Saturday, August 29, 2015

Vice Chairman Stanley Fischer At the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming

August 29, 2015
U.S. Inflation Developments

I am delighted to be here in Jackson Hole in the company of such distinguished panelists and such a distinguished group of participants.

I will focus my remarks today on forces--domestic and international--that have been holding down inflation in the United States,1 and some of the consequences of recent--primarily international--developments.

Although the economy has continued to recover and the labor market is approaching our maximum employment objective, inflation has been persistently below 2 percent. That has been especially true recently, as the drop in oil prices over the past year, on the order of about 60 percent, has led directly to lower inflation as it feeds through to lower prices of gasoline and other energy items. As a result, 12-month changes in the overall personal consumption expenditure (PCE) price index have recently been only a little above zero (chart 1).

The past year's energy price declines ought to be largely a one-off event (chart 2). That is, while futures markets suggest that the level of oil prices is expected to remain well below levels seen last summer, markets do not expect oil prices to fall further, so their influence in holding down inflation should be temporary. But measures of core inflation, which are intended to help us look through such transitory price movements, have also been relatively low (return to chart 1). The PCE index excluding food and energy is up 1.2 percent over the past year. The Dallas Fed's trimmed mean measure of the PCE price index is higher, at 1.6 percent, but still somewhat below our 2 percent objective. Moreover, these measures of core inflation have been persistently below 2 percent throughout the economic recovery. That said, as with total inflation, core inflation can be somewhat variable, especially at frequencies higher than 12-month changes. Moreover, note that core inflation does not entirely "exclude" food and energy, because changes in energy prices affect firms' costs and so can pass into prices of non-energy items.

Inflation as measured by the consumer price index (CPI) generally sends the same broad message as does the PCE price index (chart 3). That similarity should not be surprising, because the CPI is the most important input used for constructing PCE prices. On average, CPI inflation tends to run a few tenths higher than PCE inflation, and, because the CPI has a modestly larger weight on energy prices, fluctuations in the CPI measure tend to be a bit larger.

Of course, ongoing economic slack is one reason core inflation has been low. Although the economy has made great progress, we started seven years ago from an unemployment rate of 10 percent, which guaranteed a lengthy period of high unemployment. Even so, with inflation expectations apparently stable, we would have expected the gradual reduction of slack to be associated with less downward price pressure. All else equal, we might therefore have expected both headline and core inflation to be moving up more noticeably toward our 2 percent objective. Yet, we have seen no clear evidence of core inflation moving higher over the past few years. This fact helps drive home an important point: While much evidence points to at least some ongoing role for slack in helping to explain movements in inflation, this influence is typically estimated to be modest in magnitude, and can easily be masked by other factors.2

In the first instance, as already noted, core inflation can to some extent be influenced by oil prices. However, a larger effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low (chart 4). A higher value of the dollar passes through to lower import prices, which hold down U.S. inflation both because imports make up part of final consumption, and because lower prices for imported components hold down business costs more generally. In addition, a rise in the dollar restrains the growth of aggregate demand and overall economic activity, and so has some effect on inflation through that more indirect channel.3

To get a sense of the timing and magnitude of these exchange rate effects, chart 5 shows dynamic simulations of a 10 percent real dollar appreciation, based on one of the models we maintain at the Federal Reserve.4 The estimated pass-through from import prices to consumer price inflation occurs relatively quickly, with effects becoming evident within a quarter and the bulk of the overall effect occurring within one year. By contrast, the portion of the dollar effects on inflation that work through the channel of overall economic activity occurs with considerable lags. In the model shown here, the appreciation has its largest effect on gross domestic product (GDP) growth in the second year after the shock. Thus, it is plausible to think that the rise in the dollar over the past year would restrain growth of real GDP through 2016 and perhaps into 2017 as well. The rise in the dollar since last summer, of about 17 percent in nominal terms, with its associated declines in non-oil import prices, could plausibly be holding down core inflation quite noticeably this year.

Commodity prices other than oil are also of relevance for inflation in the United States. Prices of metals and other industrial commodities, and agricultural products, are affected to a considerable extent by developments outside the United States, and the softness we've seen in these commodity prices, has in part reflected a slowing of demand from China and elsewhere. These prices likely have also been a factor in holding down inflation in the United States.

The dynamics with which all these factors affect inflation depend crucially on the behavior of inflation expectations. One striking feature of the economic environment is that longer-term inflation expectations in the United States appear to have remained generally stable since the late 1990s (chart 6). The source of that stability is open to debate, but the fact that the Fed has kept inflation relatively low and stable for three decades must be an important part of the explanation. Expectations that are not stable, but instead follow actual inflation up or down, would allow inflation to drift persistently. In the recent period, movements in inflation have tended to be transitory. For example, one might have expected the Great Recession to generate a downward wage-price spiral, but this did not occur. Thus, the stability of inflation expectations has prevented inflation from falling further below our objective than occurred, and it has enabled the Federal Open Market Committee to look through some upward inflation shocks without compromising price stability.5

We should however be cautious in our assessment that inflation expectations are remaining stable. One reason is that measures of inflation compensation in the market for Treasury securities have moved down somewhat since last summer (chart 7). But these movements can be hard to interpret, as at times they may reflect factors other than inflation expectations, such as changes in demand for the unparalleled liquidity of nominal Treasury securities.

