macroblog

The September CPI with all the trimmings

Yesterday, the U.S. Bureau of Labor Statistics reported that retail prices rose 2 percent (annualized) in September, and it characterized the increase as "broad based, although tempered by a decline in the food index." Indeed, the traditional measure of core inflation (the consumer price index, or CPI, less food and energy) also rose 2 percent (annualized) in September.

But if you read just a few sentences further into the report, you get this observation:

"Contributing to this increase were advances in the indexes for lodging away from home, medical care, new vehicles, used cars and trucks, and public transportation. The increase occurred despite declines in the indexes for rent and owners' equivalent rent, the first decreases in those indexes since 1992. The energy index also increased in September, as increases in the indexes for gasoline, fuel oil and electricity more than offset a decline in the index for natural gas."

This observation begs an important question: What exactly does "broad based" mean here? Rent and owners' equivalent rent actually declined last month. These categories represent a shade more than 30 percent of the CPI. If you add in all the other things that showed outright price declines in September, like food, car rentals, men's apparel, and furniture, about 44 percent of the CPI fell last month. In fact, the two of us believe there is ample evidence in the data of significant disinflationary pressure—much more than the CPI or the core CPI would imply.

One way to get a sense of how broadly based the September price increases are is to examine the "trimmed-mean" estimators produced by the Federal Reserve Bank of Cleveland. Trimmed-means compute the rise in the CPI after excluding, or trimming, a proportion of the most extreme price movements. (If you want to learn more about this procedure, we suggest you read here or watch the Cleveland Fed's "Drawing Board" segment on the idea.)

The figure below shows all of the trimmed-mean CPI estimators ranging from just a tiny proportion of the items trimmed to virtually all of the items trimmed.

For the September CPI, note the rather dramatic drop in the estimate of retail inflation as you trim only a small share of the extreme price changes in the CPI market basket. Just cutting out the most extreme 6 percent of the highest and 6 percent of the lowest price changes reduces the measured inflation rate from 2 percent to 1.5 percent. And the more you trim, the lower the inflation estimate. The median CPI rose a mere 0.5 percent last month.

An interpretation of these data is that the September CPI increase was anything but broad-based. Moreover, the data seem consistent with the idea that prices overall are on a path of disinflation. During the first four months of 2009, the majority of the trimmed-mean estimators put retail inflation roughly between 2 percent and 2.3 percent. In the May to August period, most of the estimators were under 1.3 percent. In September, the majority were under 1 percent.

By Michael Bryan, a vice president in research at the Atlanta Fed, and Brent Meyer, an economic analyst at the Cleveland Fed

A look at another job market number

As we've written in this blog recently, U.S. labor markets are weak at present and are likely to remain that way for some time. Last week's U.S. Bureau of Labor Statistics' August JOLTS (Job Opening and Labor Turnover Survey) report provided further evidence of labor market weakness (see here and here), with both the vacancy and quit rates at record lows (the JOLTS survey has comparable data back to December 2000).

At the end of August there were estimated to be fewer than 2.4 million job openings, equal to only 1.8 percent of the total filled and unfilled positions—a new record low. This is an especially significant issue given the large number of people who are looking for work. The ratio of the number of unemployed to the number of job openings was greater than 6 in August. In contrast, that ratio was under 1.5 in 2007 and previously peaked at 2.8 in mid-2003, suggesting that finding a job right now is extremely difficult (see the chart).

The quit rate moved back down to its record low of 1.3 percent, as relatively few people want to leave a job voluntarily in the face of such a weak labor market. At the same time, the rate of involuntary separations moved up from 1.6 percent to 1.8 percent, not far below the peak of 1.9 percent in April.

The low probability of finding a job has also caused the average amount of time spent unemployed to rise substantially. The average duration of unemployment is up from around 20 weeks in 2004 (the previous peak) to 26 weeks now, with those unemployed more than 26 weeks now accounting for 36 percent of all unemployed versus 22 percent in 2004. Congress is considering an extension of unemployment insurance benefits (currently due to expire December 31) as the mismatch between job openings and the number of people looking for jobs grows.

