so one has to be careful about using these prices as forecasts, even if one were to assume risk neutral agents

TO BE NOTED: From Econbrowser:

"House Prices Continue to Slide

House prices continued to tumble in March, according to the Case-Shiller index. Time to see what the futures say (keeping in mind the forecasting capacity of the Case Shiller futures are not well known).

Figure 2: Case-Shiller 10 city price index, (blue line), CME futures prices, 26 May 2009 (red triangle), and CME futures prices, 21 Sep 2008 (green diamond). NBER-defined recessions shaded gray, and start date dashed gray line Source: Standard and Poors' [xls], ino.com, St. Louis FRED II, NBER, and author's calculations.

So as of March, the 10 city is 40% lower than its May 2006 peak, in log terms (37%, in percent terms). The CME futures indicate that the 10 city index will be 52.7% lower by May 2010 (41% in percent terms). Compared to last September, the trough has moved up (the trough back then was slated to be in May 2011). However, one doesn't want to make too much of these long horizon indications, since the futures prices for these dates (November 2011 onward) have not changed since, for instance, the February 25 futures (shown in this post).

Of course, futures prices incorporate both expectations and risk preferences. In addition, these markets -- particularly at longer horizons -- are not likely to be particularly thick, so one has to be careful about using these prices as forecasts, even if one were to assume risk neutral agents. For an alternative, one can use the forecasts of the old OFHEO indices and convert to implied Case-Shiller (see this post for example).

More commentary at Calculated Risk.

Posted by Menzie Chinn"

That, too, is a disappointment for those who are waiting for increased consumption spending to lift us out of recession

TO BE NOTED: From Econbrowser:

Where's my recovery, dude?

A couple of disappointments in this week's data.

New claims for unemployment insurance have peaked just before the end of each of the last half-dozen recessions.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Shaded areas correspond to recessions as judged by the National Bureau of Economic Research.

Unfortunately, the Labor Department reported today that seasonally adjusted new claims for unemployment insurance rose by 32,000 for the most recent available week. That bumps the 4-week average to 630,000, up 6,000 from its value the previous week, though the average is still below its peak of 659,000 reported April 9. That the downward trajectory will resume next week is far from clear.

Black line: seasonally adjusted weekly new claims for unemployment insurance from January 1 through May 14, 2009. Blue line: 4-week average.

We also received the news yesterday that monthly sales for retail and food services fell 0.4% in April, the second consecutive monthly drop. That, too, is a disappointment for those who are waiting for increased consumption spending to lift us out of recession.

Source: FRED.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton "

could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus

TO BE NOTED: From Econbrowser:

"Inflation and relative prices

There are persuasive reasons why we'd be better off today with an inflation rate higher than what we've seen over the last six months. But while a uniform expansion that raised all wages and prices by the same amount would be helpful, what the Fed could actually achieve in the present situation may be something less desirable.

When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good. But in the real world, in any given month some prices rise and others fall, and we can only measure inflation in terms of the broad central tendency behind those individual price changes.

A recent research paper by Columbia Professor Ricardo Reis and Princeton Professor Mark Watson suggests that real-world measured inflation may behave very little like the textbook ideal. Reis and Watson introduce the hypothetical concept of a pure inflation shock as something that changes every price by x(t) percent, where in any given quarter t the magnitude x(t) is the same number for every item in the economy. Reis and Watson show how such a shock can be measured for any given quarter by observing the behavior of separate components of the PCE deflator. Their principal finding is that this concept of pure inflation in fact plays very little role in quarterly changes in broad price indexes such as the GDP deflator or the consumer price index, accounting for only 15-20% of measured inflation. The authors instead find that changes in relative prices are much more important than pure inflation for determining what happens to the broad CPI. For example, the measured deflation over the last 6 months is heavily influenced by falling energy prices.

If you think that the Federal Reserve is responsible for more than 15-20% of the variation in the CPI, the implication is that part of its influence comes from changes it causes in relative prices. But changes in relative prices-- such as the huge run-up in energy prices in the first half of 2008-- can be much more destabilizing than the textbook pure inflation.

I would therefore think that the Fed might be somewhat concerned by the surge in commodity prices over the last few weeks. The graph below plots the prices of 11 commodities since the Fed's announcement of quantitative targets on March 18. Gold is the only one of these commodities that hasn't gone up in price, with the average of these commodities up 13% over the last two months.

Prices of assorted commodities normalized at March 17, 2009 = 100. Data source: WSJ commodity cash prices, via Webstract.

Some increase in relative commodity prices is certainly to be expected if we are indeed about to see a recovery in real economic activity. But this is a trend the Fed needs to watch closely from here, and could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus.

Because I for one do not think it's a good idea to call for a replay of the 2008:H1 commodity market show.

---

Technorati Tags: macroeconomics, commodity prices, economics, Federal Reserve, deflation, inflation

Posted by James Hamilton"

That brings the 4-week average down for the third consecutive week and puts it 3.3% below the peak reached April 9

TO BE NOTED: From Econbrowser:

"April 30, 2009

Further progress for initial claims for unemployment insurance

The Labor Department reported today that initial claims for unemployment insurance fell by 14,000 during the most recent available week. That brings the 4-week average down for the third consecutive week and puts it 3.3% below the peak reached April 9.

Black line: seasonally adjusted new claims for unemployment insurance, weekly since January. Blue line: average of 4 most recent weeks as of each date.

That ongoing drop in the 4-week average is noteworthy because in each of the last 5 recessions, once the new claims number began declining from its peak value reached during the recession, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Reasoning as in my last discussion of these data, one can try to judge how meaningful the latest numbers might be as follows. If we leave out the 1970 recession, there are 230 weeks in which the NBER declared the economy to have been in recession during the 5 recessions of 1974, 1980, 1982, 1990, and 2001. In 22 of these weeks, we saw as big a drop as we've seen this month, namely, the 4-week average dropped by more than 3.3% over a 3-week period. Of these 22 favorable readings, 11 turned out to be part of the final move out of recession, while in the other 11, new claims turned back up to reach a subsequent higher peak. Thus, if all you had to go on was the data on new unemployment claims and its behavior in previous recessions, you might conclude that there's a 50% chance that an economic recovery will have started by the beginning of June.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton"

Though I grant it takes a little imagination to see that in the graph above

TO BE NOTED: From Econbrowser:

"April 29, 2009

Good economic news?

