The fundamental question for the U.S. macroeconomic forecast is if the pandemic recovery can continue or if the economy is heading into a recession. This outcome will be determined largely by Federal Reserve actions during the quarters ahead. Given how long the Fed waited to fight the current bought of inflation, it is not likely they can return inflation to its target rate without monetary policy changes which would also induce a recession.

It is an open question if the Fed has the fortitude to follow-through fighting inflation. The forecast then, is either for recession, or anemic growth accompanied by continued inflation.

CERF’s baseline forecast embodies the assumption that the Fed will cease substantive hikes by December 31^st of 2022 and that the economy will not be pushed into recession. We do have one 25 basis point hike in early 2023, but no other hikes. This is a low confidence forecast, since it necessarily involves predicting the behavior of a body of political actors at the Fed.

This forecast for the Fed’s policy rate has implications for inflation. Inflation, with substantial momentum at the current time of writing, will not be much reined in by this forecast of Fed policy.

How strong is the Fed’s policy stance on inflation? The real ten-year Treasury yield was -3.1 percent using September yields with the core PCE deflator. As conventional wisdom has always argued, a negative interest rate of that magnitude indicates policy that is massively stimulative.

The presumed level of short term interest rates under this forecast scenario is that they reach 4.625 percent (based on the midpoint of the Fed’s target range) by mid-2023. By the Fed’s own analysis the rate needs to be above 6 percent in order to adequately combat inflation.

Inflation will subside, but it will not subside quickly, and the real 10-year Treasury yield will remain in negative territory for all of 2023, indicating that instead of being restrictive, the Fed’s policy will remain stimulative, for about a year.

We forecast that the Core PCE deflator will still be 4.8 percent at the end of 2022, and that it will still be 4.3 percent at the end of 2023. This is higher than the consensus forecast of 3.2 percent, but our forecast is lower than inflation expectations, such as the University of Michigan’s survey value of 4.8 percent.

This forecast is one where rates are not really that high. The chart below shows the third quarter real 10-year Treasury is still quite negative, and it shows real rates during the Volcker policy era in the early 1980s that did succeed in fighting inflation, and also pushed the economy into recession.

Because rates are not really that high, inflation will remain persistent, and, growth will be weak but positive. We do not forecast a recession in this scenario, in part because rates are not actually that high. They will not get high enough to halt inflation, and they will not be high enough to cause a recession.

CERF has argued that monetary and fiscal policy has been much too stimulative. While it is possible to justify stimulating the economy in the time of crises, policies have been a ratchet, ramping up support through payments and credit in times of crises and not subsiding thereafter. This occurred after the 2007-08 financial crises and again during the Pandemic in 2020.

Overly-stimulative policies help us understand the macroeconomic environment we are in today. Some forecasters are saying that the Fed’s impotence against inflation, with 300 basis points of hikes in seven months having failed to slow inflation momentum, has surprised almost everyone. This does not surprise CERF. The economy is overstimulated. According to CoBank estimates the U.S. household sector still has $2 Trillion in excess savings. And, we point to the most recent University of Michigan survey data, which as of October showed consumer’s expect inflation will still be 4.8 percent a year from now.

There are risks to this forecast. One alternate scenario is that the Fed does continue raising rates aggressively during 2023, sending the short term policy target well-over 6 percent. In this scenario, the real 10-year Treasury yield would surge into positive territory more rapidly, inflation would subside more quickly during 2023, and the economy would experience a recession.

Why is our baseline case that the Fed does not get in front of inflation? They have shown before that they are sensitive to markets, especially, the stock market. In October of 2018, they announced a balance sheet normalization policy that sent the S&P 500 into a 24 percent decline in just 3 months. On January 4, 2019, Fed chair Jerome Powell signaled a reversal of policy normalization, and in March of that year, stated that a multi-trillion dollar balance sheet might go on indefinitely. This of course, gave rise to the notion of QE-infinity, the idea that the Fed would never normalize policy.

The effect of significantly higher rates will have an important follow-on effect of raising the debt service costs for the U.S. This is more of an issue now, where the debt to GDP ratio is 120 percent, a historically high level for the U.S. This will be another source of pressure against further Fed rate hikes to levels above 5 percent.

CERF’s economic forecast for the next eight quarters is for growth substantially below potential. Many forecasters, including the Fed, point to demographic factors and make post-industrialized economy arguments to rationalize below potential growth. CERF disagrees. Most of the sub-par growth is driven by poor policies, policies that throw a blanket on what would be a much more healthy and robust economy.

Monetary and fiscal policies should follow policy rules, or a logic that is guided by economic theory and analysis. Policies since 2008, especially monetary policy, have been ad hoc. They depress economic activity through the specific disincentivizing impacts they impart on investing for the future, but in addition, they depress the economy through policy uncertainty. This uncertainty doesn’t just add difficulty to forecasting, but it also reduces the ability of households, establishments, and governments to make decisions for their, and the our nation’s, future.

The post U.S. Forecast Highlights appeared first on Center for Economic Research and Forecasting.

