Hi folks, it’s good to be back again. A change in job and
hectic study schedule has proven too much for me recently. But nevertheless,
the germs of curiosity in my blood have kept me motivated for searching and analyzing
data (a thing I’m crazy about).
While Federal Reserves (Fed) and other central banks have
faced a diversity of opinions (both positive as well as negative), one thing
can be said with fair amount of certainty. The central bank has been broadly
successful in arresting the escalation of crisis, (if not helping recovery).
Even Ben reiterated on several occasions that the current crisis was indeed a
novel yet challenging experience for the policymakers (including the central
banks). However, despite fiscal constraints in place -amid fiscal cliff fiasco-
fed has to undertake the risky yet uncertain task of simulating the crisis
ridden economy. While overall picture may not be as impressive as one could
hope, but there are certainly some bright spots for which Fed deserves its due
share of appreciation.
Let me start up by a simple concept that why fed needed to
act when the economy was dwindling. As the economic activity contracted, so the
prices started to cool down. Now though a common man would love to see the
prices fall (since it increases his real income), a consistent fall of prices
is as equally dangerous for an economy as a consistent rapid increase (aka
hyperinflation). On the face of it this looks quite disturbing -since the
deflation has a positive effect on consumer’s welfare- yet a deflation spiral is as dangerous for the
general economy as hyperinflation. And yes we do have living examples of both
phenomenon. If the examples of hyperinflation include Germany, Russia and more
recently Zimbabwe. Japan serves as the classical example of a deflation spiral
where consistently falling prices can cause an economic limbo. How does that
work? It’s quite simple. The spending and saving decisions of economic agents
are inter-temporal (though Stochasticity
is also an important component but it’s less relevant to current discussion). This
means that economic decisions are not only motivated by current state of
affairs but also the expectations. So
if expectations change, the optimal mix of saving consumption decision
changes. Thus, if an average economic
agent expects that the prices are going to be lower in the subsequent period,
he will postpone his consumption. Resultantly, the aggregate demand will
shrink, resulting in further deflation and market surpluses. The producers don’t
like surpluses, so the aggregate supply curve would shrink resultantly,
bringing economy to lower output (GDP) level. And this spiral would turn
vicious if the deflation expectations are not combated by appropriate policy
mix.
Here I have put forth some data analysis of inflation
expectations using data from Bloomberg and FRED to understand whether Fed’s achievements
are confirmed empirically. The data
consists of monthly observations from Jan-05 to Nov-12 (95 Obs) for a
generalized index of inflation expectations (U Michigan Inflation Expectations)
, data for short and long term Nominal Rates (2Y,10Y) –intentionally skipped
5Y- and their respective breakeven –another proxy for market inflation
expectations- I also included the data for avg weekly labor hours and overtime
for analyzing the implications of Fed’s policies on Labor market.
Question 1: Does
implied inflation necessarily reflects the general inflation?
Well since the participants in financial markets are
believed to behave in a similar way as the economic agents in the general
economy, it can be implied that the expectations revealed by the investors in
financial markets should be similar to the latent preferences in the general
economy. Here is a graph showing relationship between U Michigan IE and 2 Year BE. Figure 0A reveals a strong
relationship between general inflation expectations and BE. However, the
analysis through time –Figure 0B- reveals that BE is a more sensitive and
volatile measure than the general inflation expectations. This makes intuitive
sense since the participants in the financial markets adjust more rapidly to
new inflation expectations than the general economy.
Question 2: Was Fed
able to successfully combat the deflation spiral?
A close analysis of
Figure 1 reveals that though the inflation expectations fell sharply amid the
financial meltdown. Fed’s QE program (Especially QE2) was able to restore the
inflation expectations to pre-crisis levels, successfully evading the dangerous
deflation spiral (though deleveraging impact undermined the importance and
success of restoration of inflation expectations). So Fed does deserve the
credit for not allowing US economy to slip into Japan-type economic limbo.
Question 3: Was the introduction of O-Twist and QE3 a good decision?
Well Fed can be allowed benefit of the doubt since the
macroeconomic picture was 1)Desperate 2)Complex. However, Figure 3A suggests
that inflation expectations were pretty much averaged along the long term mean
and became more well behaved. Furthermore, Figure 3B indicates a decoupling
between the longer term nominal interest rates and Breakeven. This effectively
means promotion of a wealth destruction effect for the longer term. In fact, it
was post QE2 that the decoupling effect became more prominent. Thus if Fed
continues to encourage wealth destruction, agents would tend to rebalance their
portfolios by either 1) Seeking insurance in TIPS 2) Spending (which Fed Wants
them to do) 3)shifting to the shorter
end of the curve being risk averse. Thus, except scenario 2 Fed’s policy -of
promoting lower long-term lending rates- would be undermined as long term funds
market may face a shrinkage of supply. Yet one thing that goes to Fed’s
advantage is that the long term inflation expectations are fairly upward sticky
(Figure 2).
Question 4: What are the implications for Labor Markets?
Since Fed operates with dual mandate (inflation and
employment), it is also crucial to see if Fed’s actions may have a significant
effect on the labor market.
Figures 4A, 4B and 4C plot the average weekly over-time and
labor-hours against inflation expectations against both short and the long term
inflation expectations. What’s more interesting to note is that the short term
inflation expectations actually drive the dynamics of the labor market. The
average amount of labor and overtime supplied tend to fall as the inflation
expectations exceed around 3.5%. However, the long term inflation expectations don’t
have any negative impact on the labor market. Thus this leaves us with two arguments
1) Fed can employ as much OT as it wants in the Longer-end of the yield curve
because it doesn’t impact the labor dynamics or 2) Fed is targeting the wrong
expectations since the bulk of the labor market is driven by more volatile
short term inflation expectations.
Its getting 2:23 in the night and I have a training to
attend at 8PM so I would call this a day. However, I’ve uploaded both the data
as well as the code file (do file). Feel free to extend the analysis and
correct me if I have got it wrong somewhere. Here's the link
https://www.dropbox.com/sh/xmzz7h533zzv3e3/H1dfc1v5jR
Appendix:
Is this done in stata?
ReplyDeleteYes indeed
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