Thursday, May 17, 2007

Economic Puzzles

Irwin Kellner does a nice job laying out some of the puzzling features of the US economy today:
Conundrum redux: The U.S. economy keeps getting harder to explain

HEMPSTEAD, N.Y. (MarketWatch) -- On January 2 of this year, I opined that this would be the year of the conundrum. I wasn't kidding. Originally used by former Federal Reserve chairman Alan Greenspan to describe the drop in bond yields while the Fed was pushing up its federal funds rate, the word conundrum can also describe a number of anomalies and disconnects that have appeared as the year 2007 has unfolded.

For example, economic growth has slowed markedly since the beginning of 2006... You would expect this kind of performance to push up unemployment while pulling down the rate of inflation. You would be wrong.

During this same period of time, the unemployment rate actually fell while the rate of inflation has picked up. The failure of unemployment to rise as the economy has slowed is a good thing in the short run, since it helps maintain jobs and buying power for the nation's workers. This helps to explain another conundrum: the failure of consumer spending to collapse as the housing bubble has popped.

Over the longer term, however, low unemployment in a slow-growth economy may not be so good, since it appears to reflect a slowdown in productivity. When productivity fails to grow, any increase in workers' pay either hurts companies' bottom lines, or shows up in the form of higher prices. So far, corporate profits are doing just fine -- another conundrum, by the way, but the key reason why the stock market has been on a tear of late.

But what's good for earnings in a period of slower economic growth and declining efficiency is not so good for prices. No matter which index you look at, the rate of inflation has not receded as the central bank has expected, but rather, has remained above the Fed's so-called "comfort zone."

In my view, the Fed has aided and abetted this surge in inflation by pumping up money growth even as it has raised interest rates. As we all know, the basis for inflation is too much money chasing too few goods. Talk about a conundrum: after 17 hikes in the fed funds rate from the middle of 2004 to the middle of 2006, the money supply is actually growing faster, not slower.
I'm not so sure that I agree with Kellner's statement that consumer spending is not showing any signs of slowing... but I do think he's right that there are a couple of stylized facts about the US economy right now that fit together pretty awkwardly.

I suspect that most of them can be explained by lag times, though. For example, inflation generally lags economic growth, and so it's not uncommon for weaker economic growth to take some time before it causes inflation to fall.

The one that is most puzzling to me is the continued apparent rise in profits - or at least in corporate profits as reported. Given declining productivity, and slowing demand, it's very hard for me to see how profit growth can continue as it has. We'll know a lot more about that particular puzzle on May 31, however, when the BEA releases data on corporate profits for the first quarter of 2007. It should be interesting to see how well it matches with profits as reported on Wall Street.


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