Liftoff has market watchers glued to their monitors for a number of important economic reasons. Because the rate is related to other longer-term interest rates through the Term Structure, and the longer-term rates are used to discount cash flows, this affects net present value (NPV) calculations, making more investment projects appear profitable. Aside from new projects, lower corporate bond rates bring down a firm’s borrowing costs, raising their net income.

The argument for low rates in late 2008/early 2009 was a good one. We had faced a serious financial crises and were in the middle of a serious recession, one that appeared at the time to be the second greatest economic contraction since 1929. Many financial entities faced a liquidity crunch, where short-term credit had vanished. Firms shelved positive NPV projects. Households were upside down on their homes. Because the housing market was so decimated the lower mortgage rates were thought to be needed to help resurrect home sales activity and promote refinancing which in some cases could help a household remain as a homeowner.

The Fed’s dual mandate of price stability and economic growth, argue in a conventional way against raising rates at this time. Historically, rates were raised as a way to cool down an economy with rising inflation or dropped as a way to spur economic growth. However, inflation and economic growth continue remain low compared with postwar U.S. history.

Despite this, I think the Fed should immediately begin the process of raising rates toward historically normal levels. The abnormally low interest rates were probably justified by the double feature of a financial crises and a large economic contraction back in late 2008/early 2009, but they do not have that justification now. The canonical Taylor rule formula as published by FRED at the St. Louis District Federal Reserve bank calls for a Federal Funds Target rate of 2.44 percent.

It is safe to say that financial markets, consumption activity, and savings and investment decisions are being distorted by the low interest rates. As one example, household balance sheet rebuilding was and still is important for the long-term economic health of the U.S. A higher return to savings would aid and incentivize this activity.

The economy should be able to grow with interest rates at normal levels. If it cannot, then it needs to relearn this ability. If this process ends up taking some time, we should begin it sooner rather than later. An imminent financial crisis does not seem to be a high probability event at this time. However, if one did happen now, being at the zero lower bound would be an inconvenient reality indeed.

The post Federal Funds Rate Policy appeared first on Center for Economic Research and Forecasting.

Taylor’s trying to supply principles to guide policy makers as they try to put our economy on track again. He has five of them:

• Predictable policy framework
• Rule of law
• Strong incentives
• Reliance on markets
• Clearly limited role for government

Taylor provides lots of evidence that our current problems are a result of not following these principles. I believe him. However, I’m not sure his arguments are strong enough to convince someone not predisposed to believe him. He was clearly trying to write something for non-technical people, and that probably weakened his case. It won’t change any hard-Keynesian minds.

It’s not surprising that when it comes to monetary policy, Taylor recommends a policy rule. He created the Taylor Rule after all. I’ve never been sympathetic to policy rules. Constraints usually don’t improve outcomes. Still, Taylor makes a good argument that the short-term demands of modern politics provide irresistible incentives for action at the expense of long-term prosperity.

Once you decide to use a rule, you have to decide which rule. Again, it is not surprising that Taylor recommends a Taylor Rule. That presents a couple of problems.

There are lots of Taylor Rules. They’ve become a class of rules. Probably every monetary economist at a top-ten department has his or her own version.

The various Taylor Rules can come up with rather different policy prescriptions. So, the selection of the proper Taylor Rule is a real issue. However, probably none of them would have the devastating impacts of some of the worst mistakes the Fed has made in its almost 100 year history.

I have a bigger problem with Taylor Rules though, and it the zero bound on interest rates. Sometimes some Taylor rules recommend negative nominal interest rates, and we just haven’t figure out how to do that. I think Taylor’s response would be that if you followed a Taylor Rule in the first place, you would never have reached the problem of a zero lower bound. That’s probably true.

There is a rule that competes with the Taylor Rules, a Nominal GDP Target Rule. Scott Sumner has been a key proponent of NGDP targeting. Sumner argues that the Fed has the power to create any nominal GDP it wants.

Here’s an example: Suppose the Fed creates a target of five percent nominal GDP growth. If nominal GDP is shrinking at, say, two percent, then all the Fed has to do is generate seven percent inflation. If it can create the seven percent inflation, it will create the five percent NGDP growth.

I have a problem with this too. I don’t believe that the Fed can always create inflation. The Fed controls the monetary base, but turning the base into money, which is what is required to generate inflation, requires the cooperation of banks and borrowers. The past few years provide strong evidence that banks and borrowers can’t be counted on to cooperate. That is, banks may not lend and borrowers may not borrow, at exactly the time we need them to if monetary policy is to be effective.

I think Sumner would have two responses. First, he would argue that if the Fed had followed this policy in the first place, we would never have reached the problem of banks and borrowers not cooperating in creating money. That’s probably true.

A second response would be that the Fed just hasn’t tried hard enough. Like the Keynesian response that true fiscal stimulus was never tried, this argument can always be made, and I think they are both wrong. At over 35 percent of gross product, total government spending (including federal, state, and local) exceeds that at the peak of WWII, and no one would argue that we are seeing a vigorous recovery. Similarly, QEs 1 and 2 were unprecedented efforts to increase the money supply. They failed, because banks weren’t lending and borrowers weren’t borrowing.