Today's GDP numbers were about what I was expecting. Although economic activity continued its sharp decline, if we continue to follow the script, things should improve.

The Bureau of Economic Analysis reported today that U.S. real GDP fell at a 6.1% annual rate in the first quarter of 2009. That's enough to push our Econbrowser Recession Indicator Index up to 99.5%, its highest value since 1980:Q2. This index uses the latest GDP numbers to form a retrospective impression of the economy's status as of one quarter earlier (2008:Q4). We will declare the recession to be over when the index falls back below 33%.

The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date, with 2008:Q4 the last date shown on the graph. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Leading the retreat in real GDP was a 9.5% drop (quarterly rate) in nonresidential fixed investment. This was enough all by itself to subtract 4.7% from the annual GDP growth rate. There was a comparable drop in residential fixed investment, which subtracted another 1.4% from the implied annual GDP growth rate. The collapse in nonresidential fixed investment was what we expected, given the usual cyclical pattern of plunging business fixed investment in the later stages of an economic downturn. The drop in housing surprised me somewhat. If new home construction does no better than simply hold steady at its current abysmally low rate, the sector will stop making negative contributions to the growth rate.

Because imports are subtracted from GDP, falling imports made a big positive contribution to GDP growth, much of which was taken away by plunging exports. But it would be quite wrong-headed to summarize these twin developments solely in terms of their net implications for U.S. GDP. The simultaneous drop in imports and exports signals an accelerating collapse in world trade, which I see as the single most troubling detail of today's report.

On the bright side, inventory liquidation subtracted 2.8% from the quarter's annual real GDP growth rate, meaning that real final sales were substantially better than GDP. Most importantly, consumption rebounded from the depressed levels of 2008:Q4.

That last development is particularly key, since the historical pattern is for consumption to begin the recovery in the later phases of the recession, even as nonresidential fixed investment is headed down.

Average cumulative change in 100 times the natural log of real GDP or its respective component beginning from the business cycle peak for the 10 recessions between 1947 and 2001. Horizontal axis denotes quarters after the peak.

If you want to see that pattern of recession and recovery blown up on a bigger scale, you can look just at the downturn of 1981-82:

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 1981:Q3. Horizontal axis denotes quarters after 1981:Q3.

Here's how these series have behaved so far this time:

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 2007:Q4. Horizontal axis denotes quarters after 2007:Q4.

If this is all unfolding according to historical pattern, that's a source of comfort, because we saw how those earlier recessions ended. If consumption continues to grow, and if residential fixed investment has finally bottomed, then the 2009:Q2 decline in GDP should be milder than Q1, and positive growth by the end of the year could be in store.

Though I grant it takes a little imagination to see that in the graph above.

---

Technorati Tags: GDP, recession probability, recession indicator index, macroeconomics, economics

Posted by James Hamilton"

once new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks

TO BE NOTED: From Econbrowser:

"Initial claims for unemployment insurance

The Labor Department reported today that initial claims for unemployment insurance rose by 27,000 in the most recent available week. Although that's a disappointing development, it's still a small enough increase to allow the 4-week average to fall for the second week in a row. Since that declining 4-week average is one of the few encouraging pieces of news in an otherwise discouraging economic landscape, I wanted to take a closer look at just how significant a statistical signal it really sends.

The interest in the 4-week average of new claims for unemployment compensation results from the observation by Northwestern Professor Robert Gordon that, for each of the last six recessions, once the new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Here's a close-up of the behavior of the series so far in 2009, with the raw weekly numbers in black and the 4-week average in blue.

Will the latest downward move prove to be the beginning of a recovery, or will we turn around and head back up to a new high? Let's try to pose this as a statistical question. We're trying to figure out whether the number for the 4-week average that was reported two weeks ago will turn out to be the highest value of this recession. Let s_t equal 0 if week t turns out to come before the peak value for the recession, and s_t = 1 if it turns out we're past the peak. Of course we don't know now which is the case, but if t represents a week from one of the previous 6 recessions, we now know enough to assign a value of either 0 or 1 to that week. There are 278 of those earlier observations on s_t from the recessions of 1970, 1974, 1980, 1982, 1990, and 2001.

The question we'd like to ask statistically is the following. Let's take it as given that we're currently in a recession. Let y_t denote the observed two-week percentage change in the 4-week average as of week t. The latest observation is a 1.8% decline, so the most recent value is y_t = -1.8. We'd like to calculate the probability that s_t = 1 if we've seen a 2-week decline in y_t as big as 1.8%, that is, we'd like to find the value of

From the definition of a conditional probability, this can be found by dividing the joint probability by the marginal probability:

We know the denominator of this fraction by looking at the number of those earlier known recession weeks between 1969 and 2001 for which we observed a 2-week decline in the 4-week average for new claims of 1.8% or more. It turns out that there were 46 weeks as favorable or more so as our most recently available datum:

To get the numerator, we count how many of those favorable declines proved to be the real McCoy. The answer is, 17 of them were part of the eventual trip down and out of the recession, but the other 29 represented temporary relief on a path that would eventually reach a new peak before turning down. The answer to our original question of interest, namely what's the probability we're on our way out of the recession this time, is thus given by

In other words, there's a 63% chance that new unemployment claims will go back above the recent peak before they finally start to head back down.