In announcing its July interest rate decision, the Federal Open Market Committee (FOMC) said:

In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

Can the Committee be "reasonably confident that inflation will move back to its 2 percent objective over the medium term"? As I have discussed, given the apparent stability of inflation expectations, there is good reason to believe that inflation will move higher as the forces holding down inflation dissipate further. While some effects of the rise in the dollar may be spread over time, some of the effects on inflation are likely already starting to fade. The same is true for last year's sharp fall in oil prices, though the further declines we have seen this summer have yet to fully show through to the consumer level. And slack in the labor market has continued to diminish, so the downward pressure on inflation from that channel should be diminishing as well.

In addition, with regard to expectations of inflation, it is possible to consult the results of the SEP, the Survey of Economic Projections, which FOMC participants complete shortly before the March, June, September, and December meetings. In the June SEP, the central tendency of FOMC participants' projections for core PCE inflation was 1.3 percent to 1.4 percent this year, 1.6 percent to 1.9 percent next year, and 1.9 percent to 2.0 percent in 2017. There will be a new SEP for the forthcoming September meeting of the FOMC.

Reflecting all these factors, the Committee has indicated in its post-meeting statements that it expects inflation to return to 2 percent. With regard to our degree of confidence in this expectation, we will need to consider all the available information and assess its implications for the economic outlook before coming to a judgment.

In addition, the July announcement set a condition of requiring "some further improvement in the labor market." From May through July, non-farm payroll employment gains have averaged 235,000 per month. We now await the results of the August employment survey, which are due to be published on September 4.

Of course, the FOMC's monetary policy decision is not a mechanical one, based purely on the set of numbers reported in the payroll survey and in our judgment on the degree of confidence members of the committee have about future inflation. We are interested also in aspects of the labor market beyond the simple U-3 measure of unemployment, including for example the rates of unemployment of older workers and of those working part-time for economic reasons; we are interested also in the participation rate. And in the case of the inflation rate we look beyond the rate of increase of PCE prices and define the concept of the core rate of inflation.

While thinking of different aspects of unemployment, we are concerned mainly with trying to find the right measure of the difficulties caused to current and potential participants in the labor force by their unemployment. In the case of the core rate of inflation, we are mainly looking for a good indicator of future inflation, and for better indicators than we have at present.

In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come. That is why we need to consider the overall state of the U.S. economy as well as the influence of foreign economies on the U.S. economy as we reach our judgment on whether and how to change monetary policy. That is why we follow economic developments in the rest of the world as well as the United States in reaching our interest rate decisions. At this moment, we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.

The Fed has, appropriately, responded to the weak economy and low inflation in recent years by taking a highly accommodative policy stance. By committing to foster the movement of inflation toward our 2 percent objective, we are enhancing the credibility of monetary policy and supporting the continued stability of inflation expectations. To do what monetary policy can do towards meeting our goals of maximum employment and price stability, and to ensure that these goals will continue to be met as we move ahead, we will most likely need to proceed cautiously in normalizing the stance of monetary policy. For the purpose of meeting our goals, the entire path of interest rates matters more than the particular timing of the first increase.

With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening. Should we judge at some point in time that the economy is threatening to overheat, we will have to move appropriately rapidly to deal with that threat. The same is true should the economy unexpectedly weaken.

Finally, while I have been talking today about some international influences on economic conditions in the United States, I am well aware that, when the Federal Reserve tightens policy, this affects other economies. The Fed's statutory objectives are defined in terms of economic goals for the economy of the United States, but I believe that by meeting those objectives, and so maintaining a stable and strong macroeconomic environment at home, we will be best serving the global economy as well.6



1. The views expressed here are my own and not necessarily those of others at the Board, on the Federal Open Market Committee, or in the Federal Reserve System. Return to text

2. Among the many papers finding a role for resource utilization in affecting inflation based on evidence from macroeconomic time-series data, see Robert J. Gordon (2013), "The Phillips Curve Is Alive and Well: Inflation and the NAIRU during the Slow Recovery (PDF)," Leaving the Board NBER Working Paper Series 19390 (Cambridge, Mass.: National Bureau of Economic Research, August); or Douglas O. Staiger, James H. Stock and Mark W. Watson (1997), "How Precise Are Estimates of the Natural Rate of Unemployment?" Leaving the Board in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press), pp. 195-246. For similar results based on cross-sectional evidence, see Michael T. Kiley (2014), "An Evaluation of the Inflationary Pressure Associated with Short- and Long-Term Unemployment (PDF)," Finance and Economics Discussion Series 2014-28 (Washington: Board of Governors of the Federal Reserve System, March); or, for wages instead of prices, Christopher L. Smith (2014), "The Effect of Labor Slack on Wages: Evidence from State-Level Relationships," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, June 2). Return to text

