Wednesday, December 18, 2013

The Fed Gets it Right

It seems that Chairman Bernanke's decision to taper accompanied by very aggressive forward guidance was following the script I laid out for Janet Yellen in early November. (See Today the Fed announced that it would reduce their $85 billion/month bond buying program by a modest $10 billion and specifically stated that it will maintain its zero interest rate policy "well past the time the unemployment rate drops to 6.5%, especially if inflation continues to run below 2%."

In what looks like zero rates forever, or until well into 2015, the stock market ignited and bonds were range bound. It seems that the Fed played the stock market like a violin and avoided a feared sell-off. Instead of being the Grinch that stole Christmas the forward guidance popped the champagne corks in the equity markets.

Once the fireworks die down I suspect the markets will soon turn their attention away from the labor market and towards the inflation gauges. As I wrote in my latest UCLA Forecast, inflation will be an issue sooner than the market thinks. Even Chairman Bernanke noted in his news conference that health care inflation has been unduly suppressed. That along with rising housing costs will cause the core consumer price index to be running at a 2% rate by the second quarter and the Fed's preferred measure, the core consumption deflator, will be there by early 2015. Thus by the spring, the markets will begin to price in a quicker exit from the zero rate policy than now anticipated.

Wednesday, December 11, 2013

My Amazon Review of Jonathan Haidt's, "The Righteous Mind: Why Good People are Divided by Politics and Religion"

As I write this there are 422 reviews posted on Amazon. Why another? It is because Jonathan Haidt has written a very important book. Using insights from psychology and evolutionary biology offers us some very clear-eyed thinking into the process of making moral judgements. For me Haidt clarified the way I actually think in a very organized manner and he explains, at least to me, why I have so many political differences with my liberal friends.

Haidt builds on the works of David Hume and Emile Durkheim among others along with the works of modern evolutionary biologists to argue that moral judgments are built on intuition and emotion as opposed to reason. In fact the smarter the person the better the person is in making after the fact rationalizations of their hard-wired emotional judgement according Haidt we all have our inner lawyer or press agent.

According to Haidt we have six primary moral matrices: care/harm, liberty/oppression,fairness/cheating, loyalty/betrayal,authority/subversion and sanctity/degradation. Libertarians largely make moral judgement on the basis of liberty/oppression and liberals uses the first three with special emphasis on care/harm. On the other hand classical conservatives and social conservatives utilize all six. To them institutions really matter. Haidt analogizes this type of thinking to taste buds. Do we have only one in our mouth, three or perhaps six.

He also notes that liberals and conservatives are both for "fairness." However liberals view fairness as equality of result while conservatives view fairness as reward for effort or as the the Bible suggests the right to enjoy the fruits of your labor. That is why smart liberals who promote increasing the minimum wage argue that rewards the work efforts of hard working people at the bottom of the wage scale rather than arguing they should be paid more because wage differentials are too wide.

On a personal note Haidt recounts his own evolution from being a card carrying secular liberal to being somewhat of a conservative. Note he will not fess up to being a Republican. His journey is similar to what I encountered in the late 1970s to the mid-1980s.

Finally I thought so much of this book that I bought copies for my three children as holiday presents!

The Amazon URL is:

Saturday, December 7, 2013

"A Growing Economy, In Spite of Ourselves," UCLA Anderson Forecast, December 2013

The economy is growing despite self-inflicted wounds
caused by the 16 day partial shutdown of the federal government
and the botched roll out of the Affordable Care Act’s
(Obamacare) insurance marketplace affecting the giant
healthcare sector which accounts for 18% of the economy.
Parenthetically, it would be far better for our economy if
only our political leadership were dealing with fixing long term
entitlements, reforming the tax code and repairing
and improving our decaying infrastructure.

Although real
growth in the current quarter will likely be a modest 1.8%,
we forecast that by the second quarter of next year real GDP
growth will be on a sustained 3% growth path. (See Figure
1) In this environment employment will be on track to add
about 200,000 jobs a month and the unemployment rate will
decline to about 6% by the end of 2015.