By John Robertson, a vice president in the Atlanta Fed's research department

Reviewing the recession: Was monetary policy to blame?

Reviewing the Recession: Was Monetary Policy to Blame?
In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way."

There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did:

I'm going to resist the temptation to call this approach a "Taylor rule." The estimating "rule" used here does in fact include realizations of inflation and a measure of the output gap (that is, a measure of how different gross domestic product is from its potential). These are the essential ingredients of the Taylor rule, but not the source of the close fit evident in the chart above. Over the period covered by the chart, you could have done a pretty good job mimicking the actual federal funds rate outcomes in any given month using knowledge of the previous month's rate. (If you are interested in the details of the estimating rule, you can find them here.)

The interpretation of the tendency for today's federal funds rate to generally follow yesterday's rate—sometimes referred to as interest rate smoothing—is controversial. Glenn Rudebusch (from the Federal Reserve Bank of San Francisco) explains:

"Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy."

Rudebusch is decidedly in the second camp, but for our purposes here the exact interpretation may not be that important. Though I am glossing over some not insignificant caveats—such as the difference between final data and the information the FOMC had to react to in real time—the chart above suggests that whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy.

Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium.

There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices.

Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. The necessity of proceeding with that work was emphasized by no less an authority than Don Kohn, vice chairman of the Federal Reserve Board of Governors, speaking at just such a gathering of macroeconomists last week:

"It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research."

I will admit that economists were not exactly ahead of the curve with this agenda, but prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

By David Altig, senior vice president and research director at the Atlanta Fed

Prospects for a small business-fueled employment recovery

In a speech yesterday, William Dudley, the president of the Federal Reserve Bank of New York, identified financial constraints for small businesses as a restraint on the pace of economic recovery. Specifically, he said:

"For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector."

President Dudley's comments are even more relevant in the current recession if one considers the disproportionate effect the recession has had on very small businesses. In general, the Small Business Administration defines a small business as a firm with less than 500 employees. However, for my analysis here I focus on the very small firms (those with less than 50 employees) as the data indicate these firms have been the most affected by the current recession. (Look here for another take on how to define a small business).

During periods when national employment levels were expanding since 1992 (when this data series began), firms with less than 50 employees have made up approximately one-third of the nation's employment growth. During the employment declines associated with the 2001 recession, these firms made up only 9 percent of job losses. In the current recession, though, these very small firms have made up 45 percent of the nation's job losses.

Looking ahead, it's not clear whether small businesses will continue to play their traditional role in hiring staff and helping to fuel an employment recovery. However, if the above-mentioned financial constraints are a major contributor to the disproportionately large employment contractions for very small firms, then the post-recession employment boost these firms typically provide may be less robust than in previous recoveries.

By Melinda Pitts, research economist and associate policy adviser

Economic troughs, changes in the unemployment rate, and fed policy

Recent data on the U.S. economy have been mixed. But today's weak labor market report (discussed more here, here, and here) provides a reminder that thinking of the economy as being in anything other than a technical recovery at this time is likely an exaggeration. The report showed the unemployment rate inching higher to 9.8 percent—and it would have been even higher absent a measured decline in labor market participation. Those active in the labor market declined by an estimated 571,000 in August. Discouragement about job prospects is a likely explanation for at least part of this decline.

In the face of such a weak labor market, it is interesting to consider the relationship between the timing of a recession's end and the peak in the unemployment rate. The following table shows the National Bureau of Economic Research's recession dates, lining those dates up with the month when the unemployment rate peaks. (Note that I exclude the 1980 recession since the unemployment rate did not peak before the 1982 recession.)