The key factor that leads to this pessimistic assessment is the fact that we're conditioning on the knowledge that our current week t is definitely still part of the recession, which seems to me an entirely safe bet. Given that we are in a recession, that fact in itself would lead you to expect to see new unemployment claims go up rather than down (as they did in the vast majority of our 278-week earlier sample). The fact that we've seen the average decline for a couple of weeks now isn't enough to get you to change your mind, if you're convinced that as of right now the recession has not yet ended.

What would it take to get you to change your mind? A 2-week drop of more than 3.4% would bring the probability above 0.5. But you'd never get much more confident than that based on this line of reasoning, because you'd always be factoring in the possibility that we'd see a repeat of the big drops in new unemployment claims that were observed in the 1970 and 1974 recessions, which ended up being followed by even bigger increases. The fact we're conditioning on for these calculations-- that we're currently in a recession-- is by itself a strong enough predictor that future unemployment claims are headed higher that you'd never be completely sure the peak is behind us based on just a few weeks worth of decline.

In other words, you'd never be completely persuaded, if the only variable you had to look at was a few weeks of unemployment claims, that a recession is just about to end.

The latest number might turn out to be a green shoot, no question. But the odds are two to one that it's just another dead twig.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton "

In addition to its severity, this global recession also qualifies as the most synchronized

TO BE NOTED: From Econbrowser:

"The Great Recession Goes Global

One of the most interesting "boxes" in the IMF's World Economic Outlook (in Chapter 1) is the one entitled, somewhat innocuously "Global Business Cycles", by Marco Terrones, Ayhan Kose and Prakash Loungani at the IMF. Yet, it's important to read until the ending paragraph:

To summarize, the 2009 forecasts of economic activity, if realized, would qualify this year as the most severe global recession during the postwar period. Most indicators are expected to register sharper declines than in previous episodes of global recession. In addition to its severity, this global recession also qualifies as the most synchronized, as virtually all the advanced economies and many emerging and developing economies are in recession.

The authors are to be commended for simultaneously analyzing the data for numerous countries (not easy, as anybody who's tried this knows!) and applying a systematic procedure for dating the troughs and peaks.

From my perspective, the graphs easily summarize the main points.

Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.


Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.


Excerpt from Figure in Box: "Global Business Cycles," IMF WEO April 2009.

Related to these indicators related in the Box is the IMF's view of the world output gap. As Econbrowser readers know, I think the output gap is another important indicator -- despite the imprecision associated with such estimates -- of economic distress. Here's the relevant graph:

Excerpt from Figure 1.9 from IMF World Economic Outlook, April 2009.

Posted by Menzie Chinn at April 22, 2009 09:31 AM"

recessions are longer and deeper when associated with financial crises

TO BE NOTED: From Econbrowser:

"How Bad Is This Recession? And Why? -- Illustrated Version

Chapter 3 of the IMF's World Economic Outlook has a great summary figure:

The chapter documents the stylized facts that (1) recessions are longer and deeper when associated with financial crises, and (2) recessions are longer and deeper when the downturns are synchronized with recessions abroad. And those two points are why this otherwise reasonable -- and representative (but not from the IMF) -- prognostication from 15 months ago proved so wrong:

We know this for sure: It could be a lot worse, recessions used to last almost two years during the 1854-1919 period, and 1.5 years in the 1919-1945 period. Since WWII, the average recession lasted 10 months, and the last two recessions (1990-1991 and 2001) lasted only 8 months. With the support of a booming world economy, we could expect a short and shallow 2008 recession, IF it happens. If futures trading is correct, there's a 29% of NOT having a recession, so don't give up hope.

Source: a blog posting from January 2008.

Posted by Menzie Chinn at April 17, 2009 05:57 PM"

it's hard to envision a recovery without an upswing in consumer spending

TO BE NOTED: From Econbrowser:

"Update on the latest economic indicators

Some good news, some bad, in the indicators we follow this week.

First, the bad news. Monthly sales for retail and food services, which had been up a bit in January and February, fell 1.1% on a seasonally adjusted basis between February and March, leaving the first quarter 8.8% below 2008:Q1. That's a particularly discouraging development, since given the cyclical behavior of the other components of GDP, it's hard to envision a recovery without an upswing in consumer spending.

Source: FRED.

On the other hand, new claims for unemployment compensation were reported today to have fallen by 53,000 in the week ending April 11, bringing the 4-week average down by 8,500 from what the revised numbers show to have been the recent peak the week before. If April 4 ultimately proves to be the peak for the entire year, and if this recession behaves like each of the previous 6 recessions, we could expect the NBER eventually to declare that the economic recovery began within 6 weeks of today.

Black line: seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Blue line: 4-week average of black line. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Calculated Risk notes Goldman Sachs economist Seamus Smyth's estimate that a decline of 20,000 in the four-week average signals we've passed the real peak with probability 0.5, and a decline of 40,000 would give us 90% confidence. CR accordingly cautions not to get excited over the 8,500 drop seen so far.

Excited or no, bad news it's not, and the new claims data release was enough to allow the Aruoba-Diebold-Scott Business Conditions Index to climb up to -2.04% on April 11 from the previous assessment of -2.44% for April 4.

ADS BCI for July 1, 2007 through April 11, 2009, as assessed on April 16, 2009. Data source: Federal Reserve Bank of Philadelphia.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton"

this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy

TO BE NOTED: From Econbrowser:

"The Demise of the Dollar? Should We Worry about Quantitative Easing and Deficit Spending?

Over the weekend, I was working on my long delayed manuscript on exchange rate modeling [0], and pondering how useful the conventional econometric techniques were for making predictions about the future value of the dollar.

Figure 1: Log value of trade weighted dollar, against a basket of major currencies (blue), and against a broad basket of currencies (red); and Deutsche Bank forecasts, calculated using implied changes of DB TWI (dark blue boxes). NBER defined recession shaded gray; only peak indicated for current recession. Source: Federal Reserve via FRED II, Deutsche Bank Exchange Rate Perspectives (27 March 2009), NBER, and author's calculations.