Figure 1 U.S. Real GDP Growth, 2005Q1-2015Q4F
Figure 2 Payroll Employment, 2005Q1-2015Q4F

Figure 3 Unemployment Rate, 2005Q1-2015Q4F

The Yellen Fed

As with most observers, we expect that there will be
a great deal of continuity in Federal Reserve policy as the
chairmanship transitions from Ben Bernanke to Janet Yellen,
the current vice-chairperson. We expect the Fed to start
tapering its $85 billion a month bond buying program early
next year. With the start of tapering, we anticipate there
will be a greater commitment to keeping interest rates at
or near zero longer by, for example, lowering the threshold
unemployment rate from 6.5% to 6% before increasing the
federal funds rate.

Indeed, Chairman Bernanke has consistently
called the unemployment rate a threshold, not a trigger.
Our view is buttressed by the facts that (1) the Fed
was caught completely unprepared for the violent bond
market reaction to Chairman Bernanke’s hint of tapering in
mid-May which triggered a rise in 10-year U.S. Treasury
yields from 1.8% to just under 3 percent by early September
and (2) the release of two Fed papers written by senior
staffers that discussed the efficacy in terms of employment
and output of maintaining a forward guidance policy that
would extend the zero interest rate policy regime past 2016.
Whether or not the Fed papers represent the “correct” policy
is a separate question.

Nevertheless, for the Federal Reserve
Open Market Committee on both market psychology and
policy grounds, it seems likely that any tapering announcement
would be softened by leading market participants to
believe that interest rates will stay lower for a longer period
of time. We could also see movement towards reducing the
interest rate paid on bank reserves, now 25 basis points, to
encourage more active bank lending.

However, what the Fed intends and how policy will
actually play out are two different things. Underpinning the
Fed’s focus on the employment portion of its dual mandate
has been the quiescence of an inflation rate running well
below its 2% target. We think that is about to change. Why?
The rebound in housing prices along with rising tenant rents
will put upward pressure on the housing component of the
price indices. In addition, the chaos associated with the
roll-out of the Affordable Care Act’s insurance exchanges
will likely create the opportunity for price increases in the
healthcare sector along with the increased demand coming
from an improved economy and from people who previously
were locked out of the health insurance market.

As a result we expect that consumer prices will soon be rising at an annual
in excess of 2%. (See Figure 4) To be sure, the Fed uses
the consumption deflator in the GDP accounts, not the more
widely publicized consumer price index, for policy-making
purposes. Nevertheless, a consistent stream of 2% year-overyear
increases in the consumer prices index, including the
all-important core, will most certainly get their attention.
In the face of higher inflation we expect that the
federal funds rate will be increased in the spring of 2015
even though the unemployment rate would still be above

Figure 4 Consumer Price Index v.s. Core CPI, 2005Q1-2015Q4F
Figure 5 Federal Funds vs. 10 Year U.S. Treasury Bonds,
2005Q1 - 2015Q4

the Fed’s threshold. Concomitantly, the yields on 10-year
U.S. Treasury Bonds will be on the road to 4%. (See Figure
5) Our logic is that with a labor market recovery well
underway, the Fed (even a Yellen Fed) will pay heed to an
inflation rate running above 2%. Remember that a rise in
inflation from 1% to 2% is equivalent to a 1% drop in the
real fed funds rate.

Strength in Housing and Cars

Although we do not expect a boom in consumer
spending, both the housing sector and the automobile sector
will be aiding the growth outlook. (See Figure 6) Specifically
we are forecasting an increase in housing starts from
an estimated 913,000 this year to 1.25 million 1.44 million
units in 2014 and 2015, respectively. (See Figure 7) We do
note that this is a markdown from our last forecast to reflect
a greater sensitivity to rising mortgage rates than we previously
thought. Indeed the 1.44 million unit forecast is still
below the 54 year 1959-2012 average of 1.47 million units.
Similarly, light vehicle sales are rebounding to levels
last seen in the mid-2000s. Automobile sales are expected
Figure 6 Real Consumption Spending,
2005Q1 -2015Q4F
Figure 7 Housing Starts, 2005Q1 - 2015Q4

Figure 8 Light Vehicle Sales, 2005Q 1 – 2015Q4,
Millions of Units, SAAR

to increase from this year’s 15.5 million units to 16 million
and 16.5 million units in 2014 and 2015, respectively. (See
Figure 8) Both home and auto sales are being buttressed by
recovering home prices and new highs in the stock market.

