The Pause in the Cycle

March 26, 2023

by Stephen Stofka

This week I’ll look at things that are hard to measure and their effect on our lives. Much of human activity is recursive, meaning that the outcome of one action becomes the input to the next iteration of that same action. When we get nervous we may breathe fast and shallow which changes our body chemistry increasing our anxiety and we continue breathing fast and shallow, amplifying the effect. Because of that cyclic process prominent thinkers like Aristotle, Adam Smith, David Ricardo, Karl Marx, and Joseph Schumpeter, among others, have proposed circular models of human behavior.

The 19th century economist David Ricardo modeled the industrial process as a profit cycle. Increasing or decreasing profits mark the division between two phases of the cycle. The first phase is a series of more and higher –

rising profits,
more investment,
leading to more output,
an increased demand for labor,
a rise in wages,
a rise in population and consumption,
an increasing use of less efficient inputs,
higher prices,
then higher interest rates,
and lower profits.

The decline in profits signals the end of the expansion and begins the downward phase, a cycle of less and lower of each of those elements – less investment, output, less demand for labor, lower wages in aggregate, etc. Ricardo assumed that workers received subsistence wages so an individual worker might not work for wages any lower. Like his friend Thomas Malthus, Ricardo assumed that higher incomes would lead to an increase in population. In the early 19th century, less efficient inputs meant less fertile land. As our economy has transitioned to become almost entirely service oriented, the less efficient inputs are labor. It is difficult for a hairdresser or therapist to become more productive.

Since the pandemic companies have been rewarded for raising prices, a strategy Samuel Rines, managing director of the research advisory firm Corbu, called “price over volume” on a March 9th Odd Lots podcast. With this strategy, companies like Wal-Mart keep pushing prices higher, willing to accept lower volume as long as total revenue and profits are higher. After-tax corporate profits (CP) have risen more than 40% from pre-pandemic levels, according to the Federal Reserve.

In Ricardo’s model of the profit cycle, higher prices lead to higher interest rates as investors increase their demand for money to take advantage of the higher prices. In our economy, the Fed controls the Federal Funds interest rate that other rates are based on. As prices continued to rise, the Fed began to lift rates and has raised them more than 4% in the past year. As the Fed raises rates, bank loan officers tighten lending standards, beginning with small firms (DRTSCIS) and credit card loans (DRTSCLCC). The FRED data series identifiers are in parentheses. In the past year, banks have increased their lending standards by more than 50% for small firms and 43% for credit card loans. However, all commercial loans have increased by 15% in the past year and delinquency rates have not changed since the Fed started raising rates. This is part of Ricardo’s model. Investment does not decrease until profits decline. Profits (CP) still grew at 2.25% in the 3rd quarter of 2022. We are not there yet.

In the 4th quarter of 2022, real GDP grew at less than 1% on an annual basis. We won’t have an estimate of 1st quarter numbers until the 3rd week of April but employment remains strong. Since 1980, the population adjusted percent change in employment goes negative or approaches zero just before recessions. In the chart below, notice how closely the employment (blue line) and output series move in tandem. The red line is the annual percent change in real GDP.

We may be approaching the pause point but the point of decline could be six months to a year away. Although the Fed let up on the “gas pedal,” raising rates by ¼% rather than ½%, they showed their commitment to curbing inflation as long as the employment market stays strong. If the Fed had not raised rates this past week, they would have set expectations that they were done raising rates. For now we can look for these signs that the expansion of the business cycle in Ricardo’s model is coming to a close.


Photo by Lukas Tennie on Unsplash

The Money Treadmill

March 19, 2023

by Stephen Stofka

Inflation is a cat’s cradle of mechanisms and motivations as mysterious as time, a simple and puzzling concept that controls our lives. Our minds are caged by this thing that is objectively invariant – a second is a second – but experienced so differently by each of us. It begins when we are very young and ask a parent when we can go to the beach or an amusement park. “Next week,” we are told, and our eyes glaze over. How far away is next week? Albert Einstein was the first to understand time as a distance. Stephen Hawking, one of the most fertile minds of the last century, wrestled with the beginning of cosmological time.  Many of us struggle to knit two concepts together – time and money. To many of us the net present value of a future flow of moneylooks like something inside of a tangled ball of fishing line.

Several banks blew up recently because they mismanaged their exposure to time risk. Inflation is the experience that time is moving faster than our money. It’s like our money is running on a treadmill when someone starts increasing the speed of the treadmill. The Fed cannot directly affect the speed of the treadmill so it raises interest rates, the equivalent of adding weight to our money. More often than not, the Fed damages the treadmill, sending the economy into recession.  

I’ll include some background on the relationship between inflation and interest rates. Irving Fisher was an influential economist in the early half of the 20th century whose ideas continue to influence economic thinking. Several of these are the Quantity Theory of Money, a way of computing a price index, and a hypothetical relationship between inflation and unemployment that later became known as the Phillips Curve. Fisher hypothesized that interest rates rise in a lockstep response to inflation – an idea known as the Fisher Effect. Fisher reasoned that lenders would demand higher interest rates if they anticipated that a dollar would buy less in the future. For the same reason, depositors would demand higher interest rates on their savings. Fisher died in 1947, just after World War 2. In the decades after his death, the data did not support a simple one-for-one relationship between interest rates and inflation.

