Month: August 2023

An Alternative Monetary Rule

Leave a comment

August 27, 2023

By Stephen Stofka

This week’s letter is a prediction that house price growth will decline to near zero in the coming few years based on historical trends of price growth and the 30-year mortgage rate. The pattern is similar to that in the late 1970s and mid-2000s. In each case the Fed kept its key interest rate below the annual rate of home price appreciation to achieve a broad economic growth. In each case that accommodating monetary policy helped fuel a bubble that led to severe recessions when the economy corrected.

This week the National Association of Realtors (NAR) reported another drop in existing home sales, the fourth drop in the past five months. At the same time, the Commerce Department reported that new single family home sales in July were up 31% over the same month last year. At first glance, that seems excessive but this past quarter was the first positive annual gain in single family home sales since the second quarter of 2021. Existing homeowners are interest rate bound to their homes until mortgage rates come down. New homes are filling the inventory gap.

Residential investment, which includes new homes and remodeling costs, contributes only 3-5% to GDP, according to the National Association of Home Builders. It varies by several factors. Homebuilders rely on the crystal ball predictions of the banking industry for financing. Homeowners’ remodel plans depend on the growth in home equity and interest rates available for financing. The pandemic sparked a shift in consumer preferences for existing homes. During the pandemic, new home sales decreased but remodeling increased. In this recovery period, the opposite has occurred. Home Depot has reported two consecutive quarters of negative sales growth, the first time since the housing crisis 15 years ago.

Let’s look at two previous periods when monetary policy was a major contributing factor to a subsequent decline in home prices and a recession. In the chart below (link to FRED chart is here), the red line is the average 30-year mortgage rate. The green line is the annual change in a broad home price index. As soon as the green line gets above the red line, homebuyers are making more in price appreciation than they are paying in interest, a form of arbitrage. That signals that monetary policy is too accommodating. The dotted line in the graph is the effective federal funds rate (FRED Series FEDFUNDS). Mortgage rates follow the Fed’s lead. In the mid-2000s, home price growth, the green line in the graph, rose up above the red mortgage interest line. As it did in the late 1970s, the Fed was watching other indicators and was slow to raise interest rates.

The period between the mid-1980s and the financial crisis is called the Great Moderation. From the end of the 1982 recession until the late 1990s, the Fed kept its key interest rate (dotted line) higher than home price appreciation and lower than the 30-year mortgage rate, a moderating balance. Since 2014, home price growth has been above the 30-year mortgage rate. When this latest period of arbitrage unwinds, the effects will disturb the rest of the economy. When will that moment come?

Asset bubbles leave an economy vulnerable to shocks. In an interconnected global economy, disturbances from malinvestment can cascade through one prominent economy to test the strength of institutions and businesses in other countries. The U.S. financial crisis demonstrated that process. The foundations of companies like AIG and Goldman Sachs, thought to be financial fortresses, cracked and threatened a collapse that would bring other large companies down with them.

One of the roles of a central bank is to curb the heady expectations that fuel asset bubbles. In a 1993 paper John Taylor introduced a rule, now called the Taylor rule, to guide the Fed’s setting of interest rates. His rule was based on the actual decisions that had guided Fed policy during the decade that followed the severe 1982 recession, part of a period called the “Great Moderation.”

In their textbook on money and banking, Cecchetti & Schoenhoeltz (2021, 498) describe the rule succinctly: Taylor fed funds rate = Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap). I’ll leave the equation in the notes at the end. This policy rule was meant as a guideline so the equals sign should probably be read as an approximately equals sign. John Taylor originally used 2% as the natural rate of interest. To simplify the calculation and understand the relationships, the authors present a simple scenario. If the inflation rate is 2% and the target inflation rate is 2%, then there is no inflation gap. If real (i.e. inflation-adjusted) GDP growth is 2% and potential output is also estimated to be 2%, then there is no output gap. I’ll note the calculation in table format below:

The Congressional Budget Office (CBO) estimates potential GDP based on a full utilization of the economy’s resources. Here’s a screenshot of the two series since the financial crisis. Real potential GDP is the red line. Real actual GDP is the blue line. The financial crisis in 2007 – 2009 had profound and persistent effects on our economy. The graph is drawn on a log scale to show the difference in percent. As a guideline, the gap for 2012 is about 3%.

I propose using the inflation in house prices as a substitute for the inflation part of the calculation. I’ve included the equation in the end notes. Presumably, home price growth implicitly includes the neutral rate of interest so I exclude that from this alternative measure. The price of a home includes a decades-long stream of owner equivalent rent priced in current dollars. It incorporates estimates of housing consumption and long-term wealth accumulation. Home prices include evolving community characteristics and public investment like the quality of schools, parks, transportation, employment and personal safety. They are a broad market consensus. This particular series is compiled quarterly but follows the trend of the monthly Case & Shiller National Home Price Index, giving the central bank timely home price trends.