Figure 9 Case-Shiller Home Price Index, 2000- August 2013, Monthly Data, 2000= 100.

Figure 10 Standard & Poor’s 500 Stock Index, January 2, 1995 – November 21, 2013, Daily Data

(See Figures 9 and 10) It is here where Fed policy seems
to be working, but the beneficiaries are largely those who
own stocks and those who either own their own home or
who can qualify for a mortgage. There will also be enough
income left over to modestly increase the personal savings
rate from 4.6% in 2013 to 5.6% in 2015. (See Figure 11)

Business Investment Side of Economy to Get a
Second Wind

One of the reasons 2013 has been so sluggish is that
the growth in business investment and exports slowed
dramatically. Policy uncertainty coming out of Washington
D.C. certainly has not helped, but the underpinnings are
there for strength in domestic manufacturing, commercial
construction, energy development and the investment required
to enable the bandwidth required for the increased
usage mobile technology. To be sure, it won’t be a boom
but it will be far better than the 2% or so growth estimated
for 2013. (See Figures 12 and 13)

In our view, 2013 was more of a pause in investment
spending, not an outright decline, and with the likelihood of
a more level headed (i.e. no government shutdown) policy
discussion in Washington D.C. in 2014 the way will be
open for more spending. The major risk here, as we see it,
is that instead of investing for the future corporations will
use their excess cash flow to increase dividends and fund
share buybacks. This short-sighted behavior is due, in part,
to the Fed’s artificially suppressing long-term interest rates
which creates uncertainty about the long-run cost of capital.

Similarly exports will revive as the growth, albeit very
modest, returns to Europe and Japan. (See Figure 14) Although
not stellar compared to its history China appears to be
on a 7% growth track while the Latin American economies
with the large exception of Brazil appear to be doing well.

Figure 11 Personal Saving Rate, 2005 – 2015F, Annual Data

Figure 12 Real Investment in Equipment and Software,
2005 – 2015, Annual Data

Figure 13 Real Investment in Business Structures,
2005 -2015, Annual Data

The Worst is Over for Government Spending

Federal purchases declined an estimated whopping
4.7% in 2013! That drag will be gone in 2014 as we anticipate
there will be a minimal budget deal in early January
that will encompass a modest relaxation of the sequester and
modest increases in in non-tax revenues. As a result, federal
purchases will be roughly flat over the next two years. (See
Figure 16) Remember for GDP accounting the ever growing
entitlement spending of the federal government counts as a
transfer payment not spending. The GDP effect takes place
when the beneficiaries of the transfers spend.

After a four year decline, state and local spending will
begin to rise in 2014. (See Figure 16) Revenues are up and
spending has been held down. But make no mistake that until
the long-term pension issues are dealt with, state and local
finances will, for the most part, remain far from healthy.

As long as the federal government does no harm,
admittedly a dangerous assumption, the economy will be
spurred by strength in housing and cars combined with an
uptick in business spending and an end to the dramatic drop
in federal purchases. These factors should put the economy
on track to a 3% growth path by midyear 2014 and bring
the unemployment rate down to about 6% by year end 2015.
Policy interest rates will stay low throughout 2014, but with
inflation rising to a bit above 2%, we expect that the zero
interest rate policy of the Fed will come to an end in the
spring of 2015

Figure 14 Real Exports, 2005 – 2015, Annual Data

Figure 16 Real State and Local Spending,
2005 – 2015F, Annual Data

End notes
1. See, English, William B., J. Lopez-Salido and Robert Tetlow, “The Federal Reserve’s Framework for Monetary Policy-Recent
Changes and New Questions,” Board of Governors of the Federal Reserve System, November 2013 and Reifschneider, Dave,
William L. Wascher, and David Wilcox, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct
of Monetary Policy,” Board of Governors of the Federal Reserve System, November 2013.

