Bernanke's latest speech, and a follow up to correct the problem

[graphrix_IHB]

I really hope this can produce some dialog amongst the IHBers. It looks like Ben wants to find a way to be more realistic on inflation, and go against the Greenspan grain. Dr. Thoma points out a great paper, with proven analysis of how the Fed can better predict the inflation and business environment of the US. The paper takes several other studies in consideration, which for the most part, come to the same conclusion. The data the Fed wants is available. Click on the link for the paper here.

http://economistsview.typepad.com/photos/uncategorized/2008/06/09/diebold.gif

If you are curious about any of the papers cited, I can probably get them, and I will post them here if I can.

 

[awgee_IHB]

Sorry G, I do not think B-52 Ben has any interest in doing anything to actually decrease price or monetary inflation. He is trying to talk the dollar up because he can do nothing else.

 

[caycifish_IHB]

I really hope this can produce some dialog amongst the IHBers.

Graph, I tried. I really did. Now you get a caycifish rant in writing.

I started reading the link, and my first thought was "man...and graph thinks what I read/write for a living is gobble-dee-gook...". My brain shut off after a few mouse wheel movements, I stopped reading and came back later. And I read a few sections over and over again. I never made it to the end. I just have 0 context in which to put most of this text.

Other thoughts that came to mind as I read this one sentence:

In the context of Phillips curve analysis, a number of researchers have highlighted the difficulty of assessing the output gap--the difference between actual and potential output--in real time.

1) What is a Phillips curve analysis? And do I need to know what it is in order to understand the point? If not, then I don't really care what it is.

2) Potential output? What is that? Best case scenario? If so, what idiot is even paying attention to the best case scenario when in reality that rarely happens?

3) What does the output gap, which appears to me to be the difference between what actually happened and what could have happened, have to do with inflation? I ask that because I really haven't the foggiest idea.

Were there particular things you wanted us to discuss? And particular questions you wanted us to answer? As a person who scrolls quickly past things that look, or in this case turn out to be, long and boring, was there something in particular in that uber-long blog post that I should have stopped at? Care to summarize the part you want discussed?

You posted the chart. I've seen that chart, or something like it, before. What about it? So what? Is it different than other "we are going to have a recession" charts and I'm just not paying close enough attention? That is highly possible.

The dudes have some ingredients. I got that.

Ingredient 4. We extract and forecast latent business conditions using linear yet statistically optimal procedures, which involve no approximations. The appeal of exact as opposed to approximate procedures is obvious, but achieving exact optimality is not trivial, due to complications arising from temporal aggregation of stocks vs. flows in systems with mixedfrequency data.

Um...huh? That's neat that their procedures are "statistically optimal" and they don't like guessing. Way cool. "achieving exact optimality is not trivial". Seriously guys, if it was easy then everybody would be doing it and you wouldn't have a reason to write a paper. After that they totally lose me.

Okay, enough from me.

 

[graphrix_IHB]

So, it sounds like I need to add a bit about the basic premise of the speech and the paper. And, the forums ate my first post, so if I seem a little pissed, I am, but at the forums software.

First, here is a link to Ben's speech. A part that I think is significant...



Empirical work on inflation, including much of the classic work on Phillips curves, has generally treated changes in commodity prices as an exogenous influence on the inflation process, driven by market-specific factors such as weather conditions or geopolitical developments. By contrast, some analysts emphasize the endogeneity of commodity prices to broad macroeconomic and monetary developments such as expected growth, expected inflation, interest rates, and currency movements. Of course, in reality, commodity prices are influenced by both market-specific and aggregate factors. Market-specific influences are evident in the significant differences in price behavior across individual commodities, which often can be traced to idiosyncratic supply and demand factors. Aggregate influences are suggested by the fact that the prices of several major classes of commodities, including energy, metals, and grains, have all shown broad-based gains in recent years. In particular, it seems clear that commodity prices have been importantly influenced by secular global trends affecting the conditions of demand and supply for raw materials. We have seen rapid growth in the worldwide demand for raw materials, which in turn is largely the result of sustained global growth--particularly resources-intensive growth in emerging market economies.1 And factors including inadequate investment, long lags in the development of new capacity, and underlying resource constraints have caused the supplies of a number of important commodity classes, including energy and metals, to lag global demand. These problems have been exacerbated to some extent by a systematic underprediction of demand and overprediction of productive capacity for a number of key commodities, notably oil. Further analysis of the range of aggregate and idiosyncratic determinants of commodity prices would be fruitful.

I have only mentioned a few of the issues raised by commodity price behavior for inflation and monetary policy. Here are a few other questions that researchers could usefully address: First, how should monetary policy deal with increases in commodity prices that are not only large but potentially persistent? Second, does the link between global growth and commodity prices imply a role for global slack, along with domestic slack, in the Phillips curve? Finally, what information about the broader economy is contained in commodity prices? For example, what signal should we take from recent changes in commodity prices about the strength of global demand or about expectations of future growth and inflation?

1) What is a Phillips curve analysis? And do I need to know what it is in order to understand the point? If not, then I don’t really care what it is.

Yes, you need to understand the idea of the Phillips curve.



