Quick note on the use of “natural rates” in macro analysis

November 24th, 2015 at 9:46 am

In yesterday’s post on underemployment, I employed various concepts used by many in high places in contemporary economic analysis, including “natural rates” of un- and underemployment–i.e., the lowest rates consistent with stable inflation–the “equilibrium” Fed funds rate–the one consistent with stable growth that’s neither too hot nor too cold–and so on.

Some readers and Tweeters were unhappy with such usage, arguing in so many words that a) it is inherently conservative to adopt such constructs as in practice they generate biases against truly full employment and thus against the less advantaged, who benefit most from tight labor markets and are hurt most by slack ones, and b) they’re unobservable and impossible to pin down within a policy-useful margin of error, so why go there?

I acknowledged as much in yesterday’s post: “…there are good reasons not to truck in this whole “natural rate” business at all; there’s no reliable way to nail it down, it moves around, and economists invariably tend to pitch it too high, at great cost to those who depend on truly full employment.”

It’s also important in this corner of economic analysis to be wary of the assumption that there’s an equilibrium state for these variables. That is, even if a rate of unemployment or interest really is consistent with stable prices/growth at time t, that rate may well be out (or moving out) of said equilibrium at time t+1. Check out all the time variation in the “natural rate of interest” from this recent Fed paper (see Figure 5).

And the unobservable problem is huge.

But here’s the thing. When in Rome…That is, there is IMHO a real utility in this work to working within the model that’s in the minds of the key players pulling the key levers. First, if your goal is to nudge the course of the ship a bit, you’ve got to be able to use the same map and navigation system as the captain, even if you don’t wholly believe it.

Second, these people aren’t dopes by a long shot. My beef is more that they’re working in models driven by correlations more than causation and these models have been missing pretty big time for a pretty long time, often at great cost. But prices/wages do, in fact, correlate with slack/capacity utilization, though to different degrees over different times and for different reasons than the classical models often reflect. EG, bargaining power is a critical variable that can get lost in a lot of the macro analysis.

So I will continue to use all the tools and models that everyone else does, but I won’t be limited to them and I will employ them with caution and a dose of skepticism, not cynicism.

Our tax debate is more cramped than ever

November 24th, 2015 at 8:19 am

Hillary’s attacking Bernie for raising taxes on the middle class, which both suggests a serious constraint on a truly progressive policy agenda and may be necessary to get elected. Even while the firm is already as master tax avoider, Pfizer is inverting–moving its tax mailbox to Ireland while keeping its operations largely here (and thus using US infrastructure, education system, etc. without paying its fair share for them)–to further take down its tax rate.

It’s official: our federal tax system is a hot, revenue losing mess. How did we get into this cramped cul-de-sac of a tax debate and how do we get out of it? Over at Wapo.

What is the “natural rate” for u6?

November 23rd, 2015 at 8:04 am

Not the sexiest title, I grant you, but important stuff, nevertheless.

Those of us interested in just how close we are to full employment like to track the more comprehensive “u6” rate, aka, “underemployment.” It includes all the unemployed, but also the millions of involuntary part-timers (IPT)—who are, quite literally, underemployed—plus a small subset of those out of the labor market who might be willing to work if there were more good opportunities available. Especially because IPT has been so elevated in this recovery, and because some special factors, like depressed labor force participation, have led to a downward bias of the unemployment rate, u6 is worth watching closely.

As you see below, u6 rose more in the Great Recession and has fallen faster in the expansion than the official rate.

Unemployment and Underemployment (u6)

Source: BLS

Source: BLS

Now, for reasons I’ll explain, it’s necessary to guesstimate to the “natural rate” of unemployment, i.e., the unemployment rate consistent with stable prices. The Fed thinks it’s about 5% which is where we are now, ergo, they’re getting ready to raise rates.

But I think that these days, it’s better to gauge slack using u6, which last clocked in at 9.8%. But where is that relative to the natural rate of underemployment?

The (justifiably) influential macro team at Goldman Sachs believes that the natural rate for u6, call it u6*, is 9%. That’s about where u6 stood at the end of the last expansion (late 2007) when the official rate was at 5%, so not an unreasonable guess.

OTOH, as you can see in the figure, u6 was around 7% at the end of the 2000s expansion, when the official rate was around 4% (and inflation was perfectly well behaved, ftr). There are reasons to believe the “natural rate” is higher today than it was back then—certainly productivity and thus potential growth are lower now. And, of course, there are good reasons not to truck in this whole “natural rate” business at all; there’s no reliable way to nail it down, it moves around, and economists invariably tend to pitch it too high, at great cost to those who depend on truly full employment.

But here’s why it’s important: the Taylor Rule. This is the rule that says at least one Taylor Swift hit must be on pop radio at any given time (whoops—sorry—just a little whining from a chauffeur whose teenagers insist on controlling the radio). The other Taylor Rule is one of the methods the Fed employs to decide whether the interest rate they control needs to be raised, lowered, or left alone.

