Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week:

I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog.

A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter).

However, there are many places in the world where inflation expectations are not well anchored. Or at least we can’t tell if they’re well anchored or not. Figure 1 presents data for several key groups (using the IMF classifications): Industrial countries, LDCs excluding oil exporters, oil exporters and developing Asia.

Figure 1: Inflation rates defined as 12 month changes in CPIs, in selected groupings: Industrial countries (blue), oil exporters (black), developing countries excluding oil exporters (red) and developing Asia (green). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

It’s clear that inflation is surging in the oil exporting countries. This is occurring as reserves balloon (see Brad Setser has diligently tabulated on a number of occasions; e.g., [1]), often under pegged-to-the-dollar exchange rate regimes, and the monetary authorities are unable to sterilize money base expansion. Here, I can’t resist writing the identity:

Money Base = Foreign Exchange Reserves + Net Domestic Assets

As foreign exchange reserves increase, money base must increase, unless the central bank can (and will) sterilize by making offsetting reductions in net domestic assets.

This is why Feldstein has called for de-pegging from the dollar for oil exporter currencies [2] (for contrasting recommendations, see Paulson’s comments [3]).

Of course, this mechanism does not apply in all instances, there are oil exporting countries not under fixed exchange rates, but reserve accumulation nonetheless is making its way into money base creation. As government revenues increase, spending is also pushing up prices.

So, no surprise that inflation is rising in this group. But what is surprising is how much inflation has risen in the non-oil-exporting LDCs, and in Developing Asia (this group excludes NICs like Korea).

Figure 2: Inflation rates defined as 12 month changes in CPIs, in selected East Asian countries: China (red), Malaysia (blue), Philippines (green), Thailand (black), Vietnam (teal). NBER defined recession shaded gray. Source: IMF, International Financial Statistics accessed June 20, 2008.

Inflation has risen as food and energy prices have risen. Vietnam is the most striking example. And China, of course, has been in the spotlight, largely because of its economic mass. But note how Thailand and the Phillipines inflation rates have accelerated.

Now one might say this is all obvious - - but in several of these countries (e.g., China), energy prices were heavily subsidized. Raising these subsidized prices will - - in a mechanical fashion - - raise the recorded CPI. If prices were perfectly flexible, higher energy and food prices only represent a higher relative price for these goods. I’ll let the reader determine for him or herself whether that’s a plausible assumption. In any case, the net effect over the longer term is uncertain. Raising the subsidized prices means higher prices on those specific goods (possibly feeding into wages). But the lower government outlays for subsidies means smaller deficits (holding all else constant) and hence lower money base creation.

Is there hope to be derived from the fact that there are more inflation targeters now than there were during the previous episode of inflationary pressures, three decades ago? In a paper written two and a half years ago, Andy Rose documented the fact that inflation targeting has proven to be a relatively durable form of monetary regime. That is, compared to the “fixed” exchange rates, an average duration of an inflation targeting regime is longer. One observation I would make is that most of those inflation targeting regimes were implemented in a relatively benign global economic environment - - at least benign from the inflationary standpoint. While oil prices have been rising since 2002, it appears that the surge in food prices, on top of oil and non-food commodity prices - - is what has changed matters (Figure 3 recaps a graph from this post).

Figure 3: Log indices. NBER defined recession shaded gray. Source:.
(Of course, these oil and food price shocks may end a lot of exchange rate reimges as well).

By the way, Thailand and Philippines are classified as inflation targeters by Rose. Korea, also classified as an inflation targeter, has also experienced accelerating, but nonetheless lower, inflation (at about 4 percent). So, the jury is still out on the question whether the commitment to inflation targeting during this episode will result in a substantive difference in how matters play out.