Why wonder? Well, in the final chapter of the text, I outlined the use of Taylor rule fundamentals to explain exchange rates (see this paper and these posts [1], [2], [3]). However, the fact that several central banks have hit the zero interest rate bound, and instituted quantitative easing (QE), makes the plausibility of such models limited in the near future.

Figure 2: Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright. Source: Hamilton, "The Fed's new balance sheet".

At the same time, we are witnessing a substantial increase in government debt, as documented in this post. Working off a portfolio balance model, as discussed in this post, one would expect a depreciation of the dollar or an increase in the exchange risk premium. However, all developed countries are expanding debt to GDP ratios.

Table 1.5 from OECD, Economic Outlook (March 2009) [pdf].

(Notice that gross debt differs from net debt, so these figures are not comparable to those in this post.)

Deutsche Bank, in its most recent Exchange Rate Perspectives (March 27, 2009) [not online], concludes:

Fiscal expansion combined with QE

What is the implication of fiscal expansion combined with QE? We have argued that history suggests the implications of higher fiscal deficits for the dollar will depend on whether or not the higher deficits are accompanied by higher relative US longer-term rates (Fiscal Deficits and the Dollar, ERP, September 2008). So if relatively more activist fiscal policy in the US raises relative US yields, history suggests this should be positive for the dollar. But there is widespread concern that if the higher deficits are accompanied by expectations of or actual QE, this will be negative for the dollar. This is essentially a "risk premium" argument that even with higher relative US yields, because of or under QE, this will be negative for the dollar. Looking at historical experience for episodes of risk premia against the dollar by examining the correlation between daily returns in EURUSD versus the longer-term rate differential indicates six episodes of negative correlations between the differential and the dollar. Four of these are episodes of risk premium in favor of the dollar, with declines in the dollar rate differential associated with a higher dollar. There have only been two episodes—in the late summer and early fall of 1998 and in the summer of 2003 -- when a move in rate differentials in favor of the dollar was associated with a weaker dollar. There have thus historically been very few episodes of such a risk premium. Presently this correlation between changes in the yield differential and the dollar is running around zero to very modestly negative. This is consistent with the view that most of the recent sharp depreciation in the dollar has been in line with the decline in US rate differentials and there is little or no evidence that higher expected fiscal deficits in the US combined with QE have created a risk premium against the dollar ...

Interestingly, this perspective contrasts with Charles Wyplosz's view, who argues that QE is basically a beggar thy neighbor policy. Perhaps it is, but when many countries are undertaking QE [4] [5] the effects cancel out.

What about China? As Brad Setser points out, China has slowed accumulation of Treasurys. How this will play out depends on how much the currency composition of assets changes as a consequence. And indeed whether the slowdown in accumulation persists.

Returning to the question that inspired this post, DB asserts that the long term yield differential will drive the dollar. That seems to be a hypothesis that one will be able to test as the data roll in. So I remain hopeful that the empirical methods of the past will prove yet again useful in the future, despite the changed nature of the world.

[Addition, 8:15pm Pacific It turns out that Barry Eichengreen has already observed this nullification effect -- but adds that it would be better to coordinate QE across countries. See this article from last month.]

By the way, if you're looking for estimates of increased debt-to-GDP stocks on interest rates, see Table 3.5 of the OECD, Economic Outlook (March 2009) [pdf]....you'll see a reference to this paper.

Technorati Tags: zero interest rate policy, quanitative easing, exchange rates, Taylor rule, and portfolio balance.

Posted by Menzie Chinn at April 13, 2009 07:40 PM"

Why sell crack when taking money from a careless lender is so much easier and more profitable?

TO BE NOTED: From Econbrowser:

"Mortgage fraud

Why sell crack when taking money from a careless lender is so much easier and more profitable?

From the San Diego Union Tribune:

Federal prosecutors indicted 24 people in a massive mortgage fraud scheme that they said was led in part by a gang member from San Diego and netted participants $11 million in profits.

In an indictment unsealed yesterday, prosecutors laid out a wide-ranging racketeering conspiracy that ran from 2005 to 2008 and targeted homes across the county. Among the identified leaders was Darnell Bell, a documented member of the Lincoln Park street gang.

Bell, 38, used his status in the gang to recruit other members for the scheme and "maintain discipline," according to the indictment.

The sweeping conspiracy involved almost every element in the real estate transaction chain. The defendants include a real estate broker, a group of straw buyers, an escrow officer, an appraiser, tax preparers and a notary.

Prosecutors allege the network used fake buyers to purchase homes for more than the asking price, with the defendants pocketing the overage. Lenders were duped into funding mortgages for the inflated price and later suffered losses when the buyers walked away and the property was foreclosed.

The value of the properties involved is estimated at $100 million.

I'm wondering if the lenders were also "duped" into lending this $100+ million without income documentation or down payments.

Posted by James Hamilton at April 12, 2009 07:13 AM"

0% of respondents perceived inflation as the biggest threat to their forecast

TO BE NOTED: From Econbrowser:

"Growth Expectations Stabilize

The WSJ survey of forecasts has just come out [link]. One key finding is that the mean forecast has barely budged since March. In other words, unlike previous months, the perceived outlook has ceased deteriorating.

That being said, the dispersion of forecasts is pretty high, even q4/q4, ranging (-3.5%, 3.4%).

Figure 1: Histogram of 4q/4q growth rate of real GDP (in percent) from March WSJ survey. Source: WSJ April survey and author's calculations.

One is tempted to ask who is forecasting 3.4%. That would be James F. Smith, of Western Carolina State University and Parsec Financial Management. Dr. Smith has been extremely consistent in his forecasts for q4/q4 growth, having forecasted 3.4% in the December 2008, as well as in the January, February and March 2009 surveys (I didn't go further back than December...). Note that once his forecast is removed, the distribution of the survey responses is approximately Normal (i.e., a Jarque Bera test can't reject the null of a Normal, at the 43% msl). In addition, the mean growth rate drops to -1.48%.