These are second order problems, though. If either Taylor or Sumner were in charge of our monetary policy over the past decade, we’d probably be a lot better off than we are today. If policy makers had followed Taylor’s principles, we’d probably be a lot better off than we are today.

It’s a shame that Taylor’s principles are controversial. It is a shame that millions of Americans are unemployed, in part because we’ve moved so far away from those principles. Taylor has written an excellent guide for policy going forward. I highly recommend First Principles.

The post First Principles, by John Taylor appeared first on Center for Economic Research and Forecasting.

The estimate is higher than my forecast by a fair amount actually, but in the grand scheme of forecasting, forecast errors, and the direction of change, I am reasonably happy. I had forecasted the increase in growth with trepidation because the economic fundamentals remain weak.

The fourth quarter data implies that the economy grew 1.7 percent in 2011, compared with 3.0 percent in 2010.

What were the drivers of the increase in fourth quarter growth? Consumption and Investment expenditures both rose, $50b and $80b respectively, trade was little changed, and government expenditures fell about $30b.

Investment expenditures are driven by a four main components, business structures, equipment and software, residential, and inventory investment. All of these components are volatile, but one of them, inventory expenditures, is super volatile. Sure enough, about $55b of the $80b investment expenditure increase was due to inventory investment. I hope that the shelf-stocking was not overdone for if it was, there would be a slowdown in inventory investment this quarter.

Another interesting movement within Investment was residential, up at an annualized growth rate of about 11 percent. While residential investment in states like Nevada, California, Florida remain at historic lows, it is booming in states like North Dakota, Oklahoma, and Texas. We can thank the middle part of the country for this source of growth.

The $30b pullback in government expenditure breaks down to a $20b decline in Federal and a $10b decline in State/local expenditures. The Federal change was due to a defense spending contraction, as non-defense expenditures rose slightly.

Inflation, as measured by the GDP deflator, fell dramatically from 2.6 percent in third quarter to 0.4 percent in fourth quarter. Subdued inflation in a time of relatively high unemployment is a good thing, as it helps those unemployment or partially-unemployed households manage expenses.

The BEA measure of the personal savings rate fell from 3.9 percent in third quarter to 3.7 percent in fourth quarter. This worries me, as household debt levels are still high. I have argued this before and will do it again: consumption in an era of high household debt does not help the economy. What is needed is savings and investment. Future growth depends on it.

The post The US 2011 Quarter 4 GDP Report appeared first on Center for Economic Research and Forecasting.

The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

The post United States Forecast Highlights appeared first on Center for Economic Research and Forecasting.

BLS data show that February year-on-year growth of the Core CPI has reached 1.1 percent, up from the recent low of 0.6 set October 2010.  All items CPI growth has reached 2.1 percent. While energy was the largest driver, most of the other CPI categories also contributed to the rise.

What are the indicators for March?  March import prices were up, oil prices were up, and the next employment cost index report, due out April 29, will likely show some gains.  Any wage and salary gains will help this job-weak recovery, but will also contribute a bit to inflation.

What does this mean?  Despite ongoing fundamental economic weakness, we have likely moved past an episode where Deflation was a valid concern. 

As an aside, it also has an implication for our real interest rate forecast.  Many nominal interest rates, especially longer Treasuries, are rising.  Thus far, we have about a 100 basis point rise in the (nominal) ten-year Treasury in the last six months.  We had a similar rise in the All items inflation rate in that same time whereas the Core inflation rate increase was about half that.  In the case of the All items deflator of the Treasury yield, the implied real rate has not changed, but with the Core deflator, the implied real rate rose by about 50 basis points.  Either way, we have yet another fundmantal indicator, real interest rates, that is not improving. 

While I no longer characterize the situation as a “Good-deflation Equilibrium” we have not moved very far from that equilibrium at this point.  However, we may be in the process of moving to an equilibrium with higher inflation than the February level.  There are reasons to believe that the current course of debt-financed expansionary fiscal policy will lead to higher future inflation.  This course of fiscal policy will likely be maintained through 2012.  It is likely we will get to a point in 2011 or 2012 where the Fed will consider raising the Federal Funds Target rate.

The post The Inflation Environment Is Changing appeared first on Center for Economic Research and Forecasting.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

The post Deflation is Always Bad appeared first on Center for Economic Research and Forecasting.

However, inflation is not inevitable. For inflation to occur, increases in the monetary base have to be translated to an increase in money supply. This is the money multiplier that we teach in elementary macro-economics, and it depends on bank lending, something that is just not happening. Even if the money supply increases, velocity declines could offset the inflationary impacts.

We are seeing an alarming increase in deflation around the world. The BBC reported today that Japanese prices have fallen 8.5 percent in the past year. Prices have also been falling in Germany, Spain, Britain, Ireland, and Switzerland.

It is virtually impossible to imagine a recovery if the United States slips into deflation. So far, we’ve had small increases in prices. Let’s hope that continues.

The post Deflation, not Inflation, is the Worry appeared first on Center for Economic Research and Forecasting.