On a more speculative note, one idea that has struck me is that, as inflation rates rise, it may become more difficult for the East Asian countries to maintain their exchange rates against the dollar at their current levels. Recalling (in logs):

q^j = s – p^j + p ^US

In words, the real exchange rate for country j against the USD (defined as up is weaker) will strengthen as the domestic price level rises, holding all else constant. That may in turn a be a harbinger of the end of the tendency for the East Asian countries to export capital to the US (although the overall US current account balance will tend to remain driven largely by domestically driven by the saving/investment balance in the US, and we know where the current trajectory of the US budget deficit is going…[4]).

Figure 4: Trade weighted broad real currency values, in logs. NBER defined recession shaded gray. Dashed line is at June 2005, the month before the CNY revaluation. Source: BIS accessed June 23, 2008.

So far, this remains speculation. However, over the past couple months, China’s real currency value has appreciated in trade weighted terms, which is remarkable when one keeps in mind the dollar’s depreciation over this same period. It remains to be seen whether the other currencies follow suit. That may hinge upon how these countries respond to inflationary pressures.

Since I started this blog, my comment section has been inundated with spam.   I am not talking about bona fide comments, most of which have been intelligent and useful.   I’m talking about thinly disguised bids for sales of pornography, mortgage quotes, and other parasitical activities.    The spam has reached 35 per night, and it is time-consuming to go through it all.  For some reason I don’t understand, my software can’t  filter it out, even though other bloggers don’t seem to have this problem.

Hence I will soon turn off the comment function.    I am sorry about this.  Many of my posts will be carried by Roubini Global Economics from now on.  Readers who have access to RGE may post comments there, and I will check periodically.

Over the past month, I , citing Feldstein, have said that if one looks at available information on monthly GDP, available from estimates of MacroAdvisers, that output declined within the first quarter of the year, even though as standardly reported GDP was higher in QI overall than it had been in the last quarter of 2007.   But, as it turns out, there is some ambiguity to the question.   

The estimates do show GDP falling in February, by a hefty 10.1% anualized.   But the numbers for January and March are up.    To net out the three months, one must split hairs.     The positive numbers for January plus March are just slightly greater in absolute value than February’s negative 0.9 (monthly).   So the net is up?   Not necessarily.

We are trying to figure out the change within the quarter, from beginning to end.   Technically, that means from January 1 to March 30.  But of course even Macroadvisors doesn’t report daily or weekly estimates.   Estimated total real GDP in the month of March was just slightly above total real GDP in the month of December.   So again the net is up?   The most precise measure of the change between January 1 to March 30 is the change between the December-January average and the March-April average.     That is a tiny negative number:   GDP fell by an estimated $28 billion within the first quarter (in year-2000 $).  And April is so flat as to be essentiallz zero.

I think I am sorry I brought the subject up.

It would in any case be a mistake to make much of these numbers.  The reason the Commerce Department’s Bureau of Economic Analysis doesn’t report monthly numbers is that the data are so unreliable, and subject to revision.   For anyone who needs some sort of estimate of monthly GDP, as we do on the NBER Business Cycle Dating Committee as an input into our thinking, this is what we have to go on.    But one sees here yet another illustration as to why the BCDC waits a long time, until all the data are in, before declaring a recession.

Everyone is looking for someone to blame for high prices of oil and other mineral and agricultural commodities.    Speculators (among others) are high on the list, followed by the Federal Reserve.    While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of channels.  Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices.

A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low.    It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

US crude oil inventories do not appear to be especially low in the graph above, showing June 1998-June 2008 (from Bloomberg).  But it is true that they are not especially high either.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most.     According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows.  They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place.  These numbers are far from conclusive, but still…

The theory is meant to explain the mystery why prices of virtually all mineral and agricultural prices are high, not just oil, and in some ways fits others better.     Inventories of some commodities are indeed high now.   The price of gold, the last graph shown, is a good example.   Here the evidence supports the theory (1) that easy monetary policy has driven up the price, and (2) that one channel is low interest rates making it more attractive to stockpile the yellow metal.   But, as with oil, the biggest inventory is the one underground.

[Thanks to Pravin Chandrasekaran.]