There are many variations of Taylor rules, and I’ll let you Google them to your heart’s content. They’re a touch controversial right now because House Republicans are trying to pass legislation to make the Fed follow some version of the rule, a terrible idea that Fed chair Yellen has inveighed against. Like I said, the rule is but one input and there are too many variants to reliably count on it to give anything more than a range of impressionistic answers as to where the Fed funds rate (ffr) should be set.

The rule is just a formula that takes data on inflation and slack and spits out an ffr. If you use the version Yellen describes here in footnote #5, and you plug in u6 instead of the official rate for slack, as I strongly think you should, you have to, as part of the formula, guesstimate u6* (the natural rate for u6).

So that’s what I did, using a few different methods (data available upon request).

1) regress u6 on Levin’s comprehensive slack variable, such that u6*=the intercept term, i.e., underemployment when slack=0.

2) regress u6 on the difference between the unemployment rate and the CBOs natural rate; the intercept is again the natural rate.

3) same as #2 but just plug in 4.5% for CBO’s natural rate, under the assumption that they peg it too damn high.

The table shows the results, using Yellen’s ftnt 5 version of the Taylor rule, and the most recent observation of year/year core PCE inflation (1.3%).

Source: see text

Source: see text

If, like the GS team, you think u6* is 9%, the rule returns 0.17% which is about where the Fed’s likely heading in a few weeks, when they raise the ffr by 25 basis points. If you think u6* is something less than that, as I do, you’d be in less of rush to get started with your “normalization campaign” as the rule says the economy still needs a negative real rate to get back to full employment.

But these differences are small and there are many sensitive assumptions built into the calculations. As I’ve said here re Fed liftoff plans, go ahead and raise a tiny bit if you must. What matters now is the path of future increases which, if we are to get to and stay at truly full employment, should surely be shallow and driven by the extent to which income and wage growth are reaching those who have heretofore been left behind.

President Obama makes an interesting point about economic messaging

November 20th, 2015 at 8:47 am

From a recent interview with the President in GQ:

You can’t separate good policy from the need to bring the American people along and make sure that they know why you’re doing what you’re doing. And that’s particularly true now in this new communications era. I think that we were ahead of the curve in 2008 in social media and the Internet and digital communications. When we came into office, instead of taking some of those lessons, we suddenly adapted ourselves to the White House press room and structures that had been built back in the 1940s and ’50s. As a consequence of those missteps early, we got the policies right, and that’s why the economy now has grown for five and a half straight years, six years, and why unemployment rates have gone from 10 percent to 5.1 percent. But there was a lot of political pain along the way that might not have been necessary.

Accurately diagnosing economic problems is often challenging. Figuring out the right policy prescriptions to treat the diagnosis is also hard, as is effectively and efficiently implementing the fixes.

But on top of all of that, effectively explaining what you’re doing to “the American people,” who, despite that unfortunate phrase, are not a monolith, is especially challenging.

First, if we’re talking about countercyclical policies of the type that the administration implemented in the heart of the Great Recession, there are two strong forces pushing against efforts to sell measures like the Recovery Act. One, people don’t do “counterfactuals”—what economists think would have happened to key variables had we not intervened. The jobless rate was 8.3% in February 2009 when the Recovery Act passed. It climbed to 10% later that year and didn’t fall below 8.3% until early 2012.

The message that “yes, unemployment’s gone up since we launched the stimulus but it would have gone up more absent the intervention” is not one most people are at all willing to entertain.

Two, opposition political forces take it as their job to discredit these actions. Despite evidence to the contrary, they dubbed the Recovery Act the “failed stimulus” pretty much out of the box (no question, Christy Romer and I didn’t help by using the consensus forecast at the time to predict the impact of the Recovery Act on unemployment; ftr, we had the deltas right—the changes in unemployment, jobs, and GDP—but the levels were too optimistic; this was a huge kick in our own goal that played into opponents hands and vastly complicated the messaging; see the offending Figure 1 here, but also see our beloved Endnote 1).

If those factors didn’t pose enough of a messaging challenge, the fact that we were bailing out banks didn’t help. People correctly perceived that the folks who helped get them into the mess were being rescued with taxpayer dollars. I don’t think anyone could sell that to the public.

President Obama’s point is more about the medium than the message. After using social media arguably more successfully than any prior national election, he notes it was largely dropped in favor of old school methods. Could more Twitter have meant less “political pain?”

I don’t know and have no idea how to back out that counterfactual. I tried writing blogs for the Huffington Post (here’s an e.g.), explaining in granular terms the positive impact of the Recovery Act, but I don’t think they reached anyone. The White House has certainly well adapted social media since then, but the economy’s improved and all those countercyclical interventions are way in the past.

He’s right that the policies were effective, and in many ways, that’s the most important message to get out there now, as in this important new paper by economists Alan Blinder and Mark Zandi. There’s another recession out there somewhere and it is essential that we the correct lessons regarding what worked and what didn’t from the last one.

But other than not scoring a win for the other side, I kinda doubt we could have done a much better job selling the policies in real time, even with a bunch more Snapchatting, etc. I’m not letting us off the hook, nor am I suggesting we did everything right; we didn’t. I just think the nature of the moment, the need for the bailouts, and the fact that things were going to get worse before they got better overwhelmed our messaging skills, such as they were.