Despite the lack of a simple relationship, the Fed has limited tools to achieve – by law – two counterbalancing targets, full employment and stable prices. For several decades, its policy objective has targeted a 2% inflation rate as a quantitative mark of stable prices. To counter inflation, the Fed initiates a Fisher Effect by being the first bank to raise the interest rate it pays to all the other banks. The reasoning is that banks will charge higher interest on their loans to cover the higher cost of their funds. That should slow loan demand. Secondly, the Fed reasons that banks will raise the interest rate they pay on deposits. A higher rate should induce people to save more and spend less, thus slowing down the treadmill.

Fisher’s Quantity Theory of Money (QTM) is built on the assumption – an “if” – that interest rates stayed constant. Since interest rates were lowered to near zero during the financial crisis in 2008, there has been little movement in interest rates. This became a natural experiment that Fisher had imagined – a world where interest rates remained constant. As the Fed pumped more money into the economy during the 2010s, the QTM predicted that prices would rise. They didn’t. Just as economists had discovered that the relationship between interest rates and prices was complicated, so too was the relationship the quantity of money and prices.

Banking is the art and discipline of managing the speed and weight of money when an individual bank has no control over either the speed or the weight. Anything that stays still for long becomes invisible or at least minimizes their risk. Cats instinctively know this as they wait still and patient in the hope that a wary bird will relax its guard. The long lack of movement in interest rates tempted those at Silicon Valley Bank to take concentrated risks based on the assumption that interest rates would continue to stay low.

Retail investors are cautioned not to load up on long-term bonds just to get a higher interest rate return. From October 2021 to October 2022 Vanguard’s long-term bond index BLV lost almost 30% in value. Professional bankers broke that cautionary rule. Former Fed Chairman Alan Greenspan admitted his mistake in judgment as the 2008 financial crisis unfolded: “I made a mistake in presuming that the self-interests of … banks … were such that they were best capable of protecting their own shareholders and their equity in the firms.” By holding interest rates low for so long, some banks lost their sense of prudent risk management. The cat pounced.

This experience should guide our own choices of investment, savings and risk management. We can be lulled into thinking that some factor in our lives will stay constant. Some factors are personal – a job, a marriage, our health and the health of our family. Some factors belong to the wider community we are a part of – the local economy, the housing market and the weather. Other factors are macro – interest rates, inflation, state and federal policies. We can do what Silicon Valley Bank did not do – diversify.


Some have likened the run on SVB to the D&D model presented in a 1983 paper. Douglas Diamond and Philip Dybvig (D&D) won the 2022 Nobel Prize for their model demonstrating the efficiency and appropriateness of government deposit insurance. Douglas Diamond was interviewed this past Tuesday on the podcast Capital Isn’t. Diamond says that the bank run on SVB was not like the ones they presented in their model. In that model the depositor base was much wider and diverse, more like a random sample than the depositors of SVB who were primarily businesses in the tech industry.

Photo by Sven Mieke on Unsplash

Paradoxes in Savings

March 12, 2023

by Stephen Stofka

Paradoxes in Savings

The week’s letter is about the relationship between savings and inflation. On Tuesday, Jay Powell, the Chairman of the Fed, announced that they would continue raising rates to get inflation under control. The market dived a few percentage points. There are no shortage of explanations for persistent inflation. Despite an inflation rate above 5% for the past year, the employment market remains strong, a puzzle to economists. I will take a look at how changes in savings affect inflation.

There are times when we coordinate our behavior for apparent reasons. The weather and seasons synchronize the activities of farmers. The harvest comes at a particular time and farmers need to rent more harvesting equipment, storage capacity, rail cars and trucks for transporting their crops. Suppliers are on a different time schedule than their customers.  Supplying anything takes planning, investment and time.

Suppliers rely on the fact that buyers coordinate their buying decisions according to the seasons. Clothes, gardening and Christmas gifts are easy examples. Forty percent of homes are sold during the spring months. Except for big purchases, a buying decision takes less planning and this can create anomalies that suppliers are not prepared for. Sometimes it is a popular toy at Christmas or a clothes style made popular by a celebrity.

What causes asset buyers to coordinate their behavior? The economist John Maynard Keynes was particularly interested in that question. He attributed the phenomenon to “animal spirits,” an infectious rush of pessimism or optimism that affects the prices of assets first, then spreads to the purchases of goods. Normally, some of us are saving more than usual for something, while some of us are spending that savings, or borrowing to buy things. There is a balance of savers and borrowers. However, sometimes a general prudence causes everyone to save more than average and what emerges is a paradox, the Paradox of Saving. If everyone saves, then economic activity declines, unemployment rises, people spend down their savings and the economy finds a new equilibrium at a much lower growth rate.

In the spring of 2020, a surge of Covid deaths in Italy and New York City prompted the closing of many businesses. City morgues were overwhelmed, forcing hospitals to rent refrigerated trucks to store the bodies. The NY health department supervised several mass burials. Residents in rural areas who were unable to catch their breath were flown to distant hospitals with the equipment and personnel capable of bringing the patients some relief. Because many workers had abruptly lost their income, the government issued relief payments to households throughout the country. With many entertainment venues closed, many of us increased our rate of savings. Below is a graph of the quarterly change in the personal savings rate.