3. There has also been debate regarding other potential channels through which global factors could affect domestic inflation--for example, whether measures of foreign resource utilization play an important independent role. For evidence supporting such global factors, see Claudio Borio and Andrew Filardo (2007), "Globalisation and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation (PDF)," Leaving the Board BIS Working Papers 227 (Basel, Switzerland: Bank for International Settlements, May). For a more skeptical take, see Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez (2007), "Some Simple Tests of the Globalization and Inflation Hypothesis (PDF)," International Finance Discussion Papers 891 (Washington: Board of Governors of the Federal Reserve System, April). Return to text

4. For background information on this model, see Christopher Erceg, Luca Guerrieri, and Christopher Gust (2006), "SIGMA: A New Open Economy Model for Policy Analysis (PDF)," International Finance Discussion Paper Series 2005-835 (Washington: Board of Governors of the Federal Reserve System, January). This model incorporates monetary policy responses to economic shocks and thus may show smaller effects on real GDP and inflation than other partial-equilibrium analyses. That said, the SIGMA model is just one of a number of models that the Board staff regularly consults to inform their analysis of the U.S. economy. Return to text

5. It is noteworthy that in several inflation-targeting economies, the ten year expected inflation rate has settled precisely at the target inflation rate. Return to text

6. For more discussion on this theme, see Stanley Fischer (2014), "The Federal Reserve and the Global Economy," speech delivered at the 2014 Annual Meetings of the International Monetary Fund and the World Bank Group, Washington, October 11. Return to text

Friday, August 28, 2015

Wednesday, August 12, 2015

Monday, August 10, 2015

Ludwig Erhard

In postwar Germany, one great statesman led the fight for freedom: Ludwig Erhard. He was deeply influenced by Wilhelm Röpke, and drew heavily on the case for free markets made by Ludwig von Mises. He received his PhD from Franz Oppenheimer, the great anti-state theorist and libertarian, in 1925.

As minister of economics after 1949, he had inherited a disaster made by Hitler, wartime controls, and allied bombings. His steadfast advocacy of freedom led directly to the so-called German economic miracle. He smashed monopolies, repealed price controls, and dismantled statist controls of all sorts. Thus did he make a singular contribution to world history, one directly influenced by both the Austrian and libertarian traditions.

In 1957, he wrote a fantastic book, Prosperity Through Competition, that explains his rationale. Until now, this book has been nearly impossible to find. This new edition by the Mises Institute allows us to look again at his thinking and methods. What stands out most compellingly here is the group to whom he pitched his work. It is written not for politicians, consumers, bureaucrats, or intellectuals. The group he knew that he had to pursued was the business class. It was business that had clung to the old controls and cartels, pushed inflation, and wanted mercantile policies.

Erhard makes a passionate plead to business to embrace free enterprise and competition, in its long-term self interest. His arguments are fresh and energetic. But what this book illustrates is that free markets, by no means, are not just an excuse for the triumph of the business classes. In fact, in Germany, they were a force for statism and reaction.

"In my opinion," he writes, "the historic task of the Federal Republic in the second half of the 20th century that we have just entered upon is to underpin, to strengthen and to defend the free economic order of Europe with the full weight of German trade. The successful rehabilitation of my country must serve as clear documentary evidence to put before the still vacillating and doubting peoples, of the fact that only by firmly rejecting socialist dogmas, of whatever complexion, and by affirming a free economic order can mounting prosperity and genuine security be achieved."--The Mises Institute

Sunday, August 9, 2015

Economic Depressions: Their Cause and Cure

By Murray Rothbard

[Day 6 of Robert Wenzel's 30-day reading list that will lead you to become a knowledgeable libertarian, this essay was originally published as a minibook by the Constitutional Alliance of Lansing, Michigan, 1969.]