I noted in the first paragraph that the mean forecast had ceased deteriorating. One can see this if one plots the March and April mean forecasts. The forecasted trajectory of GDP is essentially unchanged. One has to go back to the February forecast to see the detioration, as is shown in Figure 2.

Figure 2: Log real GDP (blue), April WSJ survey mean forecast (red), real GDP advance (teal), February WSJ mean forecast (pink), CBO potential GDP (black), all in log of Ch.2000$. Source: BEA GDP final and advance releases, WSJ, CBO, NBER and author’s calculations.

In this sense, the statements by several individuals that the outlook has stopped deteriorating are consistent with forecasters' views. [0] [1] However, this is not the same as saying economic conditions have stabilized. In fact, the mean GDP forecast still indicates continued decline into 2009Q2. And of course, means by definition do not show the variance in forecasts.

Because of the aforementioned sensitivity to outliers (I'll call it the James Smith problem), I've plotted in Figure 3 (log) real GDP, the mean WSJ forecast from the April survey, and trimmed high and low forecasts (that is, looking at the 6th highest and 6th lowest q4/q4 forecasts; thus I've dropped the top 5 and bottom 5, out of 54 forecasts).

Figure 3: Log real GDP (blue), April WSJ survey mean forecast (red), trimmed high and trimmed low forecasts (gray), CBO potential GDP (black), all in log of Ch.2000$. Source: BEA GDP final release, WSJ, CBO, NBER and author’s calculations.

The mean forecast implies that the output gap will be -8% (in log terms) in 2009q4. If the optimists are right, then the output gap will only be -6%.

The survey was conducted between April 3-6. Thus, they came before the trade release for February. Since the trade balance was above consensus, conditional nowcasts of GDP have probably risen [2].

On the other hand, the OECD forecast cited in this post implies continued decline throughout 2009. I'm not certain why the OECD is so gloomy (or alternatively, why the US-based forecasters are so optimistic). Using the OECD forecast and the CBO potential, the output gap will be 10.9% (log terms) by 2010q4. Perhaps this is in part due to a more pessimistic assessment of potential GDP (eyeballing the "Output Gap" table in Appendix 1.2 of the March OECD Economic Outlook, it seems that the OECD's estimate of potential is about 1.2% ppts less CBO's).

A final observation: given the substantial negative output gap under reasonable assumptions, it's hard for me to be particularly worried about inflation in the current year, as evidenced in some fevered accounts (e.g., [3]). Given that 0% of respondents perceived inflation as the biggest threat to their forecast, I think I'm in good company. (Digression: in 2000-01, when I was following the Japanese economy on the CEA staff, I also heard worries about hyperinflation in the wake of rising debt-to-GDP ratios; so far we haven't seen that outcome materialize).

Technorati Tags: recession, GDP, inflation,output gap, potential GDP, hyper-inflation, and forecast.

Posted by Menzie Chinn at April 10, 2009 09:00 PM"

his account is one that everbody should read

From Econbrowser:

"Phillip Swagel on the Financial Crisis

I'm behind the curve on recommending Phillip Swagel's BPEA paper on the Administration's response to the financial crisis. But today he talked to the students in my macro course, and his presentation just reinforced my view that his account is one that everbody should read.

Here's a picture showing the evolution of the one-month Libor-OIS spread.

Figure 2: from P. Swagel, "The Financial Crisis: An Inside View," paper presented at Brookings Panel on Economic Activity, March 2009.

Other commentary on the paper: [0], [1], [2], [3].

Posted by Menzie Chinn at April 8, 2009 06:30 PM"

a rapid lowering of rates could actually exacerbate the magnitude of an economic downturn

TO BE NOTED: From Real Time Economics:

"By Justin Lahart

Reeling from the housing bust and the banking crisis, it’s hard to think that the energy shock — the one that carried the average price of gasoline to a peak of $4.11 a gallon last July — was much more than a minor player in the economic downturn. But there’s the uncomfortable fact previous oil shocks, like the ones that came with the 1973 oil embargo, the 1979 Iranian revolution and the 1990 invasion of Kuwait, were also associated with recessions. And the 2001 recession, too, came on the heels of a run-up in oil prices.

In a paper presented at the Brookings Panel on Economic Activity Thursday, University of Calif.-San Diego economist James Hamilton crunched some numbers on how consumer spending responds to rising energy prices and came to a surprising result: Nearly all of last year’s economic downturn could be attributed to the oil price shock.

As he writes on his blog, that’s a conclusion that he doesn’t quite believe in himself. We’d like to think that, say, the seizing up of the credit markets this fall had something to with the economy falling off the table in the fourth quarter.

But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.

A more controversial argument on energy’s role in the credit crunch could go like this. Housing prices kept on climbing, but the Federal Reserve – laboring on the idea that it couldn’t identify bubbles and that even if it could, it shouldn’t pop them — didn’t do anything about them. But then rising oil prices started adding to inflationary pressures, so the Fed kept pushing rates higher, left them high even as housing prices collapsed, and was to slow to lower them when the credit crisis got rolling."

And, from Econbrowser:

"Consequences of the Oil Shock of 2007-08

In a follow-up on my earlier post, I'd now like to discuss the second part of my paper, Causes and Consequences of the Oil Shock of 2007-08, which I presented today at a conference at the Brookings Institution. Here I'll review the role that the oil price shock may have played in causing the economic recession that began in 2007:Q4.

My paper uses a number of different models that had been fit to earlier historical episodes to see what they imply about the contribution that the oil shock of 2007-08 might have made to real GDP growth over the last year. The approaches surveyed include Edelstein and Kilian (2007), who examined the detailed response of various components of consumer spending, Blanchard and Gali (2007), who studied the extent to which the contribution of oil shocks has significantly decreased over time, my 2003 paper, which emphasized the role of nonlinearities, and a model-free data summary of the observed behavior of different economic magnitudes following this and previous oil shocks. Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

One of the most interesting calculations for me was to look at the implications of my 2003 model. I used those historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.