Fifty years ago, Alchian and Klein (1973) proposed that central banks include asset prices in their formulation of monetary policy. They wrote that a composite index of many types of assets would be an ideal measure but difficult to calculate. A broad stock index like the S&P 500 would capture the current price of capital stock but stocks can overreact to interest rate changes by the central bank (p. 180, 183). The S&P500 index is relatively volatile, with a 10-year standard deviation of 14.88%. The 30-year metric is 15%. The home price index is stable, with a 40-year standard deviation of just 4.74%, slightly above the 4.07% deviation of the Federal funds rate itself.

During the early years of the Great Moderation, this alternative policy rule was approximately the interest rate policy that the Fed adopted. In the graph below is the alternative rule in red and the actual Fed funds rate in blue. Notice the sharp divergence just before the 1990 recession. In the aftermath of the Savings and Loan crisis, the annual growth in home prices fell from 7% in 1987 to 2.5% in the fall of 1990. This was below the 4% long-term average of home price growth, signaling a call for a more accommodating monetary policy. The Fed did not recognize the economic weakness until it was too late and the economy went into a mild recession. For several years following the recession, the labor market struggled to regain its footing and this slow recovery contributed to President H.W. Bush’s defeat in his 1992 re-election bid.

The employment slack of the first half of the 1990s might have been lessened by a monetary easing. In the second half of that decade, the alternative rule called for a tighter monetary policy, which would have curbed the enthusiasm in the stock and housing markets. The divergence between the alternative rule and the actual Fed funds rate grew as the housing bubble developed. By the time the Fed started raising interest rates in 2004-2005, it was too late.

I will finish up this analysis with a look at the past decade. The alternative rule and the Taylor rule would have called for a higher policy rate. Persistent low rates helped fuel a growing price bubble in the housing market. The pandemic accentuated that trend. High home prices have contributed to unaffordable housing costs in popular coastal cities, sparking a surge in homelessness.

 Exiting an asset bubble is painful. Expansion plans are put on hold. As investment decreases, hiring growth declines and unemployment rises among those most vulnerable in the labor force. Withholding taxes decline, reducing revenues to state and federal governments who must carry the additional burden of benefit programs that automatically stabilize household incomes.

Housing costs constitute 18% of the core price index that the Fed uses to gauge inflation, but accounts for 40% of core price inflation. Because housing is a major component of household expenditures, home prices can act as a stable measure of inflation. Home prices capitalize the future flows of those expenses. Persistently low interest rates can distort those calculations, promoting malinvestment and an asset bubble. This alternative rule incorporates that signal into policymaking and should help the Fed make more timely course changes before the disturbances spread throughout the economy.

/////////////////

Photo by Tierra Mallorca on Unsplash

Keywords: Savings and Loan Crisis, Financial Crisis, Inflation, Federal Funds Rate, Taylor Rule, Home Price Index

(1) FFR = NRI +πt + α(πt – πt*) + ß(γt – γt*), where
π is the annual change in the Personal Consumption index (FRED Series PCEPI).
NRI is set at 2.0%.
γ is the natural log of real GDP (FRED Series GDPC1) and
γ* is real potential GDP (FRED Series GDPPOT).
α and ß coefficients are the degree of concern and should add up to 1. If inflation is more of a concern then α would be higher than ½. If output is more of a concern ß would be more than ½.

(2) Alternative Taylor Rule: FFR = hpi +  α(hpi – avg30(hpi)) + ß(γt – γt*), where
hpi = the annual percent change in the All-Transactions House Price Index (FRED Series USSTHPI).
avg30(hpi) is the 30 year average of the hpi.

Alchian, A. A., & Klein, B. (1973). On a correct measure of inflation. Journal of Money, Credit and Banking, 5(1), 173. https://doi.org/10.2307/1991070.

Cecchetti, S. G., & Schoenholtz, K. L. (2021). Money, banking, and Financial Markets. McGraw-Hill.

Price Consensus

Leave a comment

August 20, 2023

by Stephen Stofka

This week’s letter is about the formation of a price consensus between buyers and sellers. I’ll introduce a different perspective that might help us understand broad price changes. Visually oriented readers familiar with economics and statistics can listen to this letter and mentally picture these ideas as they walk the dog. However, I’ll present several graphs to illustrate the perspective.

