John Irons's Blog


Economic News, Data and Analysis

Interest Rates Unchanged

It looks like the Fed is still being cautious about the possibility of a strong expansion…

FRB: Press Release — FOMC statement — October 28, 2003
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.

Filed under: Economics, Monetary Policy

Economy Gets a Monetary Boost

Will the 2003 tax cuts boost the economy? Alan Greenspan doesn’t seem to think so. Today the Fed cut interest rates by 0.25 percentage points to a 45-year low.

Fed cuts interest rates a quarter point
The Federal Reserve Wednesday cut a key interest rate by a quarter-percentage point to a 45-year low in what was seen as a final bid to ensure the sluggish economy at last kicks into higher gear.

Filed under: Economics, Economy, Monetary Policy, Policy

Interest Rates at Recod Lows

Key interest rates have hit record lows, going below 1%. I almost wish I had a mortgage so that I could refinince…

Virus Targeting Banks (
T-bill rates fell. The discount rate on three-month Treasury bills auctioned yesterday fell to 1.005 percent, the lowest level since July 28, 1958, from 1.11 percent last week. Rates on six-month bills fell to 0.98 percent, the lowest level since the government began selling these bills on a regular basis in 1958, from 1.095 percent.

Filed under: Data, Economics, Economy, Monetary Policy

Liquidity Trap

The recent FOMC statement by the Federal Reserve (Fed) included the line that “… the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level” (emphasis added.)
It occurred to me that this statement might be a little confusing – isn’t inflation supposed to be bad? Why would a fall in inflation be “unwelcome”?
The answer has to do with what economists call a “liquidity trap.” (Note: the full analysis of a liquidity trap is considerably more complicated than below, but this should convey the basic idea.)
Liquidity Trap
The basic argument is that the interest elasticity of money demand increases, and monetary policy becomes less effective, when the nominal interest rate approaches zero.
Ok, here’s the English version.
The way the Fed lowers interest rates is to expand the money supply by buying bonds from the public – in this way money moves from the Fed’s vaults to people’s pockets.
Suppose that the Fed wants to lower interest rates, say because there is a recession. Normally, people have to be enticed to give up their bonds because they pay interest. So, to increase the money supply, the Fed must offer people a higher price for the bonds the public owns – thus lowering the interest rate for new borrowers (all in order to make bonds less attractive for the public to hold.)
In a liquidity trap, however, people are willing to part easily with their bonds, since they pay little or no interest and are hence roughly equivalent to holding cash; and so only a very small change in price is needed to buy the bonds – even if the Fed is buying lots of them. As a result, there will be very little change in interest rates. In the extreme, the Fed may not be able to have any significant impact on interest rates, and hence may not be able to help stimulate the economy.
In short, the economy will be in a liquidity trap if/when the Federal Reserve cannot boost the economy because they have lowered interest rates as much as they can.
The liquidity trap is more than just a theoretical possibility; some have suggested that this may be what happened in Japan in the mid 1990’s (although there are different views on the topic). In any case, they still haven’t fully recovered.
There are, of course, opponents of the idea that a liquidity trap can really be important. An easy fix would seem to be to rapidly expand the money supply to generate inflationary expectations and hence drive the economy easily out of the so-called trap.
The open question is whether the US is in, or near, a liquidity trap. Paul Krugman has some textbook econ 101 (IS/LM AS/AD) analysis of the current economic situation and the possibility of a liquidity trap. He has a more detailed analysis… and with graphs too! See below.
Real Interest Rates
A second problem arises because the Fed can’t lower (nominal) rates below zero (try this thought experiment: how much money would you borrow if interest rates were -10%?). However, the Fed can lower real rates below zero provided there is some inflation.
If there is some inflation, then the “real” rate of interest can be less than zero. Think of the real rate of inflation as what determines the purchasing power of the money you would need to repay on a loan, rather than the numerical value. The nominal rate is simply the interest rate you see reported in the newspaper. So if there is some inflation, the real rate will be less than the nominal rate, since inflation will erode some of the purchasing power of the money you have to repay. It is this real rate of return that businesses and consumers really care about – not the nominal rate.
The relation between real and nominal rates is given by the equation, well approximation, real = nominal – inflation. Now, if the nominal rate is bounded by zero, then we know that the real rate is bounded by the negative of the inflation rate. So, when the inflation rate gets near zero, we have a greater lower bound on the real interest rate.
(Ok, I’ve glossed over the expected component of inflation in the above two paragraphs, but you get the idea.)
In other words, the Fed has less room to maneuver when inflation is exceptionally low. With very low interest rates and very low inflation, the Fed, therefore, will not be able to help get the economy moving again, simply because there is no room left to lower real rates.
For more see…
Elephant [poop] (5/5/03)
Zero is not enough (5/4/03)
Even more about jobs (4/29/03)
Fiscal policy and employment (4/28/03)
For a more detailed treatment in a more complicated intertemporal model see Thinking about the Liquidity Trap.
For a nice overview and ways to escape the trap see Svensson’s Escaping from a Liquidity trap and Deflation: The Foolproof Way and Others