We live in a world of euphemism. Undertakers have become "morticians," press agents are now "public relations counselors" and janitors have all been transformed into "superintendents." In every walk of life, plain facts have been wrapped in cloudy camouflage.
No less has this been true of economics. In the old days, we used to suffer nearly periodic economic crises, the sudden onset of which was called a "panic," and the lingering trough period after the panic was called "depression."
The most famous depression in modern times, of course, was the one that began in a typical financial panic in 1929 and lasted until the advent of World War II. After the disaster of 1929, economists and politicians resolved that this must never happen again. The easiest way of succeeding at this resolve was, simply to define "depressions" out of existence. From that point on, America was to suffer no further depressions. For when the next sharp depression came along, in 1937–38, the economists simply refused to use the dread name, and came up with a new, much softer-sounding word: "recession." From that point on, we have been through quite a few recessions, but not a single depression.
But pretty soon the word "recession" also became too harsh for the delicate sensibilities of the American public. It now seems that we had our last recession in 1957–58. For since then, we have only had "downturns," or, even better, "slowdowns," or "sidewise movements." So be of good cheer; from now on, depressions and even recessions have been outlawed by the semantic fiat of economists; from now on, the worst that can possibly happen to us are "slowdowns." Such are the wonders of the "New Economics."
For 30 years, our nation's economists have adopted the view of the business cycle held by the late British economist, John Maynard Keynes, who created the Keynesian, or the "New," Economics in his book, The General Theory of Employment, Interest, and Money, published in 1936. Beneath their diagrams, mathematics, and inchoate jargon, the attitude of Keynesians toward booms and bust is simplicity, even naïveté, itself. If there is inflation, then the cause is supposed to be "excessive spending" on the part of the public; the alleged cure is for the government, the self-appointed stabilizer and regulator of the nation's economy, to step in and force people to spend less, "sopping up their excess purchasing power" through increased taxation. If there is a recession, on the other hand, this has been caused by insufficient private spending, and the cure now is for the government to increase its own spending, preferably through deficits, thereby adding to the nation's aggregate spending stream.
The idea that increased government spending or easy money is "good for business" and that budget cuts or harder money is "bad" permeates even the most conservative newspapers and magazines. These journals will also take for granted that it is the sacred task of the federal government to steer the economic system on the narrow road between the abysses of depression on the one hand and inflation on the other, for the free-market economy is supposed to be ever liable to succumb to one of these evils.
All current schools of economists have the same attitude. Note, for example, the viewpoint of Dr. Paul W. McCracken, the incoming chairman of President Nixon's Council of Economic Advisers. In an interview with theNew York Times shortly after taking office [January 24, 1969], Dr. McCracken asserted that one of the major economic problems facing the new administration is "how you cool down this inflationary economy without at the same time tripping off unacceptably high levels of unemployment. In other words, if the only thing we want to do is cool off the inflation, it could be done. But our social tolerances on unemployment are narrow." And again: "I think we have to feel our way along here. We don't really have much experience in trying to cool an economy in orderly fashion. We slammed on the brakes in 1957, but, of course, we got substantial slack in the economy."
Note the fundamental attitude of Dr. McCracken toward the economy — remarkable only in that it is shared by almost all economists of the present day. The economy is treated as a potentially workable, but always troublesome and recalcitrant patient, with a continual tendency to hive off into greater inflation or unemployment. The function of the government is to be the wise old manager and physician, ever watchful, ever tinkering to keep the economic patient in good working order. In any case, here the economic patient is clearly supposed to be the subject, and the government as "physician" the master.
It was not so long ago that this kind of attitude and policy was called "socialism"; but we live in a world of euphemism, and now we call it by far less harsh labels, such as "moderation" or "enlightened free enterprise." We live and learn.
What, then, are the causes of periodic depressions? Must we always remain agnostic about the causes of booms and busts? Is it really true that business cycles are rooted deep within the free-market economy, and that therefore some form of government planning is needed if we wish to keep the economy within some kind of stable bounds? Do booms and then busts just simply happen, or does one phase of the cycle flow logically from the other?
The currently fashionable attitude toward the business cycle stems, actually, from Karl Marx. Marx saw that, before the Industrial Revolution in approximately the late 18th century, there were no regularly recurring booms and depressions. There would be a sudden economic crisis whenever some king made war or confiscated the property of his subject; but there was no sign of the peculiarly modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions. Since these cycles also appeared on the scene at about the same time as modern industry, Marx concluded that business cycles were an inherent feature of the capitalist market economy. All the various current schools of economic thought, regardless of their other differences and the different causes that they attribute to the cycle, agree on this vital point: that these business cycles originate somewhere deep within the free-market economy. The market economy is to blame. Karl Marx believed that the periodic depressions would get worse and worse, until the masses would be moved to revolt and destroy the system, while the modern economists believe that the government can successfully stabilize depressions and the cycle. But all parties agree that the fault lies deep within the market economy and that if anything can save the day, it must be some form of massive government intervention.