The savings rate shot up 15%, a historic rise. Even during the high inflation of the 1970s, the savings rate rose by only 2.5% in 1975. Such an abrupt change in savings did have an effect on prices. When the change in the savings rate is negative, people are buying stuff with their savings. Companies could take advantage of supply chain bottlenecks and raise prices. This helped make back what they had lost in profits in 2020. The quarterly change in prices began to rise, as the red line in the chart below indicates. Note that inflation is the annual, not quarterly, change in prices.

Look on the right side of that chart and you will see the blue savings line turning positive. A steadily higher savings rate should exert some calming effect on prices. I then ran a statistical regression on the annual change in both prices, i.e. inflation, and the savings rate for the past 35 years. The effect of a 1% rise in the savings rate is about a 1% decrease in the inflation rate and explains 21% of the movement in inflation.

What can you do with this information? Quick erratic changes in savings have an effect on prices. Immediately after 9-11 there was an abrupt rise and fall in savings but the change was much less than the pandemic shock, which was truly historic. In 2008 came another shock, an abrupt shift in savings and an accompanying rise in prices in the summer of 2008 before the Lehman meltdown in September and the economy tanked in the 4th quarter of 2008. These changes in savings rates don’t occur very often, but when they do we should pay attention.


Photo by Johannes Plenio on Unsplash

The Money Cycle

March 5, 2023

by Stephen Stofka

This week’s letter is about money and a natural resource like water. The nature of money, its origin and history have long been a subject of lively debate. What similarities and differences does money have with water? Does an analogy help uncover some less apparent characteristics of money? I’ll start with the three purposes of money that every economics student learns: a medium of exchange, a store of value and a unit of account. Coincidentally, water has three phases, gas, solid and liquid, and in each of those phases has some of the characteristics of money. The quantity of money can expand. The volume of water in all its phases is fixed.

Ice stores the energy of water the way that money stores value. As freezing water locks together in a crystal lattice, it becomes its own container. Oddly enough, most ice exhibits a hexagonal form, an efficient material transformation in response to changes in temperature. Only 2.5% of the world’s water is freshwater and most of that is locked up in glaciers. Money’s store of value is contained within assets.

In Part 5, Chapter 3 of the Wealth of Nations, Adam Smith noted that people tend to hoard their capital, to lock it away from a government which has little respect for individual property – what he called a “rude state of society.” If merchants and manufacturers have confidence in a government, they are willing to lend it money because the debt of that government can be traded in the market as though it were money. It is an interest bearing money. He lamented the fact that too many governments borrowed money to finance war and taxed people to build infrastructure. He suggested that governments do the opposite – borrow as much idle capital as possible to enhance the productivity of a country and tax people to finance wars. There would be less war and more progress.

Like money, water vapor is a medium of exchange between sky and ocean, between sky and earth. It is in constant motion within the atmosphere because its density quickly changes in response to changes in heat. It carries the water from the ocean and drops it onto the land in a conveyer belt system called the hydrological cycle. When all the earth came together in one supercontinent called Pangea 250 million years ago, water vapor transported little moisture from the oceans to the interior of the vast continent and the land was mostly desert (Howgego, 2016). When businesses around the world closed their doors at the onset of the pandemic in March 2020, we became very aware that our society, not just our economy, depends on a cycle of exchange.

Money is a unit of account, a common denominator to add up all the various goods and services in an economy. We add up tons of wheat and corn and millions of hours of labor in terms of money. . While we often think of fractions as “this divided by that,” economists understand fractions as “this in relation to that.” A social scientist might question whether it is a good idea for people to think of their labor in relation to money, the common denominator. Sadly, our society judges our worth to society in relation to that common denominator, money.

Water has a density like money has a purchasing power. Water is at its most dense – its weight per unit of volume – at 39°F and that benchmark is standardized at 1 in the metric system. The density of water at 39°F is like the benchmark price that economists use when they compute real GDP. Its volume expands as it gets colder or hotter than that temperature, so it’s density declines. The most measurable changes come at higher temperatures; at 200°F, the density is .963. We often use the language of heat when talking about inflation. The economy is overheating, for example. When there is hyperinflation¸ society itself begins to change state, just as water does at the boiling point.

Changes in the market value of our assets can have a material effect on our sense of safety. We work hard and save only a small portion of what we earn. When the value of an asset declines, it seems to melt away as though it were a block of ice on a sunny day. We may get a sense of helplessness or anxiety similar to the feeling we have when we lose electricity and worry that we will have to replace all the food in our fridge.

Readers may have other insights into money based on this water analogy. Just as equations can expose relationships that we did not understand before, analogies can do the same.


Photo by Ryan Yao on Unsplash

Howgego, J. (2016, July 14). Travel back in time to the most extreme desert and monsoons ever. New Scientist. Retrieved March 3, 2023, from

Price Paths Rejoin

February 12, 2023

by Stephen Stofka

Divergent paths rejoin. This week’s letter revisits a correlation between movements in oil prices and the general price level. On July 10th of last year, I noted a divergence between the change in oil inflation and price inflation. The chart graphed the change – or momentum – in oil and price inflation, not the inflation itself. Transportation is a fundamental component and cost of our economy and companies must factor in shifts in price momentum in their pricing decisions. Here’s that chart.

At the time I had thought it likely that the change in broad price inflation – the red line in the chart – would moderate toward the momentum change in oil prices, the blue line. It did. Here is a chart with the most recent data through the end of 2022.

