Wednesday, January 31, 2007

Doing Their Job

The FOMC's statement today notes that inflation has been ebbing in recent months, but continues to highlight their concerns about inflation, and to indicate that they are ready to move interest rates higher if necessary. Then again, that's part of their job: to ensure that no one is silly enough to think that inflation could rise to an unacceptable level.
Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.
Of course, the other part of their job is to ensure steady job growth. I trust that they'll attend to that part of their job just as well, when the time comes.

2006 GDP Numbers

The numbers are in for the US's economic growth during the fourth quarter of 2006. And they're surprisingly good. From this morning's BEA news release:
Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.5 percent in the fourth quarter of 2006, according to advance estimates released by the Bureau of Economic Analysis. In the third quarter, real
GDP increased 2.0 percent.

...The acceleration in real GDP growth in the fourth quarter primarily reflected a downturn in imports and accelerations in PCE for nondurable goods, in exports, in federal government spending, and in state and local government spending that were partly offset by downturns in private inventory investment and in equipment and software and a deceleration in nonresidential structures.
Despite the worries of some (such as myself), 2006 turned out to be a pretty good year for economic growth. Not great, but certainly solid. The housing sector did indeed contract sharply in 2006, but that was more than made up for by spending by consumers, non-residential business spending, and especially by export growth (more about that in an upcoming post). The following picture illustrates.

One may still have reason to worry about the housing sector contracting further in 2007, however. As the next picture shows, the shrinkage of residential construction in 2006 was severe, but still has some room to shrink further, particularly given its heady expansion during the years 2002-05. On the other hand, non-residential business spending remained solid in 2006 -- not outstanding, but solid.

Today's data also seems to confirm that inflation moderated toward the end of 2006. Overall prices that consumers paid for their purchases fell dramatically in the fourth quarter, due primarily to lower gas prices. But even inflation in non-energy items seems to have peaked.

Despite what the Fed will say later today, the US economy seems to be quite firmly on a trajectory toward moderating inflation. Overall, the US economy seems to have done quite well in 2006. But I remain convinced that if there are any looming clouds on the horizon for 2007, they remain of the slowing-growth variety, rather than the higher-inflation sort.

Tuesday, January 30, 2007

Up or Down?

The Fed's meeting this week will conclude with an announcement on Wednesday that it is leaving the Fed Funds rate unchanged. There's nothing particularly interesting about that. What I do find interesting, however, is the speculation about whether the Fed's next move will be up or down.

It's unusual to be in a situation where there's no clear answer to that question. A couple of months ago I was firmly in the camp of those who thought that the Fed's next move would be to reduce interest rates, since I was convinced that the economy was rapidly slowing. However, last fall's slowdown has clearly eased, and with it the pressure that I thought the Fed would feel to reduce interest rates.

On the other hand, the talk from the Fed is, naturally and explicably, focused on the threat of overly-high inflation rates, with the concomitant threat to raise interest rates if inflation so much as twitches higher.

The result of this situation is that many Fed-watchers are simply guessing that the Fed will keep interest rates constant for a long time to come. For example:
With that in mind, there is a growing sense that the Fed may keep rates at 5.25 percent for the foreseeable future, even though energy prices have retreated lately, easing some inflation concerns.

"It's going to be steady as she goes, which is essentially the Fed saying that inflation trends are lower but the risks are still to the upside," said Keith Hembre, chief economist with First American Funds in Minneapolis. "I think the Fed's on hold for the next six months."

David Kelly, senior economic adviser with Putnam Investments in Boston, goes one step further. He thinks the Fed will keep rates at 5.25 percent throughout 2007.
It strikes me as faintly absurd to guess that nothing will happen in the next 11 months that would tip the balance toward higher or lower interest rates. I still suspect that the Fed's next move will end up being toward lower rates, simply because that would be consistent with historical experience, but I don't know for sure. What I do feel quite sure of is that things won't remain just as they are for all of 2007.

Thursday, January 25, 2007

Budget Forecasts

The CBO has released its annual comprehensive forecast of the federal budget balance for the next ten years. The White House and its allies are trumpeting the figures as illustrating that Bush's policies will lead to a balanced budget by the year 2012. There are just a couple of problems with that conclusion.

First, it's worth making the oft-repeated point that the budget deficit reported in the newspaper headlines is not necessarily the number that matters. Or at least, it probably shouldn't be. That's because the "headline" figure (which is the one that is causing the White House to rejoice because it will move from deficit to surplus in the year 2012) includes the Social Security surplus.

