Current Account Slips
The current account slipped on oil in the third quarter—that's the bad news. The good news is twofold: First, we could very well see some improvement in the current account going forward, at least as a share of GDP, if oil prices stabilize and foreign economic growth remains solid. Second, third-quarter data show little evidence of official diversification out of dollars.
The current-account deficit widened to $225.6 billion—6.8 percent of GDP—in the third quarter of 2006 (up from $217.1 billion or 6.6 percent of GDP), largely because of increases in oil and other commodity prices. As is typical, most of the change in the current account reflected developments in the trade account, and with this report the deficit in goods trade increased $8.0 billion. But more recent trade data look slightly different. Trade data released on a monthly basis—the current account's are quarterly—showed a significant improvement in October, so we may see a narrowing of the current account in the fourth quarter.
Current Account Balance
Source: Bureau of Economic Analysis.
The income component of the current account showed its fourth consecutive deficit—an unprecedented development. Despite our 20-year string of large current-account deficits, the income component has typically remained in surplus. It seemed, however, only a matter of time before income payments on foreign claims against the United States began to exceed income earnings from U.S. claims on foreigners, as we noted in our October Economic Trends.
Despite persistent talk about official diversification out of dollars, net foreign official assets in the United States rose in the third quarter of 2006 by slightly more than they typically have increased over the past three years. Of course, the most recent talk about dollar diversification coincided with the dollar slide that began in mid October. So, once again, we’ll have to wait for more data to see how it all plays out.
Net Foreign Official Assets
Source: Bureau of Economic Analysis.
Can't We Stand Good News?
Today we got a report of retail prices for November that, by virtually every measure, was favorable. The Consumer Price Index (CPI) was unchanged during the month, and even the traditional “core” CPI (which excludes food and energy goods) was up a very slight 0.6 percent (annualized). Both inflation indicators beat market expectations and seem to have sparked a small, though short-lived rally in bond and equity markets.
On the morning of a CPI release, we spend more than a little time sifting through the ups and downs in the data. And most of the cuts we took of today’s data seemed very positive—even the stubborn “core” services prices gave a little ground in November (rising 2.9 percent annualized from a 3.4 percent rise in October.)
But we’re dismal scientists, after all, and we just aren’t happy until we can find a cloud around its silver lining. And, well, we found one. In recent reports, we’ve noted that prices seem to be rising at virtually every rate but the rate most economists think is consistent with the current inflation trend. In November, only about 10 percent of the items in the CPI market basket registered a price increase in the 0 to 3 percent range. Either prices were falling (34 percent of items in the overall index) or rising in excess of 3 percent (about 55 percent).
In the price data, the tails can wag the dog, and that’s just what we saw in November. This month, the extreme price declines were more than enough to overpower the sizeable price increases. Some share of the price declines are coming from falling gasoline prices, just as some of the continued upward pressure on retail prices is coming from rising rents. Neither of these forces is expected to continue. Energy markets have shown some firming of late, and the growth of rents will likely moderate as the residential real estate market firms up. But even after we adjust for these transitory factors, the greatly divergent price data we have seen recently are striking, as the following chart demonstrates.
CPI (ex-energy and OER) Component Price Change Distribution
*Monthly annualized percent change.
Perhaps these data aren’t so extraordinary in light of the recently divergent growth patterns in the economy, namely weakness in housing and auto manufacturing versus just about everything else. But is today’s price report an indication that more good inflation news is just around the corner? We certainly hope so. It may be that as the growth in economic activity moderates it will take further pressure off the rate at which retail prices are rising and the CPI will show more broadly-based moderation.
But with that bit of optimism, we also caution that what we see in the November CPI is very unusual, and that makes inflation watchers like us more than a little uncomfortable. It’s a tale of the two tails—unusually sharp price declines across a wide range of goods prices versus uncomfortably high price increases that are dominated by a broad variety of services prices.
Ah, but enjoy today’s otherwise favorable read on the inflation trend. Let us worry whether or not we’ve REALLY turned the corner on inflation.
Two Top 5 Lists, Two Very Different Views of Monetary Policy
As you probably know by now, the Federal Open Market Committee met today, and decided that its federal funds rate target is fine just where it is— for now. Does it matter?