As I was writing last July, the momentum in general price inflation had already peaked and would start declining throughout the rest of the year. Think of momentum as a strong dog on a leash. Where it pulls, general price inflation will follow. Here’s a monthly comparison of inflation and its momentum.

At just a hint that inflation was moderating, the broad market began a rally in late October but it fizzled out in early December for a few reasons. The labor market was strong despite the Fed’s interest rate hikes and market participants correctly anticipated another 0.75% rate hike. In addition, Christmas retail sales were slow, increasing the likelihood that earnings gains would decrease. The broad market has rallied 7% since the beginning of the year.

A last note for those of you who are working on taxes and reviewing your portfolio, the investment advisor Edward Jones (2023) has a nice chart titled Investment Performance Benchmarks at the bottom of the page showing the 1, 3, and 5-year returns on various asset classes within the cash, bonds, and stocks categories. Despite the 18% drop in large cap stocks last year, the five-year performance is 9%, close to the decades long averages. The tech sector lost almost 30% in value last year but its 5-year return is almost 16%. During volatile years, relatively passive investors should keep their sights on the long-term averages.


Photo by Jens Lelie on Unsplash

Edward Jones. (2023, January 24). Quarterly Market Outlook. Quarterly Market Outlook | Edward Jones. Retrieved February 9, 2023, from

Money As Wave

February 5, 2023

by Stephen Stofka

This week’s letter is about money, a peculiar thing invented by people that has no intrinsic value unless exchanged between people. Unlike other goods, the consumption of money satisfies no human wants. Price is the thing on the left side of an equation. On the right side can be a physical quantity like a haircut or a quart of milk, or a less physical good like the satisfaction of a debt owed, or the title of ownership to a car. Money is the equal sign of that equation, the channel that connects the price information to real goods and services.

Many goods have two types of value – subjective and objective. A tomato’s subjective value depends on the needs, preferences, and resources – the circumstances – of the consumer. These circumstances vary with time. A consumer who is hungry and who likes the taste of tomatoes values a tomato more than a consumer who is not hungry or who doesn’t like tomatoes. The subjective value depends on a consumer’s resources. A consumer with a fridge can preserve a tomato longer and might value a tomato more than someone who has no cool place to store a tomato. A further element of subjective value is the intended use for the good. A consumer who wants to eat a fresh tomato might have different quality standards than someone who wants to puree the tomato for a soup or sauce.

The second type of value is objective, an intrinsic value of the good itself – the nutrients and calories a tomato provides, the chemical changes that it undergoes, the pests that the tomato harbors within its skin. Just as the circumstances of the consumer vary with time, the benefits or dangers of a good’s consumption can vary with time.  

Like the values of goods, the value of money has a subjective and objective component. The objective component is a decay in the exchange value of money on the left side of millions of exchange transactions. Economists measure thousands of prices each month and determine an average weighted price for a set of goods – a consumer price index. The annual, or year-over-year, percent change in that index is called inflation. It compares this month’s price index with the price index one year ago. Economists also measure the change in that percent change and the two sometimes get lumped together by the financial press. Inflation is like the odometer in a car. If I travel 50 miles in an hour, I have averaged 50 MPH but it is the speedometer that tells me my current speed, not the average over an hour. Too often the arguments on social media mix the two together. Imagine getting pulled over by a patrol car for speeding and explaining to the officer that your average speed for the past 15 minutes has been less than the speed limit. The officer cares only about your acceleration – the near instantaneous speed.

The value of money has a subjective component that depends on the user’s circumstances. Today-Money is that which is needed to satisfy current needs. Future-Money is savings. As prices go up, people tend to hold more money as a percent of their income to pay for living expenses. If a household spends 90% of their income on current needs, then much higher inflation rate might cause them to spend 100% of their income on expenses. A higher income household might spend only 60% of its income on expenses. The effect of inflation is lower for higher income households.

Savings is an exchange between two people in time, between a person today and that same person in the future. “You got to pay you,” we may be told when encouraged to save some of our paychecks. The first you is Today-You. The second you is Future-You, who will be grateful that Today-You was prudent. Future-You does no work yet enjoys all the sacrifices that Today-You makes, the extra work, the enjoyment of things not consumed in order to save. Future-You is truly the child of Today-You.

The financial system facilitates the exchange of money-value through time. In countries with a poor financial system, people place their savings in things, animals and children whose work or usefulness will provide for a person when they become less vigorous in their old age. A child may grow up with the moral and financial burden of having to care for their parents. In these pastoral societies, a child is considered a form of wealth.

Children in an area far from home or in a foreign country are expected to send a substantial part of their paychecks home to their parents or extended family. This moral burden drives young people to immigrate to another country where they can earn more money. Part of their earnings form the international flow of remittances which increased by almost 5%, according to the Migration Data Portal (2023). India, Mexico, and China were the top recipient countries in 2022, accounting for $310 billion of the $690 billion in remittances. This sum does not include informal or illegal transfers of goods and services between countries.

Money acts like a radio wave, conveying price information about the relative values of goods and services. It requires institutions to broadcast and relay that wave as it travels around the globe and through our lives.


Photo by Pawel Czerwinski on Unsplash

Migration Data Portal. (2023, January 6). Remittances. Migration data portal. Retrieved February 3, 2023, from The portal was established in 2016 as a data repository founded under the auspices of the United Nations. It collects central bank data through the World Bank and IMF.

