Category Archives: PSST and Macro

What does consumer sentiment tell us?

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A newspaper story says,

America has already slipped into a recession that could be as bad as the 2008 financial meltdown according to key consumer data, a Dartmouth College professor has warned.

David Blanchflower, of Dartmouth, and Alex Bryson, of University College London, say that every slump since the 1980s has been foreshadowed by 10-point drops in consumer indices from the Conference Board and University of Michigan.

The abstract of the Blanchflower/Bryson working paper says,

We show consumer expectations indices from both the Conference Board and the University of Michigan predict economic downturns up to 18 months in advance in the United States, both at national and at state-level. All the recessions since the 1980s have been predicted by at least 10 and sometimes many more point drops in these expectations indices. A single monthly rise of at least 0.3 percentage points in the unemployment rate also predicts recession, as does two consecutive months of employment rate declines. The economic situation in 2021 is exceptional, however, since unprecedented direct government intervention in the labor market through furlough-type arrangements has enabled employment rates to recover quickly from the huge downturn in 2020. However, downward movements in consumer expectations in the last six months suggest the economy in the United States is entering recession now (Autumn 2021) even though employment and wage growth figures suggest otherwise.

When I worked on forecasting, which was at the Fed almost 40 years ago, we thought that those consumer sentiment indices were too volatile to be useful in forecasting. Some possibilities:

1. We were stupid. We just did not understand that you could filter out volatility by looking just at large drops.

2. The consumer sentiment surveys were bad indicators in the 1970s and early 1980s, but they are better indicators now. Perhaps households have gotten better about sensing when firms are getting ready to initiate layoffs, so that their sentiment is now a good leading indicator. Perhaps the survey methods have improved.

3. The relationship that they found is mostly coincidental. Consider that “all the recessions since the 1980s” is not a particularly big sample. Since 1982, we’ve only had four. With so few observations, you cannot confirm that a statistical relationship is reliable.

My money is on (3). I wouldn’t call this work “research.” If you want to verify a statistical relationship that you will arrive at by trial and error, you need two samples of reasonable size. One sample is used to hunt for a relationship. The other sample is used to verify that you did not discover a coincidence. You can’t follow such a procedure with only the recessions since the 1980s to work from.

Blanchflower makes it sound as though their results imply a 100 percent probability that the U.S. economy is entering a recession. I think that the true probability is less than 25 percent.

Some great FITs links

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I recommend checking this out. Concerning the last link in the essay, I write

Many of my readers know that in Specialization and Trade I pointed out that the political process for industrial policy is to subsidize demand and restrict supply, which is never what orthodox economics recommends for dealing with market failures. Subsidizing demand while restricting supply has ambiguous effects on output (in the case of housing, for example, the net effect is probably negative) while certainly raising prices.

This refers to Noah Smith’s link to a paper by Steven M. Teles, Samuel Hammond, and Daniel Takash.Their paper is called Cost Disease Socialism, which I think of as synonymous with “subsidize demand and restrict supply.”

I differ from Noam and from the authors in that I don’t believe that “cost disease socialism” is some sort of mistake or aberration. Instead, it is the inevitable path for industrial policy, given the way political incentives work. See Specialization and Trade.

Is Inflation a “high-class problem”?

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I would put it this way.

High unemployment is a really bad problem. If you think that inflation is the price that you pay for avoiding high unemployment, then you can legitimately say that inflation is the problem you prefer to have.

So I think that most of the attacks on Jason Furman and others who picked up on his tweet are being uncharitable. Moral: don’t try to make a subtle economic point in a tweet!

But I would also say that I reject the premise that inflation is the price that you pay to avoid high unemployment. So I would argue against Furman and others on that level.

I also think that inflation hurts the middle class and the poor more than it hurts the rich, because inflation creates confusion, and rich people are better able to navigate through the confusion. I could say more, but I already have, in my essay What’s Wrong with Inflation?