There are, however, some critical problems in the assumption that the market economy is the culprit. For "general economic theory" teaches us that supply and demand always tend to be in equilibrium in the market and that therefore prices of products as well as of the factors that contribute to production are always tending toward some equilibrium point. Even though changes of data, which are always taking place, prevent equilibrium from ever being reached, there is nothing in the general theory of the market system that would account for regular and recurring boom-and-bust phases of the business cycle. Modern economists "solve" this problem by simply keeping their general price and market theory and their business-cycle theory in separate, tightly-sealed compartments, with never the twain meeting, much less integrated with each other. Economists, unfortunately, have forgotten that there is only one economy and therefore only one integrated economic theory. Neither economic life nor the structure of theory can or should be in watertight compartments; our knowledge of the economy is either one integrated whole or it is nothing. Yet most economists are content to apply totally separate and, indeed, mutually exclusive, theories for general price analysis and for business cycles. They cannot be genuine economic scientists so long as they are content to keep operating in this primitive way.
But there are still graver problems with the currently fashionable approach. Economists also do not see one particularly critical problem because they do not bother to square their business cycle and general price theories: the peculiar breakdown of the entrepreneurial function at times of economic crisis and depression. In the market economy, one of the most vital functions of the businessman is to be an "entrepreneur," a man who invests in productive methods, who buys equipment and hires labor to produce something which he is not sure will reap him any return. In short, the entrepreneurial function is the function of forecasting the uncertain future. Before embarking on any investment or line of production, the entrepreneur, or "enterpriser," must estimate present and future costs and future revenues and therefore estimate whether and how much profits he will earn from the investment. If he forecasts well and significantly better than his business competitors, he will reap profits from his investment. The better his forecasting, the higher the profits he will earn. If, on the other hand, he is a poor forecaster and overestimates the demand for his product, he will suffer losses and pretty soon be forced out of the business.
The market economy, then, is a profit-and-loss economy, in which the acumen and ability of business entrepreneurs is gauged by the profits and losses they reap. The market economy, moreover, contains a built-in mechanism, a kind of natural selection, that ensures the survival and the flourishing of the superior forecaster and the weeding-out of the inferior ones. For the more profits reaped by the better forecasters, the greater become their business responsibilities, and the more they will have available to invest in the productive system. On the other hand, a few years of making losses will drive the poorer forecasters and entrepreneurs out of business altogether and push them into the ranks of salaried employees.
If, then, the market economy has a built-in natural selection mechanism for good entrepreneurs, this means that, generally, we would expect not many business firms to be making losses. And, in fact, if we look around at the economy on an average day or year, we will find that losses are not very widespread. But, in that case, the odd fact that needs explaining is this: How is it that, periodically, in times of the onset of recessions and especially in steep depressions, the business world suddenly experiences a massive cluster of severe losses? A moment arrives when business firms, previously highly astute entrepreneurs in their ability to make profits and avoid losses, suddenly and dismayingly find themselves, almost all of them, suffering severe and unaccountable losses? How come? Here is a momentous fact that any theory of depressions must explain. An explanation such as "underconsumption" — a drop in total consumer spending — is not sufficient, for one thing, because what needs to be explained is why businessmen, able to forecast all manner of previous economic changes and developments, proved themselves totally and catastrophically unable to forecast this alleged drop in consumer demand. Why this sudden failure in forecasting ability?
An adequate theory of depressions, then, must account for the tendency of the economy to move through successive booms and busts, showing no sign of settling into any sort of smoothly moving, or quietly progressive, approximation of an equilibrium situation. In particular, a theory of depression must account for the mammoth cluster of errors which appears swiftly and suddenly at a moment of economic crisis, and lingers through the depression period until recovery. And there is a third universal fact that a theory of the cycle must account for. Invariably, the booms and busts are much more intense and severe in the "capital goods industries" — the industries making machines and equipment, the ones producing industrial raw materials or constructing industrial plants — than in the industries making consumers' goods. Here is another fact of business cycle life that must be explained — and obviously can't be explained by such theories of depression as the popular underconsumption doctrine: that consumers aren't spending enough on consumer goods. For if insufficient spending is the culprit, then how is it that retail sales are the last and the least to fall in any depression, and that depression really hits such industries as machine tools, capital equipment, construction, and raw materials? Conversely, it is these industries that really take off in the inflationary boom phases of the business cycle, and not those businesses serving the consumer. An adequate theory of the business cycle, then, must also explain the far greater intensity of booms and busts in the non-consumer goods, or "producers' goods," industries.
Fortunately, a correct theory of depression and of the business cycle does exist, even though it is universally neglected in present-day economics. It, too, has a long tradition in economic thought. This theory began with the 18th-century Scottish philosopher and economist David Hume, and with the eminent early 19th-century English classical economist David Ricardo. Essentially, these theorists saw that another crucial institution had developed in the mid-18th century, alongside the industrial system. This was the institution of banking, with its capacity to expand credit and the money supply (first, in the form of paper money, or bank notes, and later in the form of demand deposits, or checking accounts, that are instantly redeemable in cash at the banks). It was the operations of these commercial banks which, these economists saw, held the key to the mysterious recurrent cycles of expansion and contraction, of boom and bust, that had puzzled observers since the mid-18th century.
The Ricardian analysis of the business cycle went something as follows: The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate as it does in particular markets: a smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For the banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not. For example, if a bank has 1,000 ounces of gold in its vaults, and it issues instantly redeemable warehouse receipts for 2,500 ounces of gold, then it clearly has issued 1,500 ounces more than it can possibly redeem. But so long as there is no concerted "run" on the bank to cash in these receipts, its warehouse-receipts function on the market as equivalent to gold, and therefore the bank has been able to expand the money supply of the country by 1,500 gold ounces.