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The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is about to enter a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the early part of the year, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain:
1) The number will be revised again, and could move in either direction.
2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse later in the year.
3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. Real gross domestic purchases increased only 0.1 percent in the first quarter — almost as flat as you can get. But net exports provided an important source of demand for US products, and are likely to remain a positive engine of growth in the future. The same is true of the fiscal policy engine, as consumers receive and spend their tax cuts in the 2^nd and 3^rd quarters. On the other wing, the investment engine has been knocked out; inventory investment is likely to fall and residential construction will remain negative for sometime. The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years? If so, a recession will ensue.

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together:
(1) the odds that it will turn out that we have already passed the turning point and
(2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year.
Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Fed Vice Chairman Donald L. Kohn in a speech yesterday, addressed a theory to which I am partial: the theory that low real interest rates have been a factor behind the continued rise in prices of agricultural and mineral commodities, including oil, over the last year.

The relevant excerpt: “Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.” (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth. (See graph, where the commodity price has been inverted so that one can see the correlation visually.)

The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.

Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.

Stocks of oil held in deposits underground dwarf those held in inventories above-ground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation as apply to inventories. (The classic reference is Hotelling’s Rule.)

Apparently the Saudis have indeed deliberately decided to leave theirs in the ground. “King Abdullah, the country’s ruler, put it more bluntly: “I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it’.’’ FT 5/19/08. I see the interest rate as part of the Saudis’ decision how much oil to pump. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today’s oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.

In addition to the link from world real interest rates to world real commodity prices, there is the less novel link from individual countries’ real interest rates to commodity prices expressed in their own currencies, a link that primarily passes through their exchange rates. For almost all of the eight floating-rate countries that I tested, both the US real interest rate and the local real interest rate (as a differential relative to the US rate) simultaneously had significant effects on real commodity prices. The effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly. This despite what many have thought in the past, that there is little effect because oil is invoiced in dollars.

White House CEA Chairman Ed Lazear expressed confidence to the Wall Street Journal today that the country is not in recession.   I, like Menzie Chinn, am surprised that Lazear is willing to put his reputation on the line in this way.  

It is true that the Commerce Department BEA’s advanced estimate of first-quarter GDP growth was still above zero (+0.6%).     But there are three reasons not to take this number too seriously.
(1) Revisions in these numbers are usually substantial, so the final number could easily turn out to be negative — or twice as high.
(2) Even if the +0.6% number were to hold up, it can be entirely accounted for by measured inventory investment.   In other words, real final demand fell rather than rose in the first quarter.   It is plain that this inventory accumulation was not the outcome of deliberate decisions by bullish firms to add to their inventories in anticipation of a booming economy.   Rather it was almost certainly unintended inventory accumulation, as goods sat unsold on store shelves and in warehouses.    This overhang makes it more likely that inventory accumulation will be negative in the 2nd quarter.   (Admittedly, rising exports from the weak dollar and rising consumption from the tax rebate checks could outweigh that particular factor, and we could scrape along the ground for another quarter at near-zero growth).
(3) As Martin Feldstein has been pointing out (e.g., in the FT), it is a misinterpretation of the GDP statistics to say that growth remained positive in the first quarter.  Rather GDP for QI as a whole was estimated to have been 0.6% higher as compared to QIV as a whole.  The Commerce Department does not report monthly GDP estimates, but MacroAdvisers does, and these data suggest that monthly GDP has been declining since January.

There are other reasons as well to consider it likely that a recession may have started as early as January.     The NBER Business Cycle Dating Committee, which declares when recessions start, looks at lots of data.  But the most important information, alongside GDP, is the jobs data from the Bureau of Labor Statistics.   Employment, like GDP, offers a comprehensive measure across the economy, but it has the advantage of being available monthly and with shorter lags.    The employment data suggest that the recession may have started in January.