Monday, December 2, 2013

My Amazon Review of Margaret Macmillan's, "The War that Ended Peace: The Road to 1914"

Having read Margaret Macmillan's "Paris 1919," which focused on the political settlements that accompanied the end of World War I, I was looking forward to her take on how the war started. I was not disappointed. Her take is especially interesting because rather than honing in on how the war started, she is more interested in how the the great European peace ended. She starts her history in 1890 when a general war was far from inevitable. However with each passing year, seemingly independent decisions narrow the options of the key political decision makers that a general war becomes practically inevitable. In her view, it is not only the broad historical forces at play, but the personalities of the political leadership that puts Europe on the road to war.

To me her story is one of great diplomatic success on the part of France, Britain and Russia and monumental diplomatic failure on the part of Germany, in particular the very erratic Kaiser Wilhelm. Look at the scene in 1890, Bismarck has France isolated, has an alliance with Russia and Austria and Germany is friendly with Britain. By 1914 France is allied with Russia and Britain. How did this happen?

First Wilhelm fires Bismarck and doesn't renew the Reinsurance Traty with Russia. France jumps in and allies itself with Russia, militarily and financially. Then France settles up colonial issues with Britain and romances her into the Entente Cordial. France is no longer isolated and Germany fears the dreaded two front war which gives birth to the offense of the Schliefen Plan. Britain's diplomacy is stunning. Ending its policy of "Splendid Isolation" it settles up with U.S. over a border dispute in Venezuela, makes a deal with Japanese in the Pacific, reaches an interim settlement with Russia over Persia and gets close to France. As a result it has a free hand in Europe without having to worry about diverting forces to protect its over-stretched empire.

How did this diplomatic revolution happen. Simply put Kaiser Wilhelm does everthing he can do to antagonize Britain. First by acting as bully in Morocco and then by starting a naval arms race with Germany. Instead of building fast cruisers and submarines, Germany builds dreadnought battleships which goes to the center of gravity of British naval power. Britain was forced to respond.

In a very important chapter of what might have been were it not for Wilhelm, Britain and Germany could have been allies.This is not far fetched.. Both countries were allied in the Seven Years and Napoleonic Wars and it would make sense for the strongest land power to get together with the strongest naval power. They have no colonial conflicts and conducted the largest bilatteral trade relationship in the world. It could have happened and if it did, no World War I.

As with all World War I histories Macmillan covers the two Moroccan crises and the three Balkan crises leading up to the Sarajevo assasination. She asserts, rightly, that the successful ending of those crises made the political leadership too complacent about the severity of the crisis caused by assasination of Archduke Ferdinand. To be sure it was summer and all of Europe's political leadership were either vacationing or away from their respective capitals, but still this was an act of what we would call today, state sponsored terrorism. What is missing in Macmillan's account is the role of the "Balkan incption scenario" highlighted by Christopher Clark's "Sleepwalkers...."

Macmillan does an excellent job in portrayiing the social millieu of Europe of the early 1900s. This was a time of rapid economic growth accompanied by the rise of socialist parties, women's sufferage, militarism and most of all nationalism creating a host of tensions. For some war was viewed as the great unifier. The role of honor becomes very important to all of the statesmen involved as the countdown to war begins in late june 1914. When honor is involved a negotiated settlement becomes difficult. It hard to compromise honor without losing face.

Macmillan has written a magisterial and very readable work of history. My one quibble is that she makes more than a few snarky comments about analogies for today. For example she writes that the German Right's fear of Russian cultural penetration of Germany is analagous to today's Republican Right's fear of Mexico. I beg to differ. Mexico is not a geopolitical rival of the U.S.; the Russia of 1914 was certainly one that Germany rightfully feared.

The URL is: