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Tuesday, January 06, 2004

Ben Bernake: Oh That Speech!

I must admit reading Ben Bernankes keynote speech to the American Economic Association, I felt one of those rare spangs that fortunately are relatively unknown to me: jealously. Maybe it's just because I went to see Master and Commander yesterday or something, but I have the distinct impression that I would have enjoyed making that speech, although my god would it have been different. I would undoubtedly have warmed up with Pericles, and finished of with my favourite 'what good are economists if we can only predict bad weather after the storm is over'........are we all dishrags or what?

Mind you I am not, and never will be, one for speeches: mine is definitely a written domain. The best you're ever gonna get from me is a webcast, maybe using instant messenger onto a big screen: lots of 'smiley faces'.

But what is the big issue here. Well........hmmm. You see maybe it is impossible to be on the inside and talk plainly. Maybe plain talking is one of the priviledges you lose: you need soft cops, and you need hard cops to interpret them. Correct me if I am wrong, but I don't think I saw the word deflation once in the speech. No wonder a highly intelligent woman like Caroline Baum has her work cut out trying to see what's going on:

Coming from someone with a less benign view of the inflation outlook, one would be tempted to infer Bernanke was trying to differentiate between actual inflation -- the old-fashioned CPI fixed basket of goods and services -- and ``measured'' inflation, with its quality adjustment and increased reliance on substitution effect (consumers buying cheaper apples instead of more expensive pears), both of which tend to depress the index.

Alas, in the case of Bernanke, who is as clear as Greenspan is dense, the parenthetical probably reflects his bias that inflation is overstated, not understated.

Bernanke outlined his argument why unusually accommodative policy remains appropriate. First, core inflation is low and falling. Second, labor productivity is soaring, raising potential output and lowering production costs. Third, the labor market remains soft, acting to restrain producers' major input cost (wages).

Bernanke downplayed the risk of rising commodity prices, including gold, and a falling dollar, saying their contribution to consumer prices is minimal. He didn't mention inflation expectations, as embedded in the steep yield curve and widening spread between nominal and inflation-indexed Treasuries -- although he devoted an entire speech Saturday to expectations and the role of the central bank in shaping them through effective communication.

While a relative newcomer to the world of policymaking, Bernanke has been at the forefront of the effort to convey to the markets that this time is different, that the Fed's reaction to stronger growth won't be the same as it was in the past. The achievement of price stability has changed the landscape. And while there's no guarantee the terrain won't shift if easy policy overstays its welcome, it's hard to envision the Fed sacrificing its hard-fought gains in the battle against inflation.

Even more impressive than the inflation performance has been the Fed's ability to counteract the normal cyclical rise in long- term rates. The yield on the 10-year note drifted between 4.2 percent and 4.4 percent during the final quarter of 2003 in the face of a barrage of statistics portraying a boom in economic activity.

Confused she may be, but to the point she is. Our Caroline is no garden variety commentator. She is sharp. My proof: the last point about controlling the long rates. I will come back to that, but it is something that only occured to me last night. She understandably continues to fear inflation, since Bernanke, unfortunately, seems to have been bereft of real arguments as to why she shouldn't be, or at least those that he may have had he couldn't put on the table: hard work sitting in the throne room with the central banker.

So now for the prince himself:

Despite all this adversity, there could never have been any doubt that the diversified and resilient U.S. economy, assisted by ample monetary and fiscal stimulus, would eventually stage a comeback.

I think here we have it. Everything, or nearly. This is a declaration of faith in the fact that economics is a game played out in abstract state space. It is curious indeed to note that many of the best known criticisms of standard neo-classical theory relate to the question as to whether market mechanisms unaided reach an optimum output solution. This is an interesting, but IMOH secondary question. There is a much more interesting one which comes from the classics but which has somehow got lost in the wash: whether economics is a game played out in historical time, with evolutionary processes entering as part of the backdrop - the meta rules.

In fact Bernake's view is not new to him. This story in fact goes back to 1993, and his review in the Journal of Monetary Economics of Eichengreen's Golden Fetters, where he argues that a decline in the money supply may cause a decline in prices, but not necessarily a drop in output: or put another way there is no problem which can resist an adequate application of monetary and fiscal policy. If that is the case it is hard to understand why the US economy may now be getting itself into difficulty.