It is certainly possible that it will turn out, in the end, that the economy escaped recession in the first quarter.   Even if that is the case, however, it is difficult to be optimistic about the rest of the year.   I can’t remember a time when there have been so many worrisome danger signals:   depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, … . The odds of a recession sometime this year must be rated high.

Fed Chairman Bernanke and Treasury Secretary Paulson have wisely reined in the “happy talk” with which the initial sub-prime mortgage crisis was greeted last  year.   (Remember “the crisis looks contained”?)    If I were Ed Lazear, I would follow their lead.

Economists frequently complain that even when 98% of the profession agrees on something (say a free-trade proposition), the media will go to lengths to dig up an economist from the 2% minority in order to balance one from the 98% majority, in their feverish and misguided attempt to appear unbiased and balanced on every issue, even issues that don’t really have two sides. The New York Times op-ed page has outdone itself today by publishing “The 18-cent Solution” by Bryan Caplan. The “callout” heading is “Found: an economist who backs the summer gas-tax holiday.” The impetus, of course, was the question posed to Hillary Clinton by a reporter: can you name a single economist who supports the idea of a summer suspension of the federal gasoline tax? Newshour gave up on trying to find one.

In this case, the NYT evidently couldn’t find an economist who really takes the minority position on economic grounds, or even on reasonable political economy grounds. (The profession is all-but-unanimous on keeping the gas tax, as Greg Mankiw notes. And for good reasons.) Rather Caplan’s argument is a convoluted political rationalization: (1) the high gas prices engender populist anger that might lead to bad policies, (2) yes, a gas tax holiday is a bad policy, but (3) one can make a political argument for the gas tax holiday because it is not as bad as some of the other “populist nonsense: price controls, rationing, windfall profits taxes…” that we might get instead. This political argument is a bit of a stretch as it is, but he then goes on to make it absurd by supporting “a pairing of an excess profits tax with a gas tax holiday” on the grounds that it is not as bad as “an excess profits tax all by itself.” Apparently two bad policies are better than none.

This sort of reasoning makes me sympathize with political scientists who tell economists to leave the politics to them. A more straightforward political argument would have been “Hillary is the best candidate and so one can justify anything that will get her nominated.” Or the symmetric argument for John McCain, who originally proposed the gas tax holiday in April. But the New York Times editors, sensibly, would not have chosen to print such op-eds, out of the hundreds that are submitted every week. So they printed instead an economist’s political argument too complicated for them to understand. If they are going to do this, they might as well print economists’ economic arguments too complicated for them to understand, which they are seldom willing to do.

Bryan Caplan is a perfectly competent economist, with a Ph.D., a job and an interesting book and everything. (He may be a bit too desperate for publicity. But those of us who live in glass weblogs can’t throw stones.) Why would he spout the nonsense that is in this op-ed? The answer is very clear: it is the way to get into the New York Times. He gleefully admits as much on his blog today: “I’ve finally made the Gray Lady: Today’s New York Times features my op-ed inspired by Sunday’s post, I’ll Shill for Hillary. I hope critics don’t misrepresent me as an economic apostate; I’m not dissenting from the standard analysis… look on the bright side: I’m in the New York Times. Sweet!”

Bryan: A suggestion. You should now write a letter to the New York Times retracting your op-ed on the grounds that you should have known that readers would incorrectly infer that you were supporting the policy on economic grounds. [Arnold, can you help out here?] If you do this, the Club of Economists might let you back in. Plus, you will have gotten your name in the NYT a second time! “Sweet!”

Payroll employment peaked in December, and according to numbers released today had declined by 260,000 jobs as of April. (Source: BLS.) Since we have not yet seen a single negative number on GDP growth, this job loss is easily the most tangible statistical evidence we have so far that the much-heralded recession indeed may have started in the first quarter of 2008.

It has been noted that the unemployment rate started out from a low level — averaging 4.6 % in 2007 — so that even after a period of gradual increase, it remains relatively low by historical standards: 5.0% in April. This is still inside the range that has usually been considered by politicians as too low to generate serious discontent (and by central bankers as too low to put downward pressure on wages and prices). But why, then, is there so much popular dissatisfaction with the economy?