Anyone who has taken an Economic course has been introduced to a supply demand diagram. Quantity is on the x-axis and Price is on the y-axis. The lines may be curved or straight. The intersection of the demand and supply lines is the equilibrium price, the long term average. A capitalist economy promotes change and the supply-demand diagram is a visual aid to understand how price and quantity respond to shifting conditions. Students learn how the supply-demand curves respond to changes in income, to better production technology, to price changes in other kinds of goods. That simple diagram demonstrates responses to government policies like taxes, transfer programs, price controls like apartment rents, and agricultural price supports.

The dotted line represents demand after a period of time, the one component missing from this 2-dimensional graph. While it pictures the formation of an equlibrium price it does not emphasize the broad price consensus that forms between buyers and sellers. To picture that let’s draw a probability distribution of sales at various prices and quantities. I’ll exchange the quantity and price axes so that price is on the horizontal x-axis and quantity is on the vertical y-axis.

I’ll redraw the chart, setting the average price to $0 with a short range of prices above and below that average. The equilibrium price is just the average long term price. The chart below highlights the narrow consensus over price between consumers (blue line) and suppliers (orange line). Rising prices induce more suppliers to enter the market. Declining prices attract more buyers. The supply and demand lines are curved, representing the number of sales taking place at each price level. The total number of units sold is 10,000.

Let’s consider a garden tool whose average price is $30. We will see some customers willing to pay $34, or $4 above that average price, but there are few of them. Likewise, there are few suppliers willing to sell at a price of $26, a price that is $4 below the average price.

To show price and quantity dynamics, the normal distribution graph is not as flexible or as simple as the conventional supply-demand diagram. The normal distribution chart can be viewed as a spread of prices over time, the third dimension. Just imagine that wedge of blue is a piece of pie so many weeks or months thick. Seeing price as a probability distribution does reflect a buyer’s reality in the sense that we prefer to shop with approximate prices in mind. Monthly surveys conducted by the BLS tell us that the prices of two categories – food and energy – are volatile, making it difficult for us to anchor a price expectation. These are the prices we encounter frequently when we fill up our cars, pay our utility bills and shop at the grocery store.

The graph is similar to a 2-dimensional triangle and is missing a critical component – time. The depth of a slice of pie can represent time periods. Demand operates on a shorter time scale than supply, an idea central to the analysis of Alfred Marshall, the economist who developed the supply-demand graph we use today. It’s a thinner wedge of pie.

Imagine that the average of a weekly tank of gas is $40. The blue pie of the normal distribution in the graph is sliced into a 100 vertical strips that statisticians call “bins.” Imagine that every one of those bins is a week and the center, the zero point, is an average of gas prices over two years. That is the time scale of demand. The time scale of supply is thicker, perhaps four times as long in some industries. The chart below shows the 2-year (demand) and 4-year (supply) averages of weekly gas prices for the past 25 years. Current 2-year average prices are at a historical peak. These prices are not adjusted for inflation. Adjusted for inflation, gas prices have declined in the past 40 years. After adjusting for fuel efficiency, gas prices are comparable to those in the 1950s.

The supply chain, including the banks that fund them, must look far into the future. Each one of the bins in the normal distribution chart could represent a month, not a week, forming an eight year average. No one could have foreseen a pandemic that interrupted global production. Coming out of the pandemic, businesses responded to low interest rates and anticipated a surge in demand. In an 18-month period from the fall of 2020 to the spring of 2022, private investment increased by 22%. The inflation that erupted in the spring of 2022 was a combination of growth in short term demand and long term supply investment. As soon as the Fed began raising interest rates, the surge in private investment ended and leveled out.

The normal distribution chart helps us see price as a probability distribution dispersed over time. Any chart that reminds us of pie is a useful and welcome analytical tool.

///////////////

Photo by Michael Dziedzic on Unsplash

Keywords: probability distribution, supply, demand, price

Intended and Unintended Consequences

Leave a comment

August 13, 2023

by Stephen Stofka

This week’s letter explores the free market and rule of two laws in our lives. Advocates for a laissez-faire market quote Adam Smith’s mention of the invisible hand in The Wealth of Nations, or WON. In a free market, individuals pursuing their own self-interest unintentionally promote a general welfare, a positive outcome as a result of the Law of Unintended Consequences.

Smith was particularly concerned with what I will call the Law of Intended Consequences. Under the guise of acting in the public interest, individuals furthered their own self-interest at the expense of the public welfare. In Part I of WON, Smith spent several chapters documenting many examples of collusion between business owners and merchants, labor guilds and city magistrates to further the gains of a small minority at the expense of the majority. This included price supports, price fixing, protective trade restrictions and the granting of monopolies through licensing. The only solution was a system of governance that promoted a general law and order with as few laws as possible.