Employment Curves

January 15, 2023

by Stephen Stofka

For millennia people have claimed a power of divination by various methods, including the casting of bird bones on the ground, the magic of numbers or certain word incantations. As the New Year begins, there is no shortage of predictions for 2023. Will the Fed taper its rate increases now that inflation has moderated? Will the U.S. go into a recession? Will falling home prices invite a financial crisis like the one in 2007-9? Will bond prices recover this year? Other animals see only a few moments into the future. We have developed forecasting tools that try to time-travel weeks and months into the future, but we should not judge a tool’s accuracy by its sophistication.

Statistics is a series of methods that constructs a formula explaining a relationship between variables. Each data point requires a calculation, a tedious task for human beings but a quick operation by a computer. Before the introduction of the computer in the mid-20th century, investors used simpler tools like the comparison of two moving averages of a time series like stock prices. These simple tools are still in use today. An example is the MACD(12,26) trend that compares the 12-day and 26-day moving averages, noting those points where the short 12-day average crosses the long 26-day average (, 2023). We can apply a similar technique to the unemployment rate.

In the chart below I have graphed the 3-month and 3-year moving averages of the headline U-3 unemployment rate. The left side of each column faintly marked in gray marks the beginning of a recession has noted by the NBER (2023). These beginnings roughly coincide with the crossing of the 3-month (orange) above the 3-year (blue) average. With the exception of the 1990 recession, the end of the recessions is near the peak of the 3-month orange line, after which unemployment declines. Today’s 3-month average is well below the 3-year trend, making a recession less likely. However, except for the pandemic surge of unemployment, the 3-month average is quite low and has been below the 3-year average for the longest period in history.

I did not do any laborious trial and error of various averages to find a fit. I chose these periods because they fit my story, something I wrote about last week. A 3-year average should provide a stable long term trend line of unemployment. A 3-month average should reflect current conditions with some of the data noise removed. The crossing should capture an inflection point in the data.

The low unemployment rate implies that workers have more wage bargaining power but wage increases have lagged inflation, robbing workers of purchasing power. If inflation continues to decline in 2023, some economists predict that wage increases may finally “catch up” and surpass the inflation rate.

There are two trends that have weakened the wage bargaining power of workers. Since World War 2, an economy dominated by manufacturing has transitioned to a service economy with lower average wages. In that time, the percent of workers employed in agriculture fell from 14% to less than 2% as production and harvesting became more mechanized. The labor market has undergone structural changes that may invalidate or weaken the lessons of earlier decades.

Since WW2, self-employment has declined. Half of those employed now work for large companies with 500 or more employees (Poschke 2019, 2). Few are unionized and able to bargain collectively for wages. According to the Trade Union Dataset (2023), most European countries enjoy much higher trade union participation than in the U.S. where only 10% of workers belong to a union. Large American companies enjoy a wage-setting power that smaller companies do not have and this enables them to resist wage demands. American workers do not have enough wage bargaining power to make a significant contribution to rising prices. Stock owners, able to move money at the stroke of a computer key, hold more bargaining power.

To keep their stock prices competitive, publicly traded companies must maintain a profit margin appropriate to their industry. Investors will punish those companies who do not meet consensus expectations. Company executives rarely take responsibility for falling profit margins. Instead, they blame rising wages or material costs, shifting consumer tastes or government regulations. Interest groups like the U.S. Chamber of Commerce, a private lobbying organization funded by the largest companies in America, champion a narrative that inflation is the result of rising wages, not rising profit margins. Like any interest group, their job is to assign responsibility for a problem to someone else, to convince lawmakers to act favorably to their cause or industry. The Chamber has far better funding than advocates for labor and it uses those funds to block policies that might favor workers.

There are economists and policymakers who still believe in the Phillips Curve, a hypothetical inverse relationship between unemployment and inflation. High unemployment should coincide with low inflation and high inflation with low unemployment. Shortly after Bill Phillips published his data and hypothetical curve, Guy Routh (1959), a British economist, published a critique in the same journal Economica, pointing out the flaws in Phillips’ methodology. The chief flaw was Phillips’ lack of knowledge about the labor market itself. Despite that, American economists like Paul Samuelson, who favored an activist fiscal policy, liked the implications of a Phillips Curve. Policy makers could fine tune an economy the way a car mechanic tuned a carburetor.

In the past year, some economists and policymakers have advocated policies to drive unemployment higher and wring inflation out of the economy. Despite rising interest rates, the labor market has been strong and resilient. In January 2020, Kristie Engemann (2020), a coordinator at the St. Louis Fed, explored the debate about whether this relationship exists or not. For the past five decades, the “curve” has been flat, a statistical indication that there is no relationship between inflation and unemployment. Policymakers will continue to cite the Phillips Curve because it serves an ideological and political purpose.

We don’t need statistical software to debunk the Phillips curve. In the chart I posted earlier, there were several points where the 3-month average unemployment rate was near or below 4%. These were in the late 1960s, the late 1990s, and the late 2010s. The inflation rate was 3%, 2.5%, and 1.4% respectively. If the Phillips Curve relationship existed, inflation would have been much higher.

As our analytical tools become more sophisticated we risk being fooled by their power. With a few lines of code, researchers can turn the knobs of their statistical software machines until they reach a result that is publishable. We should be able to approximate if not confirm our hypothesis with simpler tools.  