Historical lag between end of recession, unemployment rate peak, and beginning of funds rate tightening cycle

End of Recession	Unempl. rate peak	Beginning of funds rate tightening cycle	Months from end of recession to unempl. peak	Months from unempl. peak to beginning of funds rate tightening cycle
Nov 2001	Jun 2003	Jul 2004	19	13
Mar 1991	Jun 1992	Feb 1994	15	20
Nov 1982	Dec 1982	Jun 1983	1	6
(Jul 1980)
Mar 1975	May 1975	May 1976	2	12
Nov 1970	Aug 1971*	Mar 1972	9	7

*Following the 1970 recession, the unemployment rate was 6.1 in December 1970 and again in August 1971. If the December 1970 peak is used, months from end of recession to unemployment peak is 1 and months from unemployment peak to beginning of funds rate tightening cycle is 15.
Source: Bureau of Labor Statistics, National Bureau of Economic Research, and Federal Reserve Board

From the table, it is clear that there is considerable variation in how long it takes for the unemployment rate to move lower after the economy enters recovery mode. The typical explanation for the lag is that, as the economy shows signs of improvement, more people enter the labor force. These additional people raise the denominator in the unemployment rate calculation that often more than offset actual declines in unemployment (more on the labor force from Calculated Risk).

The past two recessions stand out as cases where the months from the end of the recession before the unemployment rate peak were very long—more than a year.

Of related interest is the historical relationship between the peak in unemployment and the beginning of a policy tightening. (Tim Duy discusses prospects for Fed policy and contrasts some recent economic data with recent Fed commentary.) Of course, the Fed does not base policy solely on movements in the unemployment rate, and the always useful advice to not casually extrapolate future decisions based on the past is even more important given the unusual circumstances of this recession. Nonetheless, historically, the beginning of a tightening cycle has lagged behind the peak in the unemployment rate by many months. This pattern is true for expansions when the FOMC was felt to have done a poor job in managing inflation, such as the post-1975 period, and it is equally true for periods when the Fed is believed to have done a very good job of managing inflation, such as the post-1991 episode.

Let me be clear that I am not offering a forecast but instead a reminder that the dynamics of unemployment do not always follow the dynamics of recessions. And for what it's worth, Federal Reserve policy has not historically responded immediately to declines in the unemployment rate—for both better and worse.

By John Robertson, a vice president in the Atlanta Fed's research department

An agnostic gets a little religion

Yesterday's consumer price index (CPI) report showed further disinflation in August, at least on a year-over-year basis. Headline inflation was down 1.4 percent from last year, the largest 12-month decline since January 1950, save for the 2.1 percent decline the month before. Core inflation crept down to 1.5 percent in August, and private forecasters see slow price growth continuing through at least next year. The Blue Chip Economic Indicators, a monthly poll of around 50 business economists in the United States, showed consensus expectations for year-over-year growth in core CPI at 1.5 percent in 2010, a relatively low number compared with recent history, and a shade under the panel's forecast for 1.6 percent in 2009.

I'm a bit of an agnostic when it comes to the predictive capacity of the Phillips curve—the inverse relationship between unemployment and inflation. There is considerable evidence that looking at the gap between unemployment and the nonaccelerating inflation rate of unemployment (NAIRU, sometimes termed the natural rate of unemployment) isn't necessarily useful for estimating future inflation; Atkeson and Ohanian found that inflation predictions from Phillips curve–based models were no more accurate than a naïve forecast where future inflation is defined by its recent past, ignoring the current state of the economy. A more recent working paper by Stock and Watson supports Atkeson and Ohanian's evidence that the predictive abilities of Phillips curve forecasts are not very robust. But Stock and Watson also point out that when the gap is big, there is more information that can be gleaned.

"When the unemployment rate is near the NAIRU … Phillips curve models do worse than the UC-SV model [a modified version of the Atkeson-Ohanian naïve forecast]. But when the unemployment gap exceeds 1.5 in absolute value, the Phillips curve forecasts improve substantially upon the UC-SV model. Because the gap is largest in absolute value around turning points, this finding can be restated that the Phillips curve models provide improvements over the UC-SV model around turning points, but not during normal times."

Stock and Watson argue that large positive (or negative) unemployment gaps (like those usually found around turning points in the business cycle) do improve the inflation forecast. So when the unemployment gap swells—as it did following the 1990 and 2001 recessions—we should anticipate more downward pressure on inflation than the naïve models would have forecast. The chart above, which shows core CPI and the unemployment rate gap as estimated by the Congressional Budget Office (CBO), seems to bear out this point. High rates of unemployment following the 1990 and 2001 recessions were also associated with turning points in the core inflation trend.