Just coincidentally (or not), two (decidedly one-handed) economists weighed in on that very question yesterday and, though I am going lay them end to end here, they did not come to a conclusion.
First up, Ed Prescott, Arizona State University professor and Minneapolis Fed senior advisor (and, incidentally, co-recipient of the 2004 Nobel Prize in economics), chose the opinion page of the Wall Street Journal (subscription required) to offer his list of Five Macroeconomic Myths. His take on monetary policy kicked things off:
Myth No. 1: Monetary policy causes booms and busts.
Greg Mankiw, former chairman of the Council of Economic Advisers, wrote the following in a 2002 paper: "No aspect of U.S. policy in the 1990s is more widely hailed as a success than monetary policy. Fed Chairman Alan Greenspan is often viewed as a miracle worker"…
… it turns out that something special happened in the 1990s, and it wasn't monetary policy. In a recent paper, Minneapolis Fed senior economist Ellen McGrattan and I show that intangible capital investment—including R&D, developing new markets, building new business organizations and clientele—was above normal by 4% of GDP in the late 1990s.
…This was the people's boom, the risk-takers' boom. We should hang gold medals around these entrepreneurs' necks. So indeed, it does seem that Mr. Greenspan was lucky in that a boom happened under his watch; but we can at least say that he did a pretty good job of keeping inflation in check...
What about busts? Let's begin with the assumption that tight monetary policy caused the recession of 1978-1982. This myth is so firmly entrenched that I could have called this downturn the "Volcker recession" and readers would have understood my reference…
But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight.
These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.
5. The Imperial Fed. Our true economic overlords, the Federal Reserve Bank's Board of Governors, have arrogated to themselves the right to ignore their mandate for full employment, elevating slow-growth anti-inflation policy over the unparalleled benefits of tight labor markets.
So, which is it? Is the Fed a mere regulator of inflation, whose activities are otherwise largely irrelevant for the real economy? Or is the FOMC the fairly visible hand pushing and pulling the throttle on the engine of growth, for good and for or ill?
Here at the Cleveland Fed, we like to describe these sorts of views in pictures. Here’s an extreme version of the type of world that Dr. Sawicky describes:
The Traditional Gap Model
What does that picture mean? Let me take an assist from another eminent economist, Stanford University’s Robert Hall, who provided and explanation in a paper delivered at the 2005 meeting of the Federal Reserve Bank of Kansas City’s annual policy conference in Jackson Hole, Wyoming:
The traditional idea is that neoclassical constructs—production functions, consumption demand functions, labor supply functions, embedded in markets that clear—describe the actual operations of the economy in the longer run. There is a *-economy that generates variables such as y*, called potential GDP [the white line] …
In the early years of what Paul Samuelson called the “neoclassical synthesis,” the *-economy was viewed as generating smooth trends, as described by Solow’s growth model, the keystone of neoclassical macroeconomics. Short-run movements around the smooth trend [the red line] were transitory, the result of imperfect information, delayed adjustment of prices, or other non-neoclassical features of the economy.
The extreme version of this traditional idea is captured by the picture above: Monetary policy can be both the cause and the cure of deviations of the red line from the light-blue line—the “output gaps” that a wise and benevolent central bank would squash.
But then along came Prescott (and Finn Kydland):
<> An early milestone in the unfolding breakdown of the neoclassical synthesis was Kydland and Prescott (1982)’s discovery that the *-economy is anything but smooth, once the actual volatility of productivity growth is included in the model… This discovery forbids extracting the disequilibrium cyclical movements as deviations from a smooth trend.
In other words, maybe the white line is the red line. Ups and downs in the economy are really all just “people’s” boom—and busts.
What Professor Prescott articulates is an extreme version of what has become the picture that, I propose, most macroeconomists have in mind these days when thinking about the nature of economic activity over time and its relation to monetary policy:
The New Conventional-Wisdom Gap Model
In words, a good portion of economic ups and down—that is, fluctuations in potential GDP—are completely independent of monetary policy. But at least some of those ups and downs are changes that the central bank can cause, and can eliminate.
So is the red line far from the light-blue line today, and can monetary policy do anything about it? Sawicky says yes, Prescott says no. What say I? Two-handed economist that I am, I may not go all the way to Prescott’s view—but I lean in that direction.