Photo by Augustine Wong on Unsplash

Engemann, K. M. (2020, January 14). What is the Phillips curve (and why has it flattened)? Saint Louis Fed Eagle. Retrieved January 13, 2023, from

National Bureau of Economic Research. (2022). Business cycle dating. NBER. Retrieved January 13, 2023, from

Poschke, M. (2019). Wage employment, unemployment and self-employment across countries. SSRN Electronic Journal, (IZA No. 12367).

Routh, G. (1959). The relation between unemployment and the rate of change of money wage rates: A comment. Economica, 26(104), 299–315. (2023). Spy – SPDR S&P 500 ETF. Retrieved January 13, 2023, from  Below the price chart is the MACD indicator pane.

Trade Union Dataset. OECD.Stat. (2023, January 13). Retrieved January 13, 2023, from

U.S. Bureau of Labor Statistics, Employment Level [CE16OV], retrieved from FRED, Federal Reserve Bank of St. Louis;, January 11, 2023.

U.S. Bureau of Labor Statistics, Employment Level – Agriculture and Related Industries [LNS12034560], retrieved from FRED, Federal Reserve Bank of St. Louis;, January 11, 2023.


The Misery Index

December 18, 2022

By Stephen Stofka

This week’s letter is about a measure of economic discomfort that economist Arthur Okun developed in the 1960s. In the early 1980s President Reagan renamed it the “misery index.” Weather forecasters calculate a misery index of temperature and humidity. Okun’s measure of discomfort added the inflation rate and the unemployment rate. How reliable is this weathervane of human misery? Let’s focus on those points where the index touched a medium term low.

We can begin in the mid-60s as society began to rupture. Young people protested the restrictive norms of the post-war society when employers regarded a man whose hair was longer than “collar length” as unkempt. Polite women wore white gloves to church and formal affairs. In northern cities black people rioted over the prejudice that prevented them from access to business loans in their own neighborhoods. By law, federal home loans were not available to people who lived in “redlined” majority black neighborhoods. The courts and Indian agencies disregarded the property and civil rights of Native American families. There was a lot of misery that was not measured by the misery index.

The late 1990s – another relative low in the misery index – were a heady time. The internet and Windows 95 was but a few years old and investors were exuberant about the “new internet economy.” Fed chairman Alan Greenspan warned of “irrational exuberance” and economist Robert Shiller (2015) wrote a book of that same name, introducing his cyclically adjusted price earnings, or CAPE, ratio. Investors based their valuations on revenues, not profits. In a rush to dominate a market space, companies spent more to acquire a new customer than the revenue the customer brought in. Investors rejected “old economy” manufacturing companies like Ford and GE and turned to the new economy stocks like  Microsoft, Sun Microsystems, CompuServe, AOL and Netscape, companies that connected computers and people. Neither Google nor Facebook existed. Amazon was a company that sold books online. raised $83 million at its IPO on the promise of convenient pet food delivery. In the summer of 2000, the air started leaking from the “dot-com” bubble. By the spring of 2003, the SP500 was down 42% from its high. None of that investor misery was captured by the misery index.

The index touched another low in early 2007, a year before the beginning of the 2007-09 recession and the Great Financial Crisis. This time investors were exuberant over both housing and stocks. The top bond ratings companies, like Moody’s and S&P, dependent on the fees they collected from Wall Street firms, slapped Grade AAA stickers on the subprime mortgage backed securities their customers wanted to underwrite. Financial companies played regulatory agencies against each other, choosing the one with the most relaxed standards and supervision. Whiz kids in the back rooms of major financial firms developed trading models that blew up within a few years. Some of the largest companies in the world, champions of the free market who consistently fought regulations, ran to the government with their hands out, pleading for bailouts.  In the 3rd quarter of 2008, Lehman Brothers collapsed and threatened to take down the rest of the financial system. The misery index rose to 11.25%, slightly below our current reading of 11.88%. If the misery index were a tape measure, a carpenter would throw it in the garbage as an unreliable tool.

The collapse of oil prices in 2014 shifted the misery index to another low in 2015. After a decade of near zero interest rates, housing and stock prices had again reached nosebleed levels and the index dropped to another low in late 2019. Was that a harbinger of a coming financial crisis? We never did find out. Within six months, the pandemic crisis struck.  

The misery index is an unreliable measure of discomfort but a good measure of investor exuberance. Medium term lows are an indicator that investor optimism and asset valuations are too high. Relative index highs like the current 12% mark a period of excess investor pessimism. Sometimes a lousy tape measure can be useful after all.


Photo by patricia serna on Unsplash

Shiller, R. J. (2015). Irrational Exuberance: Revised and Expanded Third Edition. Princeton University Press.


The Change Changed

November 13, 2022

by Stephen Stofka

October’s CPI report released this week indicated an annual inflation of 7.7%, down from the previous month. Investors took that as a sign that the economy is responding to higher interest rates. In the hope that the Fed can ease up on future rate increases, the market jumped 5.5% on Thursday. Last week I wrote about the change in the inflation rate. This week I’ll look at periods when the inflation rate of several key items abruptly reverses.