The free market encourages a set of problems that subtract from the general welfare. Individuals pursue the most gain with the least cost. We want to buy low and sell high. We tout the principles of equality, but more often choose to maximize our own welfare. Transportation is most affected by this trait. Railroad, truck and airline carriers would prefer to supply the shorter distance routes which generate the most profits at the least cost. Without regulation and cross-subsidy, long distance routes that connect local or regional markets are underserved. This cripples the formation of a national transportation system. Although Adam Smith died a few decades before the introduction of railroads, he compared shipping goods by water to land based transportation by horse drawn wagon (Chapter 3). The former was far more profitable and explained why the “art and industry” of cities and towns close to water improved at a faster pace than inland communities.

This free market mechanism of the invisible hand fostered densely populated cities whose crude sanitation promoted epidemics of disease. In 1800 London had a population density averaging 30,000 people per square kilometer, a density more than twice as high as present-day New York City. The rich could afford a wagon and horse for transportation and moved to the outskirts of a city to escape the filth, smoke and disease of congested cities. The poor died prematurely. That was the invisible hand at work, subject to the same Law of Unintended Consequences.

In an ideal world, public laws would strike a balance between the laws of intended and unintended consequences. However, the very making of public law invokes the Law of Intended Consequences. Elected representatives tend to serve narrow ideological or geographical constituencies that are aligned with a representative’s own welfare. That is not a condemnation of their self interest but a description of the difficulty an elected body faces when trying to pass any law that claims to serve the public welfare.

In Article I, Section 8 of the Constitution, the framers limited Congress’ lawmaking authority to specific powers and those that promoted the general welfare. To James Madison, the main architect of the Constitution, that wording was clear. It meant only those laws that supported a broad public welfare like the common defense. Richard Lee, one of the anti-Federalists suspicious of centralized authority, protested that the general welfare could include “every possible object of human legislation,” as Michael Klarman (2016) quoted in his account of the making of the Constitution. Lee was worried that a strong central government could expand its power to tax for any reason that it deemed to be in the general welfare. A small class of people or a central government could argue that their welfare was the general welfare.

People in difficult circumstances clamor for a piece of the tax purse. Pharmaceutical manufacturers argue that a liberal extension of profit-protecting patent rights will promote more drug development and advance the general welfare. Advocates of trickle-down economics champion laws that promote lower taxes and fewer regulations, arguing that business owners will spread the wealth to working families. This is the collusion between private industry and lawmakers that Adam Smith documented 250 years ago. Our motivations and machinations do not evolve.

The welfare of the individual and that of the public must ever come in conflict. There is an inherent weighting we attach to each person’s welfare and each of us gives greater value to our own welfare. In the Part II, Chapter 3 of the Theory of Moral Sentiments, Smith remarked that we get more upset over the loss of the tip of a finger than we do over the loss of millions of lives if China were to be swallowed up by an earthquake. We cannot agree on society’s maximum welfare, or ophelimity, because we use different weighting coefficients to measure welfare. Lawmaking is a compromise between competing calculations of interest, both individual and public.

A laissez-faire market, like a pure white paint, is not efficient. A bit of black or umber tint mixed into a white paint base gets a wall covered in fewer coats and the tint is not noticeable. Each participant in a free market gains from cheating so some regulation is necessary as an incentive toward self-policing. We argue over how much regulation to mix into the free market base. We have different personal convictions, values and tastes, ensuring that our disagreements will persist.

////////////////

Photo by Tom Wilson on Unsplash

Keywords: general welfare, trickle-down economics, free market, invisible hand

Klarman, M.J. (2016). The Framers’ Coup: The making of the United States Constitution. New York: Oxford University Press, pp. 322-3. 

Money Exchange

Leave a comment

August 6, 2023

by Stephen Stofka

This week’s letter contains some idle thoughts on the exchange of money. Imagine a visitor from outer space who observes the exchange of cash for a $5 ice cream cone at a store. The buyer starts eating the ice cream. The store clerk puts the piece of paper in a black box, the cash drawer. It is clear to the visitor that the buyer has received something useful. What is not clear is what the store clerk received in exchange. The visitor has learned that creatures throughout the universe give up something in response to a reward or a threat. If the piece of paper was a threat, the clerk did not seem alarmed when the buyer offered the piece of paper across the counter. The visitor reasons that the paper is an energy packet which the clerk will consume later. Perhaps the clerk can put the paper into water and it will become food.