The banks, then, happily begin to expand credit, for the more they expand credit the greater will be their profits. This results in the expansion of the money supply within a country, say England. As the supply of paper and bank money in England increases, the money incomes and expenditures of Englishmen rise, and the increased money bids up prices of English goods. The result is inflation and a boom within the country. But this inflationary boom, while it proceeds on its merry way, sows the seeds of its own demise. For as English money supply and incomes increase, Englishmen proceed to purchase more goods from abroad. Furthermore, as English prices go up, English goods begin to lose their competitiveness with the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy less at home and more abroad, while foreigners buy less in England and more at home; the result is a deficit in the English balance of payments, with English exports falling sharply behind imports. But if imports exceed exports, this means that money must flow out of England to foreign countries. And what money will this be? Surely not English bank notes or deposits, for Frenchmen or Germans or Italians have little or no interest in keeping their funds locked up in English banks. These foreigners will therefore take their bank notes and deposits and present them to the English banks for redemption in gold — and gold will be the type of money that will tend to flow persistently out of the country as the English inflation proceeds on its way. But this means that English bank credit money will be, more and more, pyramiding on top of a dwindling gold base in the English bank vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2,500 ounces to 4,000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.
The bank contraction reverses the economic picture; contraction and bust follow boom. The banks pull in their horns, and businesses suffer as the pressure mounts for debt repayment and contraction. The fall in the supply of bank money, in turn, leads to a general fall in English prices. As money supply and incomes fall, and English prices collapse, English goods become relatively more attractive in terms of foreign products, and the balance of payments reverses itself, with exports exceeding imports. As gold flows into the country, and as bank money contracts on top of an expanding gold base, the condition of the banks becomes much sounder.
This, then, is the meaning of the depression phase of the business cycle. Note that it is a phase that comes out of, and inevitably comes out of, the preceding expansionary boom. It is the preceding inflation that makes the depression phase necessary. We can see, for example, that the depression is the process by which the market economy adjusts, throws off the excesses and distortions of the previous inflationary boom, and reestablishes a sound economic condition. The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom.
Why, then, does the next cycle begin? Why do business cycles tend to be recurrent and continuous? Because when the banks have pretty well recovered, and are in a sounder condition, they are then in a confident position to proceed to their natural path of bank credit expansion, and the next boom proceeds on its way, sowing the seeds for the next inevitable bust.
But if banking is the cause of the business cycle, aren't the banks also a part of the private market economy, and can't we therefore say that the free market is still the culprit, if only in the banking segment of that free market? The answer is no, for the banks, for one thing, would never be able to expand credit in concert were it not for the intervention and encouragement of government. For if banks were truly competitive, any expansion of credit by one bank would quickly pile up the debts of that bank in its competitors, and its competitors would quickly call upon the expanding bank for redemption in cash. In short, a bank's rivals will call upon it for redemption in gold or cash in the same way as do foreigners, except that the process is much faster and would nip any incipient inflation in the bud before it got started. Banks can only expand comfortably in unison when a central bank exists, essentially a governmental bank, enjoying a monopoly of government business, and a privileged position imposed by government over the entire banking system. It is only when central banking got established that the banks were able to expand for any length of time and the familiar business cycle got underway in the modern world.
The central bank acquires its control over the banking system by such governmental measures as: Making its own liabilities legal tender for all debts and receivable in taxes; granting the central bank monopoly of the issue of bank notes, as contrasted to deposits (in England the Bank of England, the governmentally established central bank, had a legal monopoly of bank notes in the London area); or through the outright forcing of banks to use the central bank as their client for keeping their reserves of cash (as in the United States and its Federal Reserve System). Not that the banks complain about this intervention; for it is the establishment of central banking that makes long-term bank credit expansion possible, since the expansion of central-bank notes provides added cash reserves for the entire banking system and permits all the commercial banks to expand their credit together. Central banking works like a cozy compulsory bank cartel to expand the banks' liabilities; and the banks are now able to expand on a larger base of cash in the form of central bank notes as well as gold.
So now we see, at last, that the business cycle is brought about, not by any mysterious failings of the free-market economy, but quite the opposite: by systematic intervention by government in the market process. Government intervention brings about bank expansion and inflation, and, when the inflation comes to an end, the subsequent depression-adjustment comes into play.
The Ricardian theory of the business cycle grasped the essentials of a correct cycle theory: the recurrent nature of the phases of the cycle, depression as adjustment intervention in the market rather than from the free-market economy. But two problems were as yet unexplained: Why the sudden cluster of business error, the sudden failure of the entrepreneurial function, and why the vastly greater fluctuations in the producers' goods than in the consumers' goods industries? The Ricardian theory only explained movements in the price level, in general business; there was no hint of explanation of the vastly different reactions in the capital and consumers' goods industries.