Filed under: Economics, Economy, Fiscal Policy, Monetary Policy, Policy, Recession

FOMC: No change in interest rates

No change in rates, (no surprise), but the Fed indicates that the risk is “weighted towards weakness,” (a bit of a surprise).
It looks like this decision is due to the continued low rate of inflation. In addition, falling oil prices and a weak labor market should put additional downward pressure on prices. The greater risk would thus appear to be deflation, rather than an increase in the inflation rate.

FRB: Press Release — FOMC statement — May 6, 2003
Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.
Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.

Filed under: Economics, Economy, Monetary Policy, Policy, Recession

The Investment Situation

The current economic situation in the US continues to be mixed. Employment is weak; GDP growth is slow, but positive; consumer spending is holding up, but confidence is down.
What about investment?
The graph below shows that there were signs of life at the end of last year. I would credit the Fed’s decision to lower interest rates over the past year (and to keep them at low levels) with this beginning of a recovery in investment spending.
Will it continue to recover?
Advance data for the first quarter won’t be released until the end of the month. In the meantime, data shows that Industrial Production has stabilized over the first part of the year. Unfortunately, an investment boom seems to me to be unlikely. Even though interest rates continue to be low, the start of the War in Iraq and general geo-political uncertainty will likely keep investment growth at low levels for the first quarter and into the near future.


Source: Nat Ec Trends, p. 22

Filed under: Data, Economy, Monetary Policy, Recession

CBO Hints: Recession Over

The Congressional Budge Office (CBO) today released updated estimates for the federal budget in which it projected a $199 Billion deficit for 2003.
One interesting part of the document is that it seems as thought the CBO believes that the recession that began in March of 2001 came to an end a year ago.
It is customary, when making time-series charts of macroeconomic data, to shade the time periods during which the economy is in recession. The charts produced in their recent publication show the end of the recession in early 2002 (January?).
In addition, the document indicates that there is a possibility that another, separate recession is possible.
The “Outlook” publication is usually very good reading if you want a nice summary of the current economic condition, economic forecasts, as well as possible risks to the economy.

The Budget and Economic Outlook: Fiscal Years 2004-2013

The economy has moved from the recovery period after the recession into an expansion phase, which means no more than that the level of real gross domestic product has exceeded the peak that it reached in the fourth quarter of 2000.”

Double-Dip Recession. The economy could turn rapidly worse in 2003 if the imbalances that precipitated the last recession have not been fully worked out. … The economy could tip into recession if consumers slow the growth of their spending to much below the growth of their income.

Filed under: Data, Economics, Economy, Fiscal Policy, Monetary Policy, Policy, Recession

Economic Prospects for 2002

There are some signs that the recession that began last March has already started to ease.

The Federal Reserve sees enough signs of strength in the economy
that they decided to leave interest rates unchanged.
Their statement about the future, however, does say that the risks are more on the side of weak growth rather than accelerating inflation – which shouldn’t be a surprise given very low rates of inflation.

On the Fiscal side, the economic stimulus package looks to have died in the Senate – which is probably just as well, since by the time any package would be passed, implemented, and had its effect felt, the recession would most like be long over.

GDP is Positive

The Department of Commerce recently announced that Gross Domestic Product (GDP) rose in the third quarter of 2001 by 0.2%. This was a surprise as many people expected a continuing decline in output, thus marking a continuation of the recession that began in March.

In fact, it now appears growth was been positive for 3 of the 4 quarters of 2001.

One commonly cited definition of a recession is two or more consecutive quarters of negative output growth, as measured by GDP. So did the recession-namers jump the gun?

The National Bureau of Economic Research (NBER) announced last November that the recession began back in March 2001 even though we had only seen one quarter of negative growth. The NBER, which has become the authority on dating business cycles, does not use the two-quarter definition above, but rather looks at a wider range of economic data. The NBER probably thought that the terrorist attacks on 9.11 would prolong and deepen the downturn that was already evident at the time – and was therefore probably confident that we’d see two quarters of negative growth. Some of the other data such as employment and industrial production also looked very much like the beginning of a classic recession.

In principle, we could define recessions differently – rather than defining a recession as shrinking output, we might want to define a recession as output growth that is persistently below some normal or average rate. Click here for a more extensive description of the definition of a recession.

However, if the economy did indeed hit bottom sometime in the fourth quarter of 2001, then we will have seen, by historical standards, a short and very shallow recession.

