Kind of circular, ain’t it?

Since according to Williams this fact explains “uncomfortably low inflation and growth despite very low interest rates,” it must mean he is bravely taking responsibility – since, after all, quantitative easing caused the global savings glut which, in his construct, caused low growth and inflation. Except that I don’t think that’s what he wants us to conclude.

This isn’t research – it’s a recognition that what they did didn’t work, so they are backfilling to try and find an excuse for why their theories are still good. To the Fed, it is just that something happened they didn’t realize and take account of. Williams wants to be able to claim “see, we didn’t get growth because we weren’t as stimulative as we thought we were,” because then they can use their old theories to explain how moving rates around is really important…even though it didn’t work this time. But the problem is that low rates don’t cause growth. The model is wrong. And no amount of calibration can fix a mis-specified model.

The IMF Tries to Cause Japanese Unemployment

August 15, 2016 2 comments

It is rare that I write early on a Monday morning, but today there is this. A story on Bloomberg highlighted the pressure that the IMF is putting on Japan to institute an “incomes policy” designed to nudge (and force, if necessary) companies to increase wages. IMF mission chief for Japan told reporters a couple of weeks ago that “we need policies to support wage increases in Japan;” the Bloomberg article also names a former IMF chief economist and the current president of the Peterson Institute for International Economics as proposing an immediate boost of salaries of 5-10% for unionized workers.

It is truly appalling that global economic policymakers are essentially illiterate when it comes to economic history. The IMF suggestion to institute wage hikes as part of triggering inflation is not a question of misunderstanding macroeconomic models (although it manages to do this as well, since wages follow prices and thus increasing wages won’t cause inflation unless other conditions obtain). At some level, it is a question of ignorance of history. After the stock market crash in 1929, President Hoover persuaded major industrial firms (such as GM, U.S. Steel, and the like) to hold wages constant or raise them. Since prices were falling generally, this had the effect of raising the real cost of production, which of course worsened the subsequent Depression. According to one analysis, this single decision caused GDP loss in the Great Depression to be triple what it otherwise would have been if wages were allowed to adjust (because, again, wages follow prices and are the main mechanism by which a surplus or shortage of labor is cleared). It wasn’t just Hoover, of course: later, FDR established the National Recovery Administration to administer codes of “fair competition” for every industry that established minimum wages and prices. The NRA was struck down in large part by the Supreme Court, but the notion of arresting deflation by adjusting wages was quickly reintroduced in the National Labor Relations Act of 1935.

There is wide agreement, although I am sure it is not universal, that preventing markets from adjusting is a big part of what made the Great Depression so Great. And this isn’t theory…it’s history. There is no excuse, other than ignorance, for policymakers to whiff on this one.

Deflation can be bad, but it doesn’t need to come with massive unemployment. In Japan, it has not: the unemployment rate is 3.1%, the lowest it has been since 1995. But push wages higher artificially, and Japan can have the massive unemployment as well. Thanks, IMF.

August, Productivity, and Prices

August 11, 2016 4 comments

I really don’t like August. It’s nothing about the weather, or the fact that the kids are really ready to be back in school (but aren’t). I just really can’t stand the monkey business. August is, after December, probably the month in which liquidity is the thinnest; in a world with thousands of hedge funds this means that if there is any new information the market tends to have dramatic swings. More to the point, it means that if there is not any new information, the speculators make their own swings. A case in point today was the massive 5% rally in energy futures from their lows of the day back to the recent highs. There was no news of note – the IEA said that demand will balance the oil market later this year, but they have said that in each of the last couple of months too. And the move was linear, as if there had been news.

Don’t get me wrong, I don’t care if traders monkey around with prices in the short run. They can’t change the underlying supply and demand imbalance and so it’s just noise trading for noise trading’s sake. What bothers me is that I have to take time out of my day to go and try to find out whether there is news that I should know. And that’s annoying.

But my whining is not the main reason for this column today. I am overdue to write about some of the inflation-related developments that bear comment. I’ll address one of them today. (Next week, I will probably tackle another – but Tuesday is also CPI day, so I’ll post my usual tweet summary. Incidentally, I’m scheduled to be on What Did You Miss? on Bloomberg TV at 4pm ET on Tuesday – check your local listings).

I don’t spend a lot of time worrying about productivity (other than my own, and that of my employees). We are so bad at measuring productivity that the official data are revised for many years after their release. For example, the “productivity miracle” of the late 1990s, which drove the Internet bubble and the equity boom into the end of the century, was eventually revised away almost completely. It never happened.

The problem that a lot of people have with thinking about productivity is that they confuse the level of productivity with its pace of increase. So someone will say “of course the Internet changed everything and we got more productive,” when the real question is whether the pace of productivity increase accelerated. We are always getting more productive over time. There are always new innovations. What we need to know is whether those innovations and cost savings are happening more quickly than they used to, or more slowly. And, since the national accounts are exquisitely bad at picking up new forms of economic activity, and at measuring things like intellectual property development, it is always almost impossible to reject in real time the hypothesis that “nothing is changing about the rate of productivity growth.” Therefore, I don’t spend much time worrying about it.

But, that being said, we should realize that if there is a change in the rate of productivity growth it has implications for growth, but also for inflation. And recent productivity numbers, combined with the a priori predictions in some quarters that the global economy is entering a slow-productivity phase, have started to draw attention.

Most of that attention is focused on the fact that poor productivity growth lowers overall real output. The mechanism there is straightforward: productivity growth plus population growth equals real economic output growth. (Technically, more than just population growth it is working-age population growth times labor force participation, but the point is that it’s an increase in the number of workers, compounded by the increase in each worker’s productivity, that increases real output). Especially if a populist backlash in the US against immigration causes labor force growth to slow, a slower rate of productivity growth would compound the problem of how to grow real economic growth at anything like the rate necessary to support equity markets or, for that matter, the national debt.

But there hasn’t been as much focus on the other problem of low productivity growth, if indeed we are entering into that sort of era. The other problem is that low productivity growth causes higher prices, all else equal. That mechanism is also straightforward. We know that money growth plus the change in money velocity equals real output growth plus an increase in prices: that is, MV≡PQ. If velocity is mean-reverting, then the decline in real growth precipitated by a decline in labor productivity, in the context of an unchanged rate of increase in the money supply, implies higher prices. That is, if ΔM is constant and ΔV is zero and ΔQ declines, then ΔP must increase.

One partial offset to this is the fact that a permanent decline in productivity growth rates would lower the equilibrium real interest rate, which would lower the equilibrium money velocity. But that is a one-time shift while the change in trend output would be lasting.

In fact, it wouldn’t be unreasonable to suppose that the change in interest rates we have seen in the last few years is mostly cyclical but may also be partly secular. This would imply a lower equilibrium level of interest rates (although I don’t mean to imply that anything is near equilibrium these days), and a lower equilibrium level of monetary velocity. But there are a lot of “ifs” in that statement.

The biggest “if” of all, of course, is whether there really is a permanent or semi-permanent down-shift in long-term productivity growth. I don’t have a strong opinion on that, although I suspect it’s more likely true that the current angst over low productivity growth rates is just the flip side of the 1990s ebullience about productivity. We’ll know for sure…in about a decade.

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