The correct and fully developed theory of the business cycle was finally discovered and set forth by the Austrian economist Ludwig von Mises, when he was a professor at the University of Vienna. Mises developed hints of his solution to the vital problem of the business cycle in his monumental Theory of Money and Credit, published in 1912, and still, nearly 60 years later, the best book on the theory of money and banking. Mises developed his cycle theory during the 1920s, and it was brought to the English-speaking world by Mises's leading follower, Friedrich A. von Hayek, who came from Vienna to teach at the London School of Economics in the early 1930s, and who published, in German and in English, two books which applied and elaborated the Mises cycle theory: Monetary Theory and the Trade Cycle, and Prices and Production. Since Mises and Hayek were Austrians, and also since they were in the tradition of the great 19th-century Austrian economists, this theory has become known in the literature as the "Austrian" (or the "monetary over-investment") theory of the business cycle.
Building on the Ricardians, on general "Austrian" theory, and on his own creative genius, Mises developed the following theory of the business cycle:
Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop. But then government through its central bank stimulates bank credit expansion by expanding central bank liabilities and therefore the cash reserves of all the nation's commercial banks. The banks then proceed to expand credit and hence the nation's money supply in the form of check deposits. As the Ricardians saw, this expansion of bank money drives up the prices of goods and hence causes inflation. But, Mises showed, it does something else, and something even more sinister. Bank credit expansion, by pouring new loan funds into the business world, artificially lowers the rate of interest in the economy below its free-market level.
On the free and unhampered market, the interest rate is determined purely by the "time preferences" of all the individuals that make up the market economy. For the essence of a loan is that a "present good" (money which can be used at present) is being exchanged for a "future good" (an IOU which can only be used at some point in the future). Since people always prefer money right now to the present prospect of getting the same amount of money sometime in the future, the present good always commands a premium in the market over the future. This premium is the interest rate, and its height will vary according to the degree to which people prefer the present to the future, i.e., the degree of their time preferences.
People's time preferences also determine the extent to which people will save and invest, as compared to how much they will consume. If people's time preferences should fall, i.e., if their degree of preference for present over future falls, then people will tend to consume less now and save and invest more; at the same time, and for the same reason, the rate of interest, the rate of time discount, will also fall. Economic growth comes about largely as the result of falling rates of time preference, which lead to an increase in the proportion of saving and investment to consumption, and also to a falling rate of interest.
But what happens when the rate of interest falls, not because of lower time preferences and higher savings, but from government interference that promotes the expansion of bank credit? In other words, if the rate of interest falls artificially, due to intervention, rather than naturally, as a result of changes in the valuations and preferences of the consuming public?
What happens is trouble. For businessmen, seeing the rate of interest fall, react as they always would and must to such a change of market signals: they invest more in capital and producers' goods. Investments, particularly in lengthy and time-consuming projects, which previously looked unprofitable now seem profitable, because of the fall of the interest charge. In short, businessmen react as they would react if savings had genuinelyincreased: they expand their investment in durable equipment, in capital goods, in industrial raw material, in construction as compared to their direct production of consumer goods.
Businesses, in short, happily borrow the newly expanded bank money that is coming to them at cheaper rates; they use the money to invest in capital goods, and eventually this money gets paid out in higher rents to land, and higher wages to workers in the capital goods industries. The increased business demand bids up labor costs, but businesses think they can pay these higher costs because they have been fooled by the government-and-bank intervention in the loan market and its decisively important tampering with the interest-rate signal of the marketplace.
The problem comes as soon as the workers and landlords — largely the former, since most gross business income is paid out in wages — begin to spend the new bank money that they have received in the form of higher wages. For the time preferences of the public have not really gotten lower; the public doesn't want to save more than it has. So the workers set about to consume most of their new income, in short to reestablish the old consumer/saving proportions. This means that they redirect the spending back to the consumer goods industries, and they don't save and invest enough to buy the newly-produced machines, capital equipment, industrial raw materials, etc. This all reveals itself as a sudden sharp and continuing depression in the producers' goods industries. Once the consumers reestablished their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods and had underinvested in consumer goods. Business had been seduced by the governmental tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there. As soon as the new bank money filtered through the system and the consumers reestablished their old proportions, it became clear that there were not enough savings to buy all the producers' goods, and that business had misinvested the limited savings available. Business had overinvested in capital goods and underinvested in consumer products.
The inflationary boom thus leads to distortions of the pricing and production system. Prices of labor and raw materials in the capital goods industries had been bid up during the boom too high to be profitable once the consumers reassert their old consumption/investment preferences. The "depression" is then seen as the necessary and healthy phase by which the market economy sloughs off and liquidates the unsound, uneconomic investments of the boom, and reestablishes those proportions between consumption and investment that are truly desired by the consumers. The depression is the painful but necessary process by which the free market sloughs off the excesses and errors of the boom and reestablishes the market economy in its function of efficient service to the mass of consumers. Since prices of factors of production have been bid too high in the boom, this means that prices of labor and goods in these capital goods industries must be allowed to fall until proper market relations are resumed.