Solid line: 100 times the natural log of real GDP. Dotted line: dynamic forecast (1- to 5-quarters ahead) based on coefficients of univariate AR(4) estimated 1949:Q2 to 2001:Q3 and applied to GDP data through 2007:Q3. Dashed line: dynamic conditional forecast (1- to 5-quarters ahead) based on coefficients reported in equation (3.8) in Hamilton (2003) (which was estimated over 1949:Q2 to 2001:Q3) applied to GDP data through 2007:Q3 and conditioning on the ex-post realizations of the net oil price increase measure.

The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don't fully believe myself. Unquestionably there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

It is interesting also that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters. The mortgage delinquencies and financial turmoil in the current episode are of course not the specific stresses that operated in earlier downturns, but the broad features of that multiplier process are surprisingly similar to the historical pattern.

My paper concludes:

Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.

---

Technorati Tags: oil, oil prices, oil shocks

Posted by James Hamilton at April 2, 2009 07:27 PM"

"A more conventional policy tool would be monetary policy. A number of observers
suggested that the very rapid declines of short-term interest rates in 2008:Q1 fanned the
flames of commodity speculation, with negative real interest rates encouraging investments
in physical commodities (e.g., Frankel, 2008). In January 2009, Federal Reserve Chair Ben
Bernanke offered the following retrospective on that debate:
The [Federal Open Market] Committee’s aggressive monetary easing was not
without risks. During the early phase of rate reductions, some observers expressed
concern that these policy actions would stoke inflation. These concerns
intensified as inflation reached high levels in mid-2008, mostly reflecting a surge
in the prices of oil and other commodities. The Committee takes its responsibility
to ensure price stability extremely seriously, and throughout this period
it remained closely attuned to developments in inflation and inflation expectations.
However, the Committee also maintained the view that the rapid rise in
commodity prices in 2008 primarily reflected sharply increased demand for raw
materials in emerging market economies, in combination with constraints on the
supply of these materials, rather than general inflationary pressures. Committee
members expected that, at some point, global economic growth would moderate,
41
resulting in slower increases in the demand for commodities and a leveling out in
their prices—as reflected, for example, in the pattern of futures market prices. As
you know, commodity prices peaked during the summer and, rather than leveling
out, have actually fallen dramatically with the weakening in global economic
activity. As a consequence, overall inflation has already declined significantly
and appears likely to moderate further.
Bernanke seemed here to be taking the position that since the Fed got the long run
correct (ultimately there would be a significant downturn in both the economy and commodity
prices, with strong disinflationary pressure), the short-run consequences (booming
commodity prices in 2008:H1) were less relevant. On the other hand, if it is indeed the
case that the spike in oil prices was one causal factor contributing to the downturn itself,
there are concerns to be raised about ignoring those short-run implications. The evidence
examined here is consistent with the claim that if a slower easing of interest rates in 2008:H1
had succeeded in mitigating the magnitude of the oil price run-up, the result could well
have been a better outcome in terms of the 2008:H1 real GDP growth rate. Although the
Fed is not accustomed to think in such terms— that a rapid lowering of rates could actually
exacerbate the magnitude of an economic downturn— I think there is some reason to take
such a possibility seriously in this case.
But while the question of the possible contribution of speculators and the Fed is a very
interesting one, it should not distract us from the broader fact: some degree of significant
oil price appreciation during 2007-08 was an inevitable consequence of booming demand and
42
stagnant production. It is worth emphasizing that this is fundamentally a long-run problem,
which has been resolved rather spectacularly for the time being by a collapse in the world
economy. However, the economic collapse will hopefully prove to be a short-run cure for the
problem of excess energy demand. If growth in the newly industrialized countries resumes at
its former pace, it would not be too many more years before we find ourself back in the kind
of calculus that was the driving factor behind the problem in the first place. Policy-makers
would be wise to focus on real options for addressing those long-run challenges, rather than
blame what happened last year entirely on a market aberration."

large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets

TO BE NOTED: From Econbrowser:

"Stress

As the G-20 leaders meet in London, one graph should remind the representatives of these disparate countries of their shared interest in restoring the health of the financial systems of the developed countries.

Figure from Box 2 IMF.

What this graph shows is financial stress in the advanced economies leads to financial stress in the emerging markets.

The indices depicted were developed for individual countries and will be detailed in a chapter in the forthcoming* IMF World Economic Outlook (by Ravi Balakrishnan, Stephan Danninger, Selim Elekdag and Irina Tytell), to be released later in April. The advanced country financial stress indices (FSI) are a composite of banking sector, interbank spreads, term spreads (described in the October 2008 WEO, Chapter 4). Specifically:

• Banking sector: rolling 12-month covariance of the year-over-year percent change of a country’s banking sector equity index and its overall stock market index, divided by the rolling 12-month variance of the year-over-year percent change of the overall stock market index.
• TED spread: three-month LIBOR or commercial paper rate minus the government short term rate.
• Inverted term spread: government short term rate minus government long-term rate.

The emerging market FSI is constructed as a weighted average of the exchange market pressure index, sovereign spreads, the banking sector beta, stock returns, and time-varying stock return volatility.

The authors note that the pass through of financial stress from advanced countries to emerging markets is almost one-for-one. That being said:

there is significant cross-country variation. An empirical analysis of stress comovement shows that stronger financial (i.e., banking, portfolio, and FDI) linkages are associated with a higher stress pass-through from advanced to emerging economies. During the most recent crisis, bank lending linkages have been the main driver of stress transmission.

This characterization is obtained via a two-step procedure, as in Forbes and Chinn (2004). In the first step, the coefficient relating emerging market stress to advanced is obtained. These coefficients are then treated as data, in a regression on determinants such as FDI and banking linkages.