Food and energy purchases are fairly resistant to price changes. Economists at the Bureau of Labor Statistics (BLS) construct a separate “core” CPI index that includes only those spending categories that do respond to changing prices. It is odd that a core price index should exclude two categories, food and energy, that are core items of household budgets.

Ed Bennion and other researchers (2022) at the BLS just published an analysis of inflationary trends over several decades. Below is a chart of the annual change in energy prices. Except for the 1973-74 oil shock, a large change in energy prices led to a recession which caused a big negative change in energy prices.

We spend less of our income on food than we did decades ago so higher food prices have a more gradual effect, squeezing budgets tight. Lower income families really feel the bite because they spend a higher proportion of their income on food. In the graph below a series of high food price inflation often precedes a recession. Unlike energy prices, there is rarely a fall in food prices. Following the 2008 financial crisis, food prices fell ½% in 2009. It is an indication of the economic shock of that time.

Let me put up a chart of the headline CPI (blue line) that includes food and energy and the core inflation index (red line) which does not. Just once in 75 years, during the high inflation of the 1970s, the two indexes closely matched each other. Following the 1982-83 recession, the core CPI has outrun the headline CPI.

A big component of both measures of inflation is housing. The Federal Reserve (2022) publishes a series of home listing prices calculated per square foot using data. You can click on the name of a city and see its graph of square foot prices for the past year. You can select several cities, then click the “Add to Graph” button below the page title and FRED will load the graph for you. Here’s a comparison of Denver and Portland. They have similar costs.

The pandemic touched off a sharp rise in house prices in both cities. Denver residents have attributed the big change to an influx of people from other areas. However, Census Bureau data shows that the Denver metro area lost a few thousand people from July 2020 to July 2021 (Denver Gazette, 2022). In the decade after the financial crisis, there simply wasn’t enough housing built for the adults that were already here.

The surge in home buying has not been in population but in demographics. As people approach the age of 30, they become more interested in and capable of buying a home. The pandemic helped boost home buying because interest rates plunged from 5% in 2018 to 2.6% in 2021.

Record low interest rates enabled Millennials in their 20s and 30s to buy a lot more home with their mortgage payment. That leverage caused housing prices to rise. A 30-year mortgage of $320K has a monthly mortgage payment of $1349 at 3%. At 5%, it is $1718 and at 7% it rises to $2129. Ouch!

Rising rental costs and home prices drive lower income families to less expensive areas in a metro area or entirely out of an area. Declining public school enrollment has forced two Denver area counties to announce the closing of 26 schools and transfer them to other schools (Seaman, 2022). As the number of students decreases, the schools infrastructure costs do not change, increasing the per student costs. Buses have to be maintained, drivers paid, schools staffed with guards, cafeteria staff, janitors and administrative personnel. Once schools are shuttered, the building may be sold and converted to other uses, either residential or commercial. The public schooling system is like a large ship that takes some time to change course.

During our lifetimes we experience many changes. They can happen quickly or emerge over time. The effects may be short lived or last decades. Families are still living with the consequences of the financial crisis fourteen years ago. Carelessly planned urban development isolates the residents of a community. The social and economic effects can last several generations. As we grow older, we learn to appreciate William Faulkner’s line, “The past is never dead. It’s not even past.”


Photo by Davies Designs Studio on Unsplash

Bennion, E., Bergqvist, T., Camp, K. M., Kowal, J., & Mead, D. (2022, October). Why inflation matters. U.S. Bureau of Labor Statistics. Retrieved November 11, 2022, from

Denver Gazette. (2022, March 25). Denver joins big city trend with pandemic population slip. Denver Gazette. Retrieved November 11, 2022, from

Federal Reserve. (2022). Median listing price per square feet:Metropolitan Areas. FRED. Retrieved November 11, 2022, from

Seaman, J. (2022, November 10). Schools targeted for closure in Denver, Jeffco have disproportionately high numbers of students of color, data shows. The Denver Post. Retrieved November 11, 2022, from


Economic Puzzles

November 6, 2022

by Stephen Stofka

Many people compare today’s inflation with that of the 1970s. A better comparison might be with a much earlier period. This week’s letter will be about the change in the inflation rate. Inflation is like the speed on a speedometer. If I accelerated from 50 to 60 MPH over a certain time period, perhaps 10 seconds, the change in the speed is 10 MPH. The time period I’m looking at is one year. If inflation rose from 1% to 5% in a year’s time then the change is 4%.

I’ll start with the current year. The one year change peaked at 6.1% in the first quarter of 2022. As the Fed raised rates, that change moderated. It’s like accelerating to 60 MPH and realizing that the speed is over the speed limit and reducing speed by easing up on the gas pedal or braking.  

Most of the time the inflation rate changes by less than 2% up or down. During and after recessions it can become more volatile. In 1980, inflation soared above 14% and the one year change peaked at 5.8%, slightly less than our recent experience.

There has only been one time in the past 70 years when the inflation rate rose faster than today. That was in 1951, shortly after the Korean War began. For the first six months of 1950, prices sank – deflation – then war was declared in June 1950 and the U.S. again ramped up defense production. The one year change in inflation peaked above 10% as Federal defense spending shot up 45%.

If you would like to explore this period in more detail Tim McMahon (2014) presents 1950s inflation data in an easy to read format. A hundred years ago, a period of persistent deflation – not inflation – followed the last pandemic.  See Tim’s second link below. The Federal Reserve was still fairly new and the U.S. and European nations had adopted a gold standard that would eventually lead to the Great Depression. That’s another story. Today the world’s commerce is interlocked and pandemic shutdowns continue to deliver a series of supply shocks. Getting policy right is more difficult when circumstances are this unusual.