Trade Deficit on the Mend?
In just two short months, the trade balance reversed over a year’s worth of deficits. It sound’s too good to last, and probably won’t. But, then things might not get much worse.
Lower oil prices helped bring the trade deficit in October down to $58.9 billion, the smallest deficit since August 2005. Imports fell 2.7 percent to $182.5 billion, largely because of declines in the prices of oil and other industrial supplies. Imports of capital goods and vehicles also fell. Exports advanced just 0.2 percent to $123.6 billion with prominent gains in services and consumer goods. Exports of industrial supplies fell.
Trade Balance: Goods and Services
Source(s): U.S. Census Bureau
The favorable effects of lower oil prices are gone, at least for the time being. The West Texas intermediate price of crude oil fell from a peak of $74.41 per barrel in July (monthly average) to $58.88 per barrel in October. Oil prices averaged $59.37 per barrel in November and have recently traded just north of $60 per barrel.
Even if the trade deficit fails to show further improvement, it’s hard to imagine it getting much worse anytime soon. The dollar is heading south again, the pace of economic activity abroad—while slowing—remains solid, and U.S. economic activity looks to cool off for awhile.
West Texas Intermediate Oil Prices
Source(s): Bloomberg; Wall Street Journal.
Heard any Good News Lately?
If you’re like us, you spent some part of your morning mulling over the November employment report. If you haven’t heard, the economy managed to post a net 132 thousand gain in nonfarm payroll employment, just a bit above market expectations and not much under the average jobs growth seen over the past year (149 thousand).
If you’re a glass-half-empty sort, here’s something you probably saw in the data. In addition to widespread declines in construction employment (indeed, all five of the major building industries lost jobs last month), the manufacturing sector trimmed another 15 thousand workers from its payrolls in November and have piled up 72 thousand job cuts since July.
If you’re a glass-half-full person, you may have noticed that employment growth appears to have expanded its breadth a little in November. If you read all the way to the end of the Labor Department’s report, you would have eventually come to the table showing that the employment diffusion index for all 278 industries in the survey was 57.2, up from 55 in October. Roughly speaking, that means that a little more than 57 percent of industries were showing job gains last month, not a great number, but the highest proportion we’ve seen since last April. (OK, the diffusion index of 84 manufacturing industries was only 45.8, so more manufacturers are posting job declines than increases, but this is the best number here since June.)
Diffusion Index, Nonfarm Employment Change over One Month (%)
Could it be that the rather long string of softer-than-expected reports coming from construction and industry are masking continued underlying strength in the economy? Well, that’s a lot to put on this employment report. We’re glass-half-full types, so you’ll forgive us if we take the rest of the morning and bask in the first positive news on the economy we’ve read in a few weeks.
Are the Inflation Clouds Lifting?
A slight parting of the inflation clouds made its way into the news a few days ago:
… hourly compensation was revised downward in both the second and third quarters and, as a result, nonfarm business unit labor cost growth was significantly reduced from the preliminary 3.8 percent to 2.3 percent in the third quarter and from 5.4 percent to 2.4 percent in the second quarter.
Good news, right?
Maybe. It is true that conventional macro theories tell us that unit labor costs (a broad measure of labor compensation adjusted for productivity growth) are key to understanding inflation—if you are not too math intolerant you can find a good explanation here. And it is true that it doesn’t take all that much imagination to see a connection between unit labor costs and inflation in the data:
Unfortunately, on closer inspection, the facts are not entirely clear. Anirvan Banerji, the Director of Research at the Bureau of Labor Statistics’ Economic Cycle Research Institute, has studied the relationship between labor costs (ULC) and inflation and concluded:
… that labor cost inflation is not a consistent predictor of cyclical upswings and downswings in general consumer price inflation. As a result, analysts should use caution when interpreting cyclical swings in labor costs growth rates…
… downturns in ULC growth anticipate about half of the downturns in consumer price inflation but upturns in ULC growth actually lag upturns in CPI inflation 80 percent of the time.
If that is true, it means that if you see a consistent rise in unit labor costs, it is likely you have already seen the worst of the inflation. On the other (happy) hand, a dip in ULC does anticipate an eventual decline in inflation—at least about half the time. We may not be there quite yet—but here’s hoping.