Another way of seeing the importance of, for instance, bank linkages is by inspecting the emerging market liabilities to advanced country banks:

Figure from Box 2 IMF.

In my view, large liabilities are important to the extent that bank deleveraging implies a long drawn out curtailment of credit to emerging markets. The IMF analysis observes:

Evidence from past episodes of systemic banking stress in advanced economies (Latin American debt crisis of the early 1980s and the Japanese banking crisis of the 1990s) implies that the decline in capital flows may be sizeable and drawn out. Given their large exposure, emerging European economies might be heavily affected, although EU membership offers some protection.

The complete analysis will come out in the next WEO.

* Full Disclosure: I was a consultant on this forthcoming chapter.

Posted by Menzie Chinn at March 31, 2009 09:24 PM"

What we need in the current situation is a central bank that is a bulwark of stability.

TO BE NOTED: From Econbrowser:

"The Fed's new balance sheet

My previous post reviewed the profound changes in the balance sheet of the U.S. Federal Reserve over the last 18 months. Here I comment on some of the concerns that the new Fed balance sheet raises for the conduct of monetary policy.

I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward. Apart from that general unease, I have a particular concern about the motivation for the Term Asset-Backed Securities Loan Facility, whose goal is to generate up to $1 trillion of lending for businesses and households by catalyzing a revival of loan securitization. I grant that securitization was an enormously successful device for funneling vast sums into sundry loans. For example, securitization successfully turned 80% of quite shaky subprime loans into Aaa-rated assets. To put that in perspective, only five U.S. companies currently have the ability to issue Aaa-rated debt. So yes, a device that transformed weak loans into Aaa-rated debt was marvelously successful at attracting capital from all over the world into U.S. private lending.

Ratio of total mortgage debt (from Table L.2 of Flow of Funds Accounts) to nominal GDP (from BEA Table 1.1.5).

But the whole premise behind those Aaa ratings-- that securitization could isolate a "safe" component of a pool of fundamentally risky loans-- was deeply flawed. It is impossible to diversify away aggregate or systemic risk. All that the device did was to mislead investors into thinking they were protected from those nondiversifiable risks and push those risks onto the taxpayers and the Fed. Before we decide that securitization is the road out of our present difficulties, I would like a detailed and convincing explanation of why the past mistakes are not going to be repeated again.

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require doubling the personal income tax rate on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed's ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed's new assets would it sell off when it needs to absorb back in the huge volume of reserves it has recently created? The Fed's hoped-for scenario is that the reserves won't need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation. Tim Iacono says that's like the Mafia buying "protection" from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it's not clear the Fed has either the means or the credibility."

Plan B is for the Fed to borrow directly from the public

TO BE NOTED: From Econbrowser:

"Money creation and the Fed

A lot of people have seen this picture of the recent behavior of the monetary base and wondered what it means.

Figure 1. Adjusted monetary base. Source: FRED.

To understand the explosion in the monetary base since September, let's begin with a little background. The Federal Reserve has the ability to purchase assets or make loans with funds (money) that are created by the Fed itself. To buy a billion dollars worth of assets, the Fed doesn't show up with new cash in a wheelbarrow. Instead the Fed pays for any assets it purchases or loans it extends by crediting the funds that the recipient bank has in an account with the Fed, known as reserve deposits. A bank can later withdraw those deposits in the form of green currency, if it chooses, and that's the point at which an armored truck from the Fed would be involved with physical delivery of cash.

The monetary base is essentially the sum of (1) the currency that's been withdrawn from private banks and is being held by the public, (2) the currency that's sitting in the vaults of private banks that could potentially be withdrawn by the banks' customers if they wanted, and (3) banks' reserve deposits, which you could think of as electronic credits for currency that the banks could ask for from the Fed any time the banks choose. Historically, newly created reserve deposits have usually shown up pretty quickly as currency withdrawn by banks and then by the public. Choosing a pace at which to allow that supply of currency to grow so as to accommodate the increased currency demands from a growing economy without cultivating excessive inflation is one of the main responsibilities of the Fed.

Figure 2 below plots the assorted "factors absorbing reserve funds" from the Fed's H41 release during the halcyon period from 2003 to the middle of 2007. At that time, currency held by the public was by far the biggest component in the liabilities side of the Fed's balance sheet, with the currency supply increasing 20% over these 5 years and with temporary seasonal bumps to accommodate the annual Christmas surge in currency demand. Reserve deposits (the sum of the "reserves" and "service" components in Figure 2) were quite minor relative to total quantity of currency in circulation.

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

With this increase in newly created money, the Fed was over this period acquiring assets primarily in the form of short-term Treasury securities, which holdings grew 25% over this 5-year period. The Fed at that time used short-term repurchase agreements as a device for adjusting the supply of reserves on a temporary basis. Note that for each date the height of the components in Figure 3 below (essentially the asset side of the Fed's balance sheet) is exactly equal, by definition, to the height of the liabilities portrayed in the previous Figure 2.

Figure 3. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Beginning in September 2007, the Fed began a process of systematically changing the nature of its asset holdings. Over the course of the next year, the Fed sold off over $300 billion in Treasury securities (about 40% of its holdings of Treasury securities), and replaced them with $150 billion in direct bank lending in the form of term auction credit, $60 billion in loans to foreign central banks in the form of liquidity swaps, and $100 billion in repurchase agreements, used now not for temporary adjustments but instead as a device to create a market for MBS by accepting alternative assets as collateral.

Figure 4. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Because the Fed funded those measures through August 2008 by selling off its holdings of Treasuries, there was little effect on either currency in circulation or the monetary base through that time.

Figure 5. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

Beginning in September of 2008, the Fed embarked on a huge expansion in its lending efforts and holdings of alternative assets. The biggest items among assets currently held are $469 billion in term auction credit, $328 billion in currency swaps, $241 billion leant through the CPLF, and $236 billion in mortgage-backed securities now held outright.