If Stock and Watson have it right, then the huge rise in the unemployment rate we've seen over the past year isn't something that inflation forecasters will want to ignore, and the downward drift in core inflation associated with this recession could be with us for a while. That potential scenario follows their reasoning, but like I said, I'm an agnostic when it comes to Phillips curves.

By Laurel Graefe, senior economic research analyst at the Atlanta Fed

Economists got it wrong, but why?

Economists definitely received some bad publicity this past week, most prominently in the New York Times, where Paul Krugman asked "How Did Economists Get It So Wrong?," a nonrhetorical question he goes on to answer this way:

"As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth… the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

"Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets—especially financial markets—that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don't believe in regulation."

For at least one part of the Krugman critique, I have some sympathy. On the occasion of a 2005 conference honoring the 25th anniversary of Chris Sims's pathbreaking article "Macroeconomics and Reality"—an article that was itself a critique of empirical practices then dominant in central banks—I had this to say about the dangers of groupthink and questions we might be missing as a consequence:

"We are close to falling dangerously in love with the basic New Keynesian framework, the sticky price aspects of it in particular. Here is a simple observation: In the [statistical models] that are identified in the usual ways, inflation wants to drop like a rock in response to a basic technology shock. Models that engineer significant price inertia don’t want to let that happen…

One final point. In my time at the Fed, I have come to appreciate that most of the really important policy choices have nothing to do with Taylor rules or the like. They have to do with those episodes of financial crisis in which Taylor-like rules are woefully inadequate. Think here October 1987, the period from summer 1997 through the end of 1998, and the aftermath of September 11, 2001."

Though Professor Krugman spends a lot of time attacking acolytes of the so-called "Chicago" school, the fact is that the New Keynesian framework (described here by Greg Mankiw) is the workhorse theory within policymaking circles. If economists were unable to see their way to the macroeconomic consequences of the unfolding crisis, criticism needs to start with that framework.

I think such criticism is warranted, but the thrall of the New Keynesian world view has little to do with how "beautiful" the model is or that it is built on a lot of "impressive-looking mathematics." Quite the opposite. As I said in my 2005 comments, "the dynamics of the policy briefing game seem to favor forecasting performance over theoretical integrity." The models that we use for policy analysis are constructed on the basis of what connects with the facts we see (or think we see) in the data. If these models fail to contemplate things that might happen, it is precisely because there is a bias toward frameworks that explain history.

Robert Lucas zeroed in on this point in his "defence of the dismal science":

"The Economist’s briefing [criticizing the foresight of mainstream economists] also cited as an example of macroeconomic failure the 'reassuring' simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007. The charge is that the Fed’s FRB/US forecasting model failed to predict the events of September 2008. Yet the simulations were not presented as assurance that no crisis would occur, but as a forecast of what could be expected conditional on a crisis not occurring. Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period. There was a recession under way, led by the decline in housing construction. Mr Mishkin's forecast was a reasonable estimate of what would have followed if the housing decline had continued to be the only or the main factor involved in the economic downturn."

Some attempts have been made to exploit the information contained in data from the Great Depression. (If you have patience for technical analysis you can find an example here.) And there have been many attempts to jerry-rig existing models to capture the financial shocks and their aftermath, especially once we had seen what that sort of reality looks like. But, by and large, the last year has been a data point we haven’t seen before, and it is not so surprising that models designed to capture the average quarter in the economy’s life would not do so well when very unaverage events arise.

It is certainly clear that the dominant pre-2007 strain of New Keynesian models was inadequate to the task that would confront us post-2007. That this was the case was not unknown. If I may quote myself again:

"I have in the past agreed that it is useful to think of the policy choices [following financial market events like the stock market crash of 1987] as policy shocks. I would still argue that today. But it sure would be helpful if at least some of these events would appear as something more than completely random disturbances. In other words, it would be very useful to have usable measures of what we loosely call 'financial market fragility,' and more useful still to have a coherent [sophisticated] quantitative model that captures them."