The visitor from outer space has realized an essential aspect of money. It contains potential energy that can be released immediately and exchanged for a good or service. It’s like an electrical capacitor ready to deliver an energy packet. We call that exchange energy purchasing power. Immediate release means that money has no maturity period, or a maturity of 0. A one-year CD cannot be spent because it has a maturity of one-year. To spend it, I need to wait until the one year is over or convert the CD to cash and receive a reduced amount, a penalty for early withdrawal.

The charge on that money capacitor can increase or decrease. We use the terms deflation and inflation for the increase and decay of money’s purchasing power. Inflation measures the percent of purchasing power lost over a period of time and that percentage lost cannot be more than 100%. In other words, a $1 bill cannot lose more than $1 of purchasing power. There is no theoretical limit to deflation, the increase in money’s purchasing power.

We use the terms yield and discount rate for the increase and decrease of money’s nominal value at some future time. These rates of change in purchasing power reveal another aspect of money – an exchange of time. What is time? A container of probabilities and that involves risk. Instead of consuming the ice cream cone, let’s say the buyer left the ice cream cone in a freezer for a period of time. What is the chance that some random power outage occurs and the ice cream melted while the freezer was off? When the freezer is opened, will the cone of ice cream be intact and ready to enjoy or will it be a discardable mess of ice cream protoplasm? Readers will note the analogy with Schrodinger’s thought experiment about a cat in an unopened box containing a life-threatening amount of radioactive material.

A lottery winner must decide between a series of payments and a lump sum payment that is far less than the nominal amount of winnings. The difference between now consumption and future consumption is called the discount rate, which includes a rate of risk that the winner does not live to receive all the payments. Social Security allows people to claim benefits at age 62 but the monthly payments are substantially lower than someone who waits until full retirement age. The discount rate is about 8% per year, almost the average annual return on the stock market. The risk is that a retiree dies prematurely and leaves money on  the table, so to speak.

There is no objective or time-invariant value in an exchange of energy. The exchange value of time varies by person and circumstance. In case of death or injury, the insurance industry calculates an average annual loss of income, or purchasing power, multiplied by an average estimate of years remaining in a person’s life. Ken Feinberg worked pro bono as the master of the 9-11 Victim’s Compensation Fund set up by Congress to resolve and expedite the many lawsuits that victims and their families would bring against the airlines. Feinberg agreed that an objective measure like years lost cannot compensate for the subjective loss of a life to a victim’s family. Money cannot measure life.

The exchange of money for goods and services connects buyers and sellers to a tree of information. Transactions take two forms: those that are recorded or “witnessed” by a third party and those that are not. If a buyer uses a check or credit card to buy an ice cream cone, a bank records the exchange of money for ice cream. If the buyer uses cash, only the merchant and the buyer have a record. The merchant records a sale and the buyers gets a receipt if they ask. The merchant reports the sum of sales to a government agency for sales tax and income purposes. In the case of a food-borne disease the USDA will investigate the many branches of that tree, searching the vendors, distributors, packagers and growers to isolate the source of contamination.

The exchange of ice cream for money is a connection to a tree of production. The manufacture and storage of the ice cream involved a network of power plants to generate electricity, machinery and labor for production, as well as natural and artificial ingredients. The buyer has the purchasing power in her pocket because of some past exchange of energy as part of a production process.

The sidewalk and street outside a store connects a buyer to a tree of organizational authority. Some public entity had the ability to gather the resources to build that infrastructure. The use of those public facilities might have cost the ice cream buyer 30 to 40 cents in sales tax. Over decades metropolitan areas have attracted people because cities offer an economic bargain of public benefit for relatively small cost.

The exchange of ice cream for money connects the buyer and seller to a network of rules and expectations of behavior. The clerk won’t sing the Star Spangled Banner when she receives the money. She won’t do a magic trick with the ice cream. The buyer will not give a dramatic reading of the serial number on the $5 bill before handing it to the clerk. Exchange requires a tacit cooperation, an agreement to follow the rules.

As a child I learned that there was electricity inside the walls. The air I walked through and breathed was full of radio waves in addition to light and sound waves. There was literally music in the air, captured and translated by a portable radio. Today our cell phones interpret the microwave radiation emitted by hundreds of nearby cell towers. Our thoughts and senses are connected to each other as we walk through the information stream. The ultimate source of every bit of that information is the effort of another human being. For the monthly cost of a cell phone bill, we have access to that effort, that infrastructure, the taxing and regulatory authority that supports that exchange. The exchange of money connects our efforts, yet talking about money usually introduces dissension. We disagree about the distribution of money, the priorities of public spending and the principles of taxation. Then we blame money instead of ourselves.     

///////////////

Photo by Artem Sapegin on Unsplash