The Phillips curve represents the relationship between the rate of inflation and the unemployment rate. Although several people had made similar observations before him, A. W. H. Phillips published a study in 1958 that represented a milestone in the development of macroeconomics. Phillips discovered that there was a consistent inverse, or negative, relationship between the rate of wage inflation and the rate of unemployment in the United Kingdom from 1861 to 1957. When unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. The only important exception was during the period of volatile inflation between the two world wars.

In Phillips's analysis, when the unemployment rate was low, the labor market was tight and employers had to offer higher wages to attract scarce labor. At higher rates of unemployment there was less pressure to increase wages. Phillips's "curve" represented the average relationship between unemployment and wage behavior over the business cycle. It showed the rate of wage inflation that would result if a particular level of unemployment persisted for some time. Significantly, however, the relationship between wages and unemployment changed over the course of the business cycle. When the economy was expanding, firms would raise wages faster than "normal" for a given level of unemployment; when the economy was contracting, they would raise wages more slowly than "normal."

Economists soon estimated Phillips curves for most developed economies. Because the prices a company charges are closely connected to the wages it pays, economists also frequently used Phillips curves to relate general price inflation (as opposed to wage inflation) to unemployment rates. Chart 1 shows a typical Phillips curve fitted to data for the United States from 1961 to 1969. The individual observations appear to lie closely along the fitted curve, indicating that the cyclical behavior of inflation and unemployment is similar to the average behavior. That is, the relationship between inflation and unemployment does not seem to change much over the course of the business cycle.

2) Potential output? What is that? Best case scenario? If so, what idiot is even paying attention to the best case scenario when in reality that rarely happens?

Potential output is the estimate of what the actual output will be. It isn't best case or worst case, but if something like rising commodity prices were not factored it could make the gap larger.

3) What does the output gap, which appears to me to be the difference between what actually happened and what could have happened, have to do with inflation? I ask that because I really haven’t the foggiest idea.

You are right, it is the difference between the actual and potential output. Output is in real terms, so if the inflation data is not in real time the potential output could be lower or higher than the actual out, and therefore increasing the gap between the two.

What Ben was speaking about was having better and more real time data to use, and asks what could be used to improve the data, especially for the rising commodity costs and what has a greater effect on them; domestically or globally. What Dr. Thoma was pointing out was the paper that has an amazingly proven track record for real time data. Ben seems to be an agent of change for the Fed, and IMO it sounds like he would like to implement something along the lines of what was discussed in the paper. Per Ben's speech...

The growing literature on learning in macroeconomic models appears to be a useful vehicle to address many of these issues.10 In a traditional model with rational expectations, a fixed economic structure, and stable policy objectives, there is no role for learning by the public. In such a model, there is generally a unique long-run equilibrium inflation rate which is fully anticipated; in particular, the public makes no inferences based on central bankers' words or deeds. But in fact, the public has only incomplete information about both the economy and policymakers' objectives, which themselves may change over time. Allowing for the possibility of learning by the public is more realistic and tends to generate more reasonable conclusions about how inflation expectations change and, in particular, about how they can be influenced by monetary policy actions and communications.

The second category of questions involves the channels through which inflation expectations affect actual inflation. Is the primary linkage from inflation expectations to wage bargains, or are other channels important? One somewhat puzzling finding comes from a survey of business pricing decisions conducted by Blinder, Canetti, Lebow, and Rudd, in which only a small share of respondents claimed that expected aggregate inflation affected their pricing at all.11 How do we reconcile this result with our strong presumption that expectations are of central importance for explaining inflation? Perhaps expectations affect actual inflation through some channel that is relatively indirect. The growing literature on disaggregated price setting may be able to shed some light on this question.12

Finally, a large set of questions revolve around how the central bank can best monitor the public's inflation expectations. Many measures of expected inflation exist, including expectations taken from surveys of households, forecasts by professional economists, and information extracted from markets for inflation-indexed securities. Unfortunately, only very limited information is available on expectations of price-setters themselves, namely businesses. Which of these agents' expectations are most important for inflation dynamics, and how can central bankers best extract the relevant information from the various available measures?

You posted the chart. I’ve seen that chart, or something like it, before. What about it? So what? Is it different than other “we are going to have a recession” charts and I’m just not paying close enough attention? That is highly possible.

The dudes have some ingredients. I got that.

That chart is the results of their ingredients in a real time factor predicting a recession. It has been amazingly correct, but still needs to be adjusted and tested with other economies.

 

[graphrix_IHB]

Damn... I am wordy, er stealing more wordy people's words.

Um...huh? That’s neat that their procedures are “statistically optimal” and they don’t like guessing. Way cool. “achieving exact optimality is not trivial”. Seriously guys, if it was easy then everybody would be doing it and you wouldn’t have a reason to write a paper. After that they totally lose me.

That was Dr. Thoma's point, Ben was asking for more real time or optimal data, and here is a paper that confirms what he wants.

So, what I want discussed is... is using more real time data a good thing for the Fed, is the paper correct with their ingredients to have a model for more of real time and optimal data, are there other ingredients the right ingredients, and if not what other ingredients would need to be included? Aside from understanding the ingredients, the mathematical equations are way beyond me (talk about gobble-dee-gook), but the premise makes sense to me. But, how does rising commodity prices influence their variables? That is just a start, much more could come from this.