The problem with that prescription was that the relative infrequency of such events would likely have required us to step outside of our existing data-driven policy models and apply more theory, not less.

So does all this lead to the conclusion that we ought to ditch the presumptions of rationality and (largely) efficient markets, as Professor Krugman suggests? I have my doubts. Even some of the examples in the Krugman article seem to rely on the power of those ideas. In describing the problem of the lower bound of zero on nominal federal funds rates, he says this:

"During a normal recession, the Fed responds by buying Treasury bills—short-term government debt—from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback…

"But zero, it turned out, isn’t low enough to end this recession. And the Fed can't push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the 'zero lower bound' even as the recession continued to deepen, conventional monetary policy had lost all traction."

That whole story relies on a conventional monetary transmission mechanism, one that fundamentally plays off of efficient markets thinking.

In another passage from the New York Times article, we have this:

"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

"This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time…

"Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer…

"In short, the co-op fell into a recession."

That's a great example, but where is the irrationality? That tight monetary policy might cause a downturn in the economy may be absent from purely classical models, but it is dead center of the New Keynesian framework. The problem was that our mechanism for capturing monetary nonneutrality—essentially wage and price stickiness—was far too simplistic to capture the shocks that we were about to face (and that we arguably faced to lesser degrees during past financial market events).

In short, I accept the criticism that the dominant New Keynesian framework for forecasting and economic modeling needs some work (to say the least). I'm less convinced that we require a major paradigm shift. Despite suggestions to the contrary, I've yet to see the evidence that progress requires moving beyond the intellectual boundaries in which most economists already live.

By David Altig, senior vice president and research director at the Atlanta Fed

Words of wisdom from the South and East (way South and East)

I've had an interesting few weeks, starting with attending the Federal Reserve Bank of Kansas City's annual economic symposium at Jackson Hole to finalizing a cooperative research initiative between the Atlanta Fed's Americas Center and the Institute for Applied Economic Research (note that IPEA's site is in Portuguese) in Brasilia to a speech delivered at the BM&F Bovespa fourth International Financial and Capital Markets Conference in Campos do Jordao, Brazil, to sitting in on the Central Bank of Argentina's annual Money and Banking Conference. I tell you this not because I expect you to care about my schedule but because I plan to spend the next couple of blog entries trying to spill out of my brain some impressions and thoughts gleaned from some intensive listening to a wide variety of policymakers, businesspeople, and scholars explaining their impressions and thoughts.

On several points there appears to be a fair amount of unanimity: (1) the global economy has moved a substantial distance from the financial abyss and is now in the first phase of recovery from recession; (2) the financial crisis of the past two years originated, ironically, in the economies with the deepest and most advanced financial markets—the United States representing the epicenter—and is likely to have the longest-lasting negative impact in those economies; and (3) the time has come to begin building a market and regulatory infrastructure that can avoid or withstand the events associated with the recent turmoil.

There is a lot to be said on these topics, but a great starting point for conversation was provided at the Central Bank of Argentina's conference by Dr. Kiyohiko Nishimura, deputy governor of the Bank of Japan. Commenting on policy lessons learned, Governor Nishimura first offered two criteria that ought to govern the application of “unconventional” policy tools in times of stress, defined as those policies that entail microeconomic interventions and explicit risk taking by the monetary authority:

First criterion: Unconventional policies, as defined, inevitably distort resource allocation. The potential benefits of any such intervention must therefore be measured against these costs.

Second criterion: Because unconventional approaches entail taking more than the usual amount of risk onto a central bank's balance sheet, measures should be taken to guarantee adequate capital buffers in the event that substantial losses are incurred.

Assuming these criteria are met, what principles should guide the implementation of unconventional policies? Governor Nishimura offered four:

1. Select what sorts of interventions are most important, and concentrate efforts in those areas.
2. In any intervention, be careful to think through the broad implications and avoid creating further dysfunction. The example given was the decision, made by most central banks, to set the effective floor on short-run policy rates near but above zero in order to avoid eliminating all returns to participating in the market and hence driving all private players out of the market.
3. Provide extensive safety nets to short-circuit panics.
4. Design measures to be “self-fading” as conditions improve. For example, set lending rates and terms at levels above those that private providers will set once the acute phase of a crisis passes.