Figure 6. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf, represented by the pale yellow region in Figure 7 below, and a sum that last week amounted to a quarter trillion dollars. Note that magnitude is not part of the monetary base drawn in Figure 1. Some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen in Figure 1. But by far the biggest factor was a 100-fold increase in excess reserves, the green region in Figure 7. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.

Figure 7. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

That idleness, as I read the situation, was something the Fed initially actually wanted, and deliberately cultivated by choosing to pay an interest rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks do just sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.

But what would happen if those electronic credits start to be redeemed for actual cash? Then we would have a concern, and the Fed would need to call the reserves back in by selling assets or failing to renew loans. But that presents a potential problem, as noted by Charles Plosser, President of the Federal Reserve Bank of Philadelphia:

It is true that a number of the Fed's new programs will unwind naturally and fairly quickly as they are terminated because they involve primarily short-term assets. Yet we must anticipate that special interests and political pressures may make it harder to terminate these programs in a timely manner, thus making it difficult to shrink our balance sheet when the time comes. Moreover, some of these programs involve longer-term assets-- like the agency MBS. Such assets may prove difficult to sell for an extended period of time if markets are viewed as "fragile" or specific interest groups are strongly opposed, which could prove very damaging to our longer-term objective of price stability.

Last Monday's joint statement by the Treasury and the Fed indicated that the plan is for the worst of the Fed's assets (reported as "Maiden Lane" and part of the "AIG" sums in Figure 4) to be taken over by the Treasury, and Plosser for one wants the Treasury to take all the non-Treasury assets off the Fed's balance sheet. But as the Fed has declared its intention to raise its MBS holdings to $1.25 trillion it seems the current plan calls for more, not less of non-Treasury assets. And the following clause in the joint Fed-Treasury statement suggests that perhaps the Fed intends this, like most of the previous balance sheet changes, to not be allowed to impact total currency in circulation:

the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

John Jansen (hat tip: Tim Duy) construes that clause to mean that the Fed is going to request the ability to borrow directly as well as for exemption of any borrowing done by the Treasury on behalf of the Fed from the congressional debt ceiling. Also via Tim, FRB San Francisco President Janet Yellen offers this elaboration:

As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools. One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.

In other words, if the Fed decides that, as a result of inflationary pressures, it needs to undo some of the expansion in its liabilities at a time when it is not prepared to unwind its asset positions, Plan B is for the Fed to borrow directly from the public.

Which brings me back to the original question. Does the explosive growth of the monetary base in Figure 1 imply uncontrollable inflationary pressures? My answer: not yet, but stay tuned."

I suspect we'd have a lot more latitude for stimulus

TO BE NOTED: From Econbrowser:

"The Debt to GDP Trajectory in Perspective

There's been substantial discussion of how the debt-to-GDP ratio evolves under the Obama plan. In part, the House attempts to pare back certain provisions of the Obama budget are a reaction to the projected rise in the debt-to-GDP ratio [0].

Inspection of Figure 1 does provide some support for the view that we need to pare back spending, or raise taxes (seldom mentioned).

Figure 1: Ratio of Federal debt held by public to GDP (blue), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. In the baseline minus stimulus, I have merely subtracted the cumulated stimulus bill deficits; hence, no accounting for associated interest is included. Dashed line indicates last observation on actual data. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), and author's calculations.

I'll make three observations at this point.

• A big chunk of the increase in the debt-to-GDP ratio occurs because of the recession-driven collapse in revenues and the policy actions undertaken by the previous administration and Congress. Graphically, this is shown by the sharp jump in the series in FY 2009 (which started in October 2008).
• The debt-to-GDP projections do not take into account the stimulative effects of the stimulus plan, and in the budget. This is appropriate (as I have argued in the past, in my discussion of dynamic scoring [1]) because the magnitude of the stimulative effect is a subject of debate. Still, for those who are neither RBCers, nor Classical economists, we would expect the actual path of the debt-to-GDP ratio to be lower than projected (ceteris paribus) as GDP is higher than baseline in the first few years of the outlook [2] [3].
• The baseline debt-to-GDP ratio is in some sense unrealistic because it assumes discretionary spending grows with the CPI. Assuming that discretionary spending grows with nominal GDP -- a more realistic assumption [4] -- would make the gap between the baseline and the Obama budget debt/gdp ratio as scored by CBO smaller.

Still, even taking into account these factors, one should worry about crowding out, and the possibility that dollar denominated assets will become less desirable as the supply of Federal debt increases.

At this juncture, it might be useful to take a longer, historical, perspective on this issue. Below I plot data going back to FY 1938

Figure 2: Ratio of Federal debt held by public to GDP (blue), Ratio of end-FY Federal debt held by public to Calender Year GDP (real), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. In the baseline minus stimulus, I have merely subtracted the cumulated stimulus bill deficits; hence, no accounting for associated interest is included. Dashed line indicates last observation on actual data. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), FRED II, and author's calculations.

So, in the past, the Federal debt-to-GDP ratio has been higher than it is projected to be. Admittedly, the times are different. Financial autarky (approximately) prevailed in the 1940's and early 1950's, so the degree of substitubility between dollar and pound (and franc) denominated assets was low. That is not so now. However, it's also important to realize that debt-to-GDP ratios are rising in many other economies that are associated with currencies that might be thought to be close substitutes (think UK). And in the euro area, doubts about the government debt of certain economies is likely to make euro denominated assets also poor substitutes. (Remember that many of the debt-to-GDP ratios in Europe are higher than that in the US -- see slightly different [gross] ratios here). In any case, the analysis of the dilemma we are currently facing I laid out in this post from last July.

A last observation. Just think if the 2001 and 2003 tax cuts had never occurred. What would the debt-to-GDP ratio look like? I suspect we'd have a lot more latitude for stimulus. Not a new observation -- see here (and the accompanying commentary, which in retrospect is quite amusing) -- but one useful to recall.

Posted by Menzie Chinn at March 26, 2009 05:42 AM"