Ben has always been one to want to have honed in inflation expectations. The rest at the Fed want to keep doing things the old way, but is the old way the right way, is Ben's way the right way? The conclusion of the paper...

We view this paper as providing both (1) a “call to action” for measuring macroeconomic

activity in real time, using a variety of stock and flow data observed at mixed frequencies,

potentially also including very high frequencies, and (2) a prototype empirical application,

illustrating the gains achieved by moving beyond the customary monthly data frequency.

Specifically, we have proposed a dynamic factor model that permits exactly optimal extraction

of the latent state of macroeconomic activity, and we have illustrated it in a four-variable

empirical application with a daily base frequency, and in a parallel calibrated simulation.

We look forward to a variety of variations and extensions of our basic theme, including

but not limited to:

(1) Incorporation of indicators beyond macroeconomic and financial data. In particular,

it will be of interest to attempt inclusion of qualitative information such as headline news.

(2) Construction of a real time composite leading index (CLI). Thus far we have focused

only on construction of a composite coincident index (CCI), which is the more fundamental

problem, because a CLI is simply a forecast of a CCI. Explicit construction of a leading

index will nevertheless be of interest.

(3) Allowance for nonlinear regime-switching dynamics. The linear methods used in this

paper provide only a partial (linear) statistical distillation of the rich business cycle literature.

A more complete approach would incorporate the insight that expansions and contractions

16

may be probabilistically different regimes, separated by the “turning points” corresponding

to peaks and troughs, as emphasized for many decades in the business cycle literature and

rigorously embodied Hamilton’s (1989) Markov-switching model. Diebold and Rudebusch

(1996) and Kim and Nelson (1998) show that the linear and nonlinear traditions can be naturally

joined via dynamic factor modeling with a regime-switching factor. Such an approach

could be productively implemented in the present context, particularly if interest centers on

turning points, which are intrinsically well-defined only in regime-switching environments.

(4) Comparative assessment of experiences and results from “small data” approaches,

such as ours, vs. “big data” approaches. Although much professional attention has recently

turned to big data approaches, as for example in Forni, Hallin, Lippi and Reichlin (2000) and

Stock and Watson (2002), recent theoretical work by Boivin and Ng (2006) shows that bigger

is not necessarily better. The matter is ultimately empirical, requiring detailed comparative

assessment. It would be of great interest, for example, to compare results from our approach

to those from the Altissimo et al. (2002) EuroCOIN approach, for the same economy and

time period. Such comparisons are very difficult, of course, because the “true” state of the

economy is never known, even ex post.

(5) Exploration of direct indicators of daily activity, such as debit card transactions data,

as in Galbraith and Tkacz (2007).

Indeed progress is already being made in subsequent work, such as Camacho and Perez-

Quiros (2008).

 

[acpme_IHB]

i'll probably have to delve into this more but its interesting. at first glance, the concept is sort of troublesome. the fed is supposed to be like the rudder on the US(S) Economy. small action and corrections eventually make their impact and can steer the giant ship. what we're talking about here is trying to steer the titanic like a kayak.

bernanke's tenure as fed chairman has been rocky to say the least. he gets criticism for every action/inaction the fed has made. far more embattled and far less beloved (at the time) than his predecessor... despite all that he has unassumingly managed to become the most powerful fed chairman we have ever had. the fed now has far more tools at its disposal than the traditional big 3, and now he's talking about real-time active mgmt of the economy. ok, maybe that's an exaggeration but measuring macroeconomic activity in real time would be quite an accomplishment.

edit: something else that crossed my mind, esp when he mentions what information can be extracted from rising commodity prices. i wonder how they would extract out the rise in commodity prices due to underlying fundamentals from that which was caused by speculation -- and what portion of that is attributed to the fed's own actions. in other words, the fed's own actions is intermingled with all this real-time data they are analyzing. they are watching what everyone else is doing, and everyone else is watching what they are doing. the perfect control situation would be what happens in a universe that the fed had not affected in any way. there are proxies for this sort of analysis but obviously not in real-time.

quantitative trading cost models often deal with the same dilemma. you can pour through data in stock prices to find supposed arbitrages. as soon as you enter the mkt to grab them, they're gone. what happened? well, you happened. there are models out there that supposedly estimate market impact but most of the ones i've seen work poorly more often than not.

 

[alan_IHB]

As a noneconomist I'll chime in.

The philips cure represents the ratio of wage inflation to employement.

Hmmm

Does the new cure also include public service workers.. I don't think there is the same relationship there, they are paid because their unions (prision guards) contributes to election of candidates that sign their contracts... see Valeijo. Public service workers will skew the curve.

How about health care workers, health care is devoid from the laws of supply and demand and the goverment or insurance sets pay rates.

I just don't see this kind of analyisis valid anymore. Not at least until more cities declare bankrupcy and health care is significantly reformed as those two sectors account for 25% of the economy (10% public service and 25% health care).

Everyone else is going broke except Google and Apple.