Since the workers receive the increased money in the form of higher wages fairly rapidly, how is it that booms can go on for years without having their unsound investments revealed, their errors due to tampering with market signals become evident, and the depression-adjustment process begins its work? The answer is that booms would be very short lived if the bank credit expansion and subsequent pushing of the rate of interest below the free-market level were a one-shot affair. But the point is that the credit expansion is not one-shot; it proceeds on and on, never giving consumers the chance to reestablish their preferred proportions of consumption and saving, never allowing the rise in costs in the capital goods industries to catch up to the inflationary rise in prices. Like the repeated doping of a horse, the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit. It is only when bank credit expansion must finally stop, either because the banks are getting into a shaky condition or because the public begins to balk at the continuing inflation, that retribution finally catches up with the boom. As soon as credit expansion stops, then the piper must be paid, and the inevitable readjustments liquidate the unsound over-investments of the boom, with the reassertion of a greater proportionate emphasis on consumers' goods production.
Thus, the Misesian theory of the business cycle accounts for all of our puzzles: the repeated and recurrent nature of the cycle, the massive cluster of entrepreneurial error, the far greater intensity of the boom and bust in the producers' goods industries.
Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.
Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands-off, laissez-faire policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.
The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.
It has today been completely forgotten, even among economists, that the Misesian explanation and analysis of the depression gained great headway precisely during the Great Depression of the 1930s — the very depression that is always held up to advocates of the free-market economy as the greatest single and catastrophic failure of laissez-faire capitalism. It was no such thing. Nineteen twenty-nine was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: a policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States. It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a nonexistent free-market economy.
If Coolidge made 1929 inevitable, it was President Hoover who prolonged and deepened the depression, transforming it from a typically sharp but swiftly disappearing depression into a lingering and near-fatal malady, a malady "cured" only by the holocaust of World War II. Hoover, not Franklin Roosevelt, was the founder of the policy of the "New Deal": essentially the massive use of the State to do exactly what Misesian theory would most warn against — to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions. Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression.
Ludwig von Mises had predicted the depression during the heyday of the great boom of the 1920s — a time, just like today, when economists and politicians, armed with a "new economics" of perpetual inflation, and with new "tools" provided by the Federal Reserve System, proclaimed a perpetual "New Era" of permanent prosperity guaranteed by our wise economic doctors in Washington. Ludwig von Mises, alone armed with a correct theory of the business cycle, was one of the very few economists to predict the Great Depression, and hence the economic world was forced to listen to him with respect. F.A. Hayek spread the word in England, and the younger English economists were all, in the early 1930s, beginning to adopt the Misesian cycle theory for their analysis of the depression — and also to adopt, of course, the strictly free-market policy prescription that flowed with this theory. Unfortunately, economists have now adopted the historical notion of Lord Keynes: that no "classical economists" had a theory of the business cycle until Keynes came along in 1936. There was a theory of the depression; it was the classical economic tradition; its prescription was strict hard money and laissez-faire; and it was rapidly being adopted, in England and even in the United States, as the accepted theory of the business cycle. (A particular irony is that the major "Austrian" proponent in the United States in the early and mid-1930s was none other than Professor Alvin Hansen, very soon to make his mark as the outstanding Keynesian disciple in this country.)
What swamped the growing acceptance of Misesian cycle theory was simply the "Keynesian Revolution" — the amazing sweep that Keynesian theory made of the economic world shortly after the publication of the General Theory in 1936. It is not that Misesian theory was refuted successfully; it was just forgotten in the rush to climb on the suddenly fashionable Keynesian bandwagon. Some of the leading adherents of the Mises theory — who clearly knew better — succumbed to the newly established winds of doctrine, and won leading American university posts as a consequence.
But now the once arch-Keynesian London Economist has recently proclaimed that "Keynes is Dead." After over a decade of facing trenchant theoretical critiques and refutation by stubborn economic facts, the Keynesians are now in general and massive retreat. Once again, the money supply and bank credit are being grudgingly acknowledged to play a leading role in the cycle. The time is ripe — for a rediscovery, a renaissance, of the Mises theory of the business cycle. It can come none too soon; if it ever does, the whole concept of a Council of Economic Advisors would be swept away, and we would see a massive retreat of government from the economic sphere. But for all this to happen, the world of economics, and the public at large, must be made aware of the existence of an explanation of the business cycle that has lain neglected on the shelf for all too many tragic years.

Friday, August 7, 2015

Trimmed Mean PCE Inflation Rate Series Description

The Dallas Federal Reserve explains:

In spite of the arcane-sounding name, the concept of a trimmed mean is a simple one. In fact, trimmed means should be familiar to any follower of international figure skating. In the wake of the controversies surrounding the judging at the 2002 Winter Olympics, the International Skating Union adopted a scoring system in which a skater’s highest and lowest marks are discarded before the skater’s average score is calculated. Trimmed mean inflation rates are derived by a similar procedure.

In any given month, the rate of inflation in a price index like the Consumer Price Index or Personal Consumption Expenditures (PCE) can be thought of as a weighted average, or mean, of the rates of change in the prices of all the goods and services that make up the index. Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are—like a skater’s best and worst marks—thrown out, or “trimmed.” The inflation rate is then calculated as a weighted average of the remaining components.

For the series presented here, 24 percent of the weight from the lower tail and 31 percent of the weight in the upper tail are trimmed. Those proportions have been chosen, based on historical data, to give the best fit between the trimmed mean inflation rate and proxies for the true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.