One answer is the old “discouraged worker” effect. Workers who stop looking for a job are not counted in the labor force, and so are not counted as unemployed. There is an obvious way to capture this phenomenon. Compare employment to the entire population, rather than only to those who are actively in the work force. The chart does that. (These figures include farm jobs, as in the standard BLS employment ratio.)

The path of the employment/population ratio during the current decade has been remarkable. The steep slide in jobs that began with the 2001 recession continued thereafter, and actually accelerated in late 2002. Finally the freefall leveled out. (The Bush Administration trumpeted the turnabout in terms similar to those it now uses to sell the aftermath of the troop surge in Iraq: the response to an unacceptable casualty rate was to make things worse for a half-year, and thereafter to compare the post-surge rate of casualties to the high-point, rather than to the period that came before.)

Employment did indeed rise between the years 2003 and 2007. But it barely stayed ahead of population growth. It did very little to make up for the decline equal to 2-3% of the population that had taken place during the first two years of the Bush Administration. The labor force participation rate normally rises in a boom, as good labor market conditions lure workers out of homes, schools and retirement. This is certainly what happened during the record expansion of 1992-2000. But it did not happen during the most recent expansion. To the contrary, the labor force participation rate was at a minimum in 2007, even though that year appears to have been the peak of the business cycle. As a result, employment as a share of the population was well below what it had been at the preceding business cycle peak year (2000). The fraction of Americans with jobs shows a decline from 64.7% to 62.6%, which translates into 4.9 million missing jobs ! Little wonder that, as employment once again starts to decline even in absolute terms, workers are unhappy.

Nicholas Kristof’s column in the New York Times today, “Better Roses than Cocaine,” says it all.   There is no good reason for the US Congress to continue to hold up the free trade agreement that the Administration has negotiated with Colombia.   

Free trade with Colombia can’t have anything to do with loss of US jobs:   Colombia’s exports already enter the US duty-free.   Rather, the Free Trade Agreement would reduce remaining Colombian barriers to imports from the US.    It could contribute (a bit) to a surge in US exports worldwide, which in turn could once again become the engine of US growth that it was in the 1990s.  

Nor would free trade with Colombia be bad for human rights in that violent country.   No government is perfect.   But the Uribe government offers the best hope of bringing some measure of peace, prosperity and justice to Colombia.   It is fighting against the guerillas and drugs.  It wants to give farmers some security, for example, so that they know they have an assured US export market in cut flowers to replace the risky business of growing coca for cocaine.   It deserves our support.

American labor unions raise the issue of killings of Colombian union leaders.  But this is a weak reason to oppose the FTA.   For one thing, the odds of being killed if you are a union leader in Colombia are now less than the odds of being killed if you are a regular citizen.

It is hard to escape the conclusion that the main reason Congressmen are opposing the Colombian free trade agreement is to pander to ill-informed American public opinon.  (Of course the White House would have been better-advised to concentrate its energies and political capital on the multilateral level, the WTO, rather than on the negotiation of myriad bilateral FTAs with small countries.   But this is an argument of economists and policy wonks.  No politicians are opposing the Colombian agreement on these grounds.)

Kristof concludes with a challenge to Democrats. “Democrats instinctively criticize Bush when he harms America’s standing in the world.”   I assume he has in mind  Kyoto, Guantanamo, Abu Graib, land mines treaty, International Criminal Court, nuclear weapons policy, energy policy, steel tariffs, and other economic missteps I could list (see The International Economy).   He continues, “But a test of intellectual honesty is your willingness to hold your own side to the same standard and to point out pandering in those politicians you normally admire.”

He is right.  Hillary and Barack: if you are listening, SUPPORT THE COLOMBIAN FREE TRADE AGREEMENT!   Everybody else:  read Kristof.