Another piece of very good news is that productivity growth for the fourth quarter came in at a very healthy 3.5% annual rate.

Unemployment Rate dips

The unemployment rate, after having risen to 5.8% from a low of 3.9% took a dip down to 5.6% in January. The unemployment rate is commonly seen as a lagging indicator (that is, it tends to react slowly to broader economic events), so if there is a continuing decline in the unemployment rate, it is a signal that the recession has already ended.

Employment appears to be stabilizing as well. Total nonfarm employment declined by a smaller amount that in any of the past 4 months.

Industrial Production

Industrial Production (IP) began to decline well before the official March beginning of the recession. IP has shown a dramatic decline leading up to and during this recession. In early and mid 2001, the NBER noted this decline but held off declaring a recession until the downturn had spread to other sectors of the economy.

In December, IP dipped by only 0.1%, while 13 of the previous 14 months saw a greater monthly decline. While not exactly great news, at least the dip seems to have stabilized.

Consumer Confidence

Consumer confidence saw a drop at the start of 2001, and another large drop in September. However, after hitting a low in November, we’ve seen two months of increases.

Backdrop of Stable Prices

Over the past several years, many people thought that we were “one recession away” from price stability – it looks like we’re there: the consumer price index declined by 0.4% in December. Prices have also fallen in the second half of 2001, and for the entire year, inflation was only 1.6%.

The lack of inflation, as well as the strong productivity growth numbers, should give the Fed plenty of cover to keep interest rates low for the foreseable future.

Reading the Economy

While each of the numbers above is merely one piece of the economic puzzle and should not be taken as conclusive, the overall picture is one of an economy that may have hit bottom. Of course, only time will tell if this is true, and other events may again shock the economy in the meantime.

Overall, the economic future is looking brighter than it did only a couple of months ago.

Filed under: Economics, Economy, Monetary Policy, Recession

Another Rate Cut – What about real rates?

The Fed for the
fifth time this year lowered interest rates by 0.5 percentage points. This
brings the target nominal interest rate down to from 4.5% to 4%. 

Today (4.26.01)
the labor department announced that for April (4.01) the consumer price
index rose by a seasonally adjusted 0.3%. This brought the rate of inflation
over the past 12 months to 3.3%. 

With inflation
slightly up, and nominal interest rates down, I though it might be interesting
to take a fresh look at the patter of real interest rates over time. But
first a quick description of what a “real interest rate” means.



Real Rates.

Loosely speaking
the real interest rate is the real value of loan repayments. The nominal
interest rate is usually quoted in newspapers, and describes the amount
of money that must be repaid on a loan, but does not take into account
that the value of the repayment may be less due to inflation. The real
interest rate makes this inflation adjustment. 

The Fisher equation
shows how one calculates the real interest rate (r) given the nominal interest
rate (i) and the inflation rate:

r = i – inflation

With inflation
running at over 3% per year, this means that current real rate of interest
is getting close to zero. 

Here’s an example.
Suppose that you put $100 in the bank and earned a (nominal) interest rate
of equal to i. After 1 year you would have 100 * (1 + i).

So if i is 10%,
you would have $110. However, if there is some amount of inflation in the
economy, then this $110 would be worth a bit less. In particular, it would
be worth $110 (1 – inflation). So if inflation were 5%, then it would be
worth slightly less than $105.

$100 –> 1 year –>  $100 (1 + i) 

which is worth –> 

$100 (1 + i ) (1 – inflation) = $100 ( 1 + i – inflation – i*inflation).

If both the interest
rate and the inflation rate are both small, then we can ignore i*inflation
and then we can write

$100 –> is next year worth –> $100 (1 + i – inflation) = $100 (1 + r),

where r = i –

This again is
the Fisher equation.

Note that the
above is only true ex post – that is only after inflation has been
determined. The real interest rate for the coming year must take into account
expected inflation, since we are not exactly sure what inflation will be
in the future. 

Since nominal
interest rates are often set in advance, if the inflation rate turns out
to be higher than expected, then the real interest rate will turn out to
be lower than expected. Since what people care about is the real exchange
rate, any unexpected inflation will benefit borrowers since the real rate
will turn out to be lower than anticipated – this is because the real value
of the payment, if not the actual number of dollars, will be less. For
the same reason, unexpected inflation will hurt lenders.

The graph below
shows the pattern of real interest rates over the past 50 years to so.
With real interest rates currently at about 1%, we will be dipping to levels
not seen since the last recession in the early ’90’s.

This would suggest
that the Fed has been taking a very aggressive stance towards what it feels
is a weakening economy. Will the recent interest rate changes do the trick?
Check back in about 6-15 months to find out.

Filed under: Economy, Monetary Policy