Since that surplus is essentially a place-holder for future liabilities that the US government is going to have to face down the road (when it has to pay SS benefits to baby-boomer retirees), a more comprehensive picture of the government's fiscal picture should focus instead on what the budget deficit would be excluding the SS surplus -- a concept called the "on-budget deficit". As the figure below shows, if you exclude the SS surplus, the on-budget (or "general fund") federal government balance will remain negative for the complete forecast range (see PGL for more on this).

By the way: many economists, including me, would be thrilled if the press shifted their emphasis from the unified budget balance to the on-budget balance. But I'm not holding my breath.

But regardless, it is true that even the on-budget balance shows a marked improvement between the years 2010 and 2012. Why is that? Simple: because during those years the Bush tax cuts are currently slated to expire. The CBO forecast assumes that they will.

But what would happen if Bush got his wish and those tax cuts were made permanent? The next chart tells the story. Instead of the current CBO projection of a deficit of $85 billion in 2012, the deficit would be about $460 billion -- quite a difference.

It will be interesting to see how Bush's 2008 budget (due out shortly) manages to hit their stated target of balance in 2012 while simultaneously making Bush's tax cuts permanent. It's true that their goal is not really a balanced general fund government budget, but rather just a deficit that's smaller than the SS surplus... but squaring this circle will take some pretty heroic assumptions on their part. I'm curious to see which ones they'll make.

One final note: not long ago, in early 2005, Bush was raising the alarm over the Social Security "crisis". Here are some typical comments, from a speech Bush gave on April 21, 2005:
Social Security system [sic] three years from now will start heading into the red. In 2017, Social Security will start paying out more in benefits than it collects in payroll taxes. A pay-as-you-go system, money coming in, money going out. More money will be going out than coming in, in 2017, and every year thereafter the situation gets worse.
Despite this slightly mangled presentation, the gist of Bush's point was one repeated ad nauseum during the spring of 2005: the Social Security trust fund will stop accumulating reserves in the year 2017, so it is imperative to act to fix this "crisis".

Now take another look at the top chart. Clearly, the CBO does not expect the SS trust fund to stop accumulating reserves in 2017. In fact, the CBO expects the SS trust fund to add over $250 billion to its reserves in that year alone.

Yes, there is an upcoming funding gap for Social Security. But the problem is moderate in size, is not imminent, and keeps moving farther into the future. I just wish the same could be said about the problems with the US's health care system...

Wednesday, January 24, 2007


Sorry for my extended absence from this blog, for various holiday-related, work-related, and personal reasons. But it's good to get back to it.

Bush's SOTU speech last night reminded me of how many interesting economic side-effects a concerted federal ethanol policy would have. But first of all, I suspect that Bush's stated goal of increased ethanol production may be a bit unrealistic. From the text of Bush's speech:
I ask Congress to join me in pursuing a great goal: Let us build on the work we've done and reduce gasoline usage in the United States by 20 percent in the next 10 years.

...To reach this goal, we must increase the supply of alternative fuels, by setting a mandatory fuels standard to require 35 billion gallons of renewable and alternative fuels in 2017.
According to the National Corn Growers' Association (no, I had no idea such a thing existed, either), ethanol production used up 1.43 billion bushels of corn in 2005, out of total US production of 11.8 billion bushels.

Meanwhile, according to this Wall Street Journal article, all of that corn produced about 5.2 billion gallons of ethanol. Yet the US consumes about 140 billion gallons of gasoline per year. To produce 35 billion gallons of ethanol per year would require a seven-fold increase in US ethanol production in just 10 years. So if that ethanol were only made from corn, it would require about 10 billion bushels of corn. (This is the point where you look one paragraph up to remind yourself what total US corn production is.)

Of course, the hope is that it will soon become feasible to start producing ethanol in other ways, but these comparisons do give us some idea of the scope of the problem. And note that all of this would only go toward meeting 20% of the US's projected gasoline consumption in 2017, which means that all of that imagined increase in ethanol production would do little more than account for the growth in forecast gasoline consumption, leaving only a bit left to actually reduce the US's consumption of petroleum for gasoline.

In other words, ethanol from corn seems to hold little hope as a way to reduce US consumption of gasoline. What it does do, however, is essentially put a price floor on corn. As the Wall Street Journal article cited above outlines, the profitability of ethanol production depends crucially on the price of corn (as well as on the price of oil, of course). That means that whenever the price of corn is low, there will be a substantial incentive to turn it into ethanol, increasing the demand for that cheap corn and boosting its price. Hence, the ability to turn corn into ethanol has effectively guaranteed corn farmers a minimum price for their product, something that farmers of almost all crops wish for (or actively lobby for); a price floor is one of the fondest, happiest dreams of most people in the farm business.

In short: it seems like it's not a bad time to be in the business of growing corn. But it also seems like the oil industry doesn't have much to worry about from ethanol.