Labor costs account for the lion's share, about two-thirds, of the cost of producing goods and services. The labor cost of producing a unit of output depends, first, on the dollar cost per hour (including wages and benefits) of employing a worker and, second, on the quantity of output that each worker produces per hour. When the cost per hour of employing a worker rises more quickly than the worker's hourly productivity--the historically normal situation--then the dollar labor cost of producing each unit of output, the so-called unit labor cost, tends to rise. Recently, however, labor productivity has grown even more quickly than the costs of employing workers, with the result that unit labor costs have declined in each of the past three years. Indeed, in the second and third quarters of 2003, unit labor costs in the nonfarm business sector are currently estimated to have declined by a remarkable 3.2 and 5.8 percent, respectively, at annual rates.

So why is productivity rising so rapidly, and labour costs falling so remarkably, you would have thought he would have had a stab at an explantation, but no: the French man o' war may be swifter and availed of greater fire power, but it is sailing blind. Everything here is craft. So let's try outsourcing and China and India: do you think they might come into the picture? And what about the ICT revolution and plummeting information costs (I don't expect him to get round to networked brains, and smiley faces, I mean central bankers can't be that modern). But if you don't know why the labour costs are falling, then you sure as hell can't talk authoritatively on how long the decline will continue. Lets just say that if you ship out the labour intensive component (not to mention globalise labour markets) then something will show up in your productivity numbers.

The third unusual factor is the persistent softness of the labor market...............Why has the labor market remained relatively weak, despite increasingly rapid growth in output? I addressed the causes of the "jobless recovery" in an earlier talk (Bernanke, 2003). Although many factors have affected the rate of job creation, I concluded in my earlier analysis that the rapid rate of productivity growth, already discussed in relation to unit labor costs, has also been an important reason for the slow pace of recovery in the labor market. All else equal, strong productivity gains allow firms to meet a given level of demand with fewer employees. Thus, for given growth in aggregate spending, a higher rate of productivity growth implies a slower rate of growth in employment

Well more of the same, but still not getting to the point. And then, and then, we get this three part summary:

the current economic situation has three unusual aspects, which together (in my view) rationalize the current stance of monetary policy. First, inflation is historically low, perhaps at the bottom of the acceptable range, and has recently continued its decline. Second, rapid productivity growth has led to actual declines in nominal production costs, which reduce current and future inflationary pressures. Finally, the labor market remains soft, reflecting the fact that growth in aggregate demand has been so far insufficient to absorb the increases in aggregate supply afforded by higher productivity. A soft labor market will keep a lid on the growth in the cost of employing workers.

Now all these three are undoubtedly inter-related, but how? That is the mystery. Now for something really to the point:

the direct effects of dollar depreciation on inflation, like those of commodity price increases, appear to be relatively small. In part, the small effect reflects the modest weight of imports in the consumer's basket of goods and services. Perhaps more importantly, however, the evidence suggests that foreign producers tend to absorb most of the effect of changes in the value of the dollar rather than "passing through" these effects to the prices they charge U.S. consumers. A reasonable estimate of the portion of changes in the value of the dollar passed through to U.S. consumers is about 30 percent. The extent of passthrough also appears to have declined over time, suggesting that foreign producers also lack "pricing power" in the current low-inflation environment in the United States. Overall, on rough estimates, a 10 percent decline in the broad value of the dollar would be expected to add between one and three tenths to the level of core consumer prices (not the inflation rate), spread out over a period of time.

So the pressure isn't on. And please note the lack of pricing power attributed to the foreign producers: could we actually be seeing a globally deflationary environment? Well you know my view. Ok, one or two last points in closing.

Firstly the thing that actually woke me up last night in a non-too-cold sweat: long-term rates and Fed policy. Do we all have such short memories? Wasn't Bernake promising not too long ago that the Fed, in the absence of visible inflation, would be prepared to intervene all the way up the yield curve. This is the novelty. With the FOMC pinned firmly on the bottom rung for as far ahead as the eye can see, real monetary policy has shifted to manipulating long rates, and keeping the curve flat. That is where we should all be looking. And what this means is that the US policy can maintain a firm rudder, constant course, and full speed ahead as far as the eye can see: or can she?

You see there is the little issue of the financial architecture, and the rising euro. This brings us back to the foolproof path and why it isn't 'foolproof' (I am still waiting to be informed who the fools are in all this!). The dollar is in freefall downwards, and as far as Bernanke is concerned this can happily continue. But from where the ECB is sitting, this ain't like this. So something is going to happen. Mind your heads!

And now for the final, final point. One think Bernanke has kindly spared us is his guesstimate for the re-entry date of the US economy into deflation mode. Now at the current rate of disinflation that should be...........anyone got an old envelope handy?

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