Speaking of Institutional Irrationality

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Ben Weingarten writes,

If Afghanistan should have taught us anything, it is this: When confronting an enemy, we need a clear set of goals, a reasonable plan to achieve those goals as efficiently as possible and an ironclad exit strategy.

He argues that the virus response failed to do this.

Go back to the quoted passage and for “When confronting an enemy” substitute “When our organization undertakes an initiative…” That might make for a pretty good definition of institutional rationality. It leaves out the possibility of rationally setting out to undertake an activity permanently. But in fact it is hardly ever viable to do the exact same thing in the exact same way long term.

PSST watch

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Timothy Taylor writes,

Every recession involves a reorganization and restructuring of the economy. In a standard recession, this involves a larger-than-usual number of companies going broke, and workers needing to scramble for different jobs. But the restructuring in the pandemic recession–and in continuing restructuring in the pandemic that has continued even though the pandemic recession ended back in April 2020–is of a different sort. There are new dividing lines across the labor force like who can work from home, and what sectors of the economy have been more affected by the pandemic on an ongoing basis, and whether parents can rely on sending their children physically off to school. There are concerns about what working environments are more or less safe.

And every recovery involves discovering new patterns of sustainable specialization and trade, requiriing entrepreneurial trial and error.

Inflation, thinking in bets

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I wrote this essay.

Do you disagree that inflation is likely to remain elevated over the next eighteen months, as GDT leads me to predict? If so, what theory do you prefer? The theory that high inflation is transitory? A theory that the Fed will step in and keep inflation at low levels? The theory that I here associate with Modern Monetary Theory, that inflation will only rise when there is hardly any unemployment? A theory that we will have another recession in the months ahead, due to COVID or some other factor?

UPDATE: John Cochrane writes,

The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%.

He makes the same point that I would, namely:

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.

Read the whole thing.

Is it 1976?

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In terms of inflation and interest rates, I think so.

By 1976, inflation was 5.74 percent. Although the interest rate in November, at 4.75 percent, was higher than in 1964, it was lower than the rate of inflation. In that sense, the interest rate was low

That was when inflation was poised to take off.

Every time I hear someone talk about “temporary supply” shortages causing inflation I want to grab them by the collar and shake them. If the government hasn’t gone wild with deficit spending, then a price increase in a supply-constrained sector will be offset by a price decline somewhere else.

How I will judge whether the economy is “back to normal”

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In a few days, the Commerce Department will release personal savings rate data for June. Meanwhile, in May the personal savings rate was 12.4 percent, which is the lowest it had been since February of 2020. But, as this chart shows, that was still far above historical experience. And it does not include the increased wealth that comes from higher prices for stocks and real estate.

The theory that inflation will subside as soon as the economy gets “back to normal” strikes me as incoherent. If “back to normal” means that all of this excess saving gets worked off, then consumer spending is going to surge. If “back to normal” means that firms invest in new capacity to get rid of supply constraints, then business investment is going to surge. For example,

Mr. Gelsinger, after little more than a month in the top job, committed Intel to making $20 billion in chip-plant investments in Arizona. Less than two months later, he added a $3.5 billion expansion plan in New Mexico. The Intel CEO has said more financial commitments are on the drawing board, both in the U.S. and overseas.

For me, the indicator that we are “back to normal” is the real interest rate, meaning the interest rate minus the rate of inflation. If that is slightly positive, we are at normal. For the last several months, it has been steeply negative, and it seem poised to remain that way for at least the rest of this year.

If you bought a 3-month T-bill in March, you paid an inflation tax of close to 10 percent at an annual rate. That’s what you get for trusting the market.

Or go back to the 1970s.

The key standout is that you really didn’t want to own Treasury bonds. The near 40% loss of purchasing power over 10 years is somewhat notional—it is derived from the compound annual returns on 10 Year Treasurys compiled by New York University’s Stern School of Business, divided by the consumer-price index—but tells a story nonetheless.

The worst thing you could have done in the 1970s would have been to trust the bond market. Today, you certainly won’t find me owning any long-term bonds that aren’t indexed for inflation.