And finally the governor articulated a list of don'ts gleaned from the crisis experience:

1. Don't assume the size of the balance sheet is, by itself, an adequate measure of monetary ease or support.
2. Don't concentrate only on those markets where specific interventions are taken. Improvement in those markets cannot be assumed successful unless they improve the big picture.
3. Don't underestimate the value of safety nets.
4. Don't ignore the differences across countries or regions. One-size-fits-all strategies may fit no one.
5. Don't assume things are going to return to the old status quo.

These thoughts strike me as a very nice departure point for debate and deliberation. If I were to add anything, I would start with one more item on the list of criteria: Unconventional policies should commence from a broad consensus on what level of risk is acceptable for a central bank to take in the “normal” course of business. In other words, the definition of unconventional policy assumes that there is a definition of conventional policy, and there should be collective agreement on how that is defined.

In the good old precrisis days, conventional policy was pretty straightforward: a buy-only-Treasury-securities policy for conducting open market operations and direct lending restricted to a narrow set of financial institutions (commercial banks) and largely on an overnight basis. There are good enough reasons to think that this is the way it should it be—Marvin Goodfriend, among others, has made this argument. But, in my view, I believe it is warranted to take to heart point number five on Governor Nishimora's list of don'ts and not yet assume the new conventional policy will look like the old one.

By Dave Altig, senior vice president and research director at the Atlanta Fed

Us and them: Reviewing central bank actions in the financial crisis

With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.

The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.

 

The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.

The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.

The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.

The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.

Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.

Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.

The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.

The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.

In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.

Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).

By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed

Is the output gap showing?

In a recent speech, Atlanta Fed President Dennis Lockhart laid out two competing risks to the inflation outlook. On one side, the usual measures of economic slack (output gap measures) suggest that there is so much excess production capacity that prices and wages are under great—and increasing—disinflationary pressure. All this is occurring at a time when inflation measures are trending below the FOMC's longer-term projection.

The other inflation risk is that the public may come to believe that the combined efforts of the monetary and fiscal authorities to prop up a sagging economy will ultimately lead to a familiar place—rising inflation—and if inflation expectations begin to move higher, so too will inflation.

So the risks to the inflation outlook seem to pivot on two, potentially opposing, forces: downward price pressure coming from a weak economy and upward price pressure resulting from a skeptical public.

Lockhart's assessment is that these "inflationary and deflationary risks are roughly balanced." But in the end, the security of such an inflation outlook rests largely with the behavior of the inflation data. So it is important to continue watching carefully for any signs that the balance of these risks is tilting in one direction or the other.

This view brings us to a chart posted in last week's Economic Highlights showing recent trends in core goods and core services prices in the consumer price index (CPI).

A key observation to take away from this picture isn't the recent acceleration in core goods prices. The highly volatile behavior of goods prices tends to make them an unreliable guide to underlying inflation trends. Rather, it is noteworthy to consider the significant downward trek of core services price growth. Indeed, the 12-month trend in core services prices was a shade under 1.6 percent in July—its lowest reading in the post-WWII era and roughly 1¾ percentage points lower than this time last year.

Some of the downward pressure on core services prices is a direct reflection of the housing crisis; a little more than half the core services price components are computed from housing rents. But that's not the whole story as a rather sharp disinflation was evident in core services excluding rents.

Likewise, productivity-adjusted labor costs—so-called "unit labor costs"—have also recently turned negative. These aren't record declines, but they are well off their prerecession growth rates.

Is this a sign that economic slack has begun to show through to the retail price numbers? It could be a bit early to bet the ranch on that one. Nonetheless, the evidence seems to offer a pretty compelling story at this time.

By Mike Bryan, vice president and senior economist, and Laurel Graefe, senior economic research analyst, both of the Atlanta Fed