Volatile Inventories

Inflation rises when there are inadequate resources to meet demand. In 2021, real private gross domestic investment rebounded quickly, rising almost 32% on an annualized basis in the 4th quarter. One component, inventories, was responsible for much of that surge. Even under normal conditions, this series is a volatile component of GDP (BEA, 2019) and the BEA publishes a figure called Final Sales of Domestic Product which excludes the change in inventories. Real final sales is approximately close to inflation-adjusted GDP.

During the pandemic manufacturing and retail goods sat in container ships off the port of Los Angeles and other ports. While the goods were in transit, they were not added to inventories. In the 2nd quarter of 2021, businesses began to open again but the ports were slow to unravel their logjams. Empty truck containers sat in parking lots and on neighborhood streets near the L.A. port while ships waited in line out on the water.

Sales surged as economy reopened

In the 2nd quarter of 2021, real final sales increased 2%, finally reaching pre-pandemic levels. In the first half of the year, real food and service sales shot up 10%. Normally that increase would occur over three years. However, within months that initial surge subsided. Over the next two quarters, real final sales barely increased. Real food sales declined slightly. This confirmed a temporary response to a post-pandemic recovery. With so many items out of stock, customers were willing to pay higher prices to get products. Some businesses had orders shipped from Asia by air. In the 4th quarter 2021, the floodgates opened and real private inventories rose by a record $197 billion.

Profits Surge

Real retail and food services sales fell slightly. In the last six months of 2021 inflation topped 5% but people were not buying and selling more stuff. Where were the price pressures? During the inflationary second half of the 1970s, profits increased a whopping 12% per year in those five years. In 2021, corporate profits rocketed up. Supply disruptions and repressed demand during the pandemic gave businesses pricing power. In 2021, corporate profits increased 18%. If demand was relatively flat, that pricing power had to fade but profit growth was still strong in the first quarter. Like the 1970s, rising corporate profits and pricing power were major contributors to inflation. This week the House Committee on Oversight and Reform (2022) came to a similar conclusion. What is the source of that pricing power?

War in Ukraine

In February 2022, Russia attacked Ukraine, sending energy prices higher. XLE, a broad energy ETF, gained 35% by early March. Two months later, the BEA reported another record rise in real private inventories of $214 billion. However, real final sales fell 2.5%. Some economists pointed to low unemployment and rising wages but ECI wages of private workers were on the same trend as before the pandemic when inflation was low. Most of the rise in the inflation rate was in housing, food and energy prices. The pandemic and low interest rates had contributed to the rise in housing costs. The war in Ukraine was responsible for volatile energy prices. There was no increase in real food sales but food prices were rising. Four large meat producers had profit growth of 134%, the committee reported.

The Puzzle

Historians still argue about the causes of World War I a century ago. Economists still cannot agree on the inflation mechanism of the 1970s. Contributing causes were rising corporate profits, shifting demographics in the work force, oil supply shocks, a shift in the international monetary regime and an evolving trans-global economy in the post war era. Economists do agree that it was a gestalt of market, fiscal and monetary forces, complicated by geopolitical and policy shocks that shaped expectations of future inflation. When people expect further price increases, they buy more now, aggravating inflationary pressures. Those expectations helped entrench inflation in the economy of the 1970s. Paul Volcker, chairman of the Fed in the late 1970s and early 1980s, raised interest rates so high that it wrung inflation out of the economy but at great economic cost to many families. The high interest rates caused two recessions, one of them the worst since the Great Depression.

The Korean War

In answer to the surge of inflation in 1951, the Fed raised rates slightly but rates stayed below 2%. The government did the heavy lifting. In September 1951, President Truman started a regime of wage and price controls administered by the Economic Stabilization Agency (ESA) and Wage Stabilization Board (WSB). There were loud protests against the controls and President Eisenhower ended them after he took office in 1953. Several months later the Korean War ended. In 1971, President Nixon instituted wage and price controls and demonstrated the failure of controls. Monetary policy is the weapon of choice to combat inflation but rising rates disproportionately affect the most vulnerable workers.


Infrequent events are an intersection of many factors that make each one unique. As economists pull apart the tangle of causal narratives, they develop new theories or modify existing ones. Economists usually cling to a favorite – either supply or demand. I’m watching profit growth. If Republicans take the House and possibly the Senate in the coming election, they will try to further enhance corporate profits at the expense of social programs like Medicare and Social Security. Republicans continue to sell a “trickle down” narrative but decades of evidence shows that the trickle is but a few drops. What goes to the top stays at the top.


Photo by Ana Municio on Unsplash

BEA: Bureau of Economic Analysis. (2019). Chapter 7: Change in private inventories. Retrieved November 4, 2022, from

The House Committee on Oversight and Reform. (2022, November 4). Subcommittee analysis reveals excessive corporate price hikes have hurt consumers and fueled inflation, while enriching certain companies. House Committee on Oversight and Reform. Retrieved November 5, 2022, from

McMahon, T. (2014, April 23). Inflation and CPI consumer price index 1950-1959. Retrieved November 3, 2022, from Inflation data for 1920-1929 is here