Federal Reserve – Page 31 – Digital Finance Analytics (DFA) Blog

The U.S. economy is in desperate need of a strong dose of fiscal penicillin

Despite six years of “recovery” from the Great Recession, America’s middle class still struggles financially amid sluggish economic growth and middling job creation.

The Federal Reserve’s near-zero interest rates have helped stabilize the economy after it nearly went into freefall in 2008 and 2009, but that policy is coming to an end, with at least one quarter-point hike expected this year and more in 2017 and 2018.

So what will support the economy once the Fed’s largesse begins to disappear?

I’ve been exploring the key economic data – from productivity and housing to wage growth and consumer spending – to better understand where we’re headed and what is needed to get out of this no-to-low growth environment, a pernicious state some economists call secular stagnation. The data show clearly why serious attention is needed to foster faster growth, a more competitive economy and more opportunities for American families.

And only one institution, I would argue, is able to do something about it: Congress.

Stagnant growth and productivity

For most of the recovery, economic growth has been lackluster.

Gross domestic product has expanded at an average annual inflation-adjusted rate of just 2 percent since the recession ended in the second quarter of 2009, far below the rate of 3.4 percent from December 1948, when the first recession after World War II started, to December 2007, when the most recent recession began. And in just the past three quarters through June, the economy has barely budged, growing at an anemic 1 percent or so.

Productivity growth, measured as the increase in inflation-adjusted output per hour, is key to propelling strong economic growth because it means that workers are getting better at doing more in the same amount of time. Yet productivity rose only a total of 6.6 percent from the second quarter of 2009 to the second quarter of 2016. That amounts to an average rate of 0.9 percent a year, a fraction of the 2.3 percent we experienced from 1948 to 2007.

Housing hasn’t recovered

When considering what’s keeping the recovery from taking off, housing deserves particular attention since it generally boosts economic growth after a recession. Not this time.

Sales of new single-family homes have been on the rise in recent years, but they’re still well below the historical average before the Great Recession, pushing homeownership down to a 50-year low. Sales averaged about 400,000 a year from 2011 to 2015, compared with 698,000 before the recession – from 1963 through 2007.

Although the pace has picked up in recent months – reaching an annual rate of 609,000 in August – it’s still not enough to stop the slide in the homeownership rate, which was 62.9 percent in the second quarter, down from 67.8 percent at the end of 2007.

And spending on housing fell 7.7 percent in the second quarter of 2016, compared with the first three months of the year.

One of the reasons housing has been slow to recover – the market’s collapse was the primary cause of the Great Recession – is that employment growth has remained mostly moderate. Many are still looking for good jobs despite the sharp drop in headline unemployment to an eight-year low of 4.9 percent.

The average annualized employment growth rate from June 2009 to August 2016 was just 1.4 percent, well below the long-run average of 1.9 percent from December 1948 to December 2007.

While there were 13.6 million more jobs in August than in June 2009 – meaning that the economy regained all those lost during and immediately after the recession – these gains and the comparatively low unemployment rate obscure that many people still cannot find the jobs they want. The jobless rate means about 7.8 million individuals were unemployed in August, yet another 7.8 million were either employed part time for economic reasons (they would have preferred a full-time job) or out of work and wanted a job but weren’t counted in the official rate because they hand’t looked in the preceding four weeks.

And communities of color still have higher unemployment rates than whites. The African-American unemployment rate stood at 8.1 percent, while for Hispanics it was 5.6 percent, compared with 4.4 percent for whites.

Wage growth, income inequality and debt

These lackluster job gains have meant there’s less pressure on employers to raise wages. And sluggish wage growth has meant less consumer spending – which typically makes up more than two-thirds of GDP.

Wages, in fact, have barely kept pace with price increases. Inflation-adjusted hourly earnings of production and non-supervisory workers – about 80 percent of the labor force – have increased only about 4.5 percent since June 2009. This amounts to an annualized growth rate of merely 0.6 percent above the rate of inflation over the past seven years.

Low wage growth has kept income inequality at very high levels. A recent report offered some good news: Real median household income grew at 5.2 percent, from US$53,718 in 2014 to $56,516 in 2015 – the fastest annual growth on record dating back to 1968. But inflation-adjusted median income was still higher in 2007 than in 2015.

Middle-class Americans are only slowly gaining ground as wealthier ones had seen bigger gains, leaving income inequality persistently high. In 2015, the top 5 percent of earners captured 22.1 percent of total income, compared with 11.3 percent for the bottom 40 percent. In 1967, those at the top took home 17.2 percent, versus 14.8 percent for the bottom 40 percent.

This lack of wage growth also makes it difficult for households to dig out from under a mountain of debt, which further contributes to limited spending on housing and other items. Household debt equaled 105.2 percent of after-tax income in the second quarter of 2016. While that’s down from a peak of 135 percent in the fourth quarter of 2007, the current level is still much higher than any level of debt observed in the 50 years before 2002.

Moreover, some especially costly forms of credit have grown. Installment debts – mainly student and car loans – have grown from 14.6 percent of after-tax income in June 2009 to 19.2 percent this past June – the highest share since records began in 1968.

Unsurprisingly, consumer spending growth has been middling as a result, increasing an average of just 2.3 percent a year since the end of the Great Recession, far below the long-term average of 3.5 percent from 1948 through 2007.

Companies on the sidelines

With their consumers still mired in debt with little gain in their pocketbooks, businesses have very few reasons to invest.

Net investment – what companies spend on new capital assets rather than on replacing obsolete items – has averaged 1.9 percent of GDP since the recession started at the end of 2007. This is the lowest since World War II.

To be clear, companies have the money. Corporate profits recovered quickly toward the end of the Great Recession and have stayed high since.

So where is all that money going? Cash reserves and shareholders.

Nonfinancial corporations hold an average of 5.2 percent of all of their assets in cash – a high rate by historical standards. At the same time, they spent on average 99 percent of their after-tax profits on dividend payouts and share repurchases to keep their shareholders happy since the start of the Great Recession.

Breathing room

With consumers not spending money because they can’t and businesses not spending money because they don’t want to, the onus falls on Congress to bolster the economy and the labor market.

Yet federal, state and local government spending has been falling. Their total spending on goods and services as a share of GDP was 17.7 percent in the second quarter of 2016, the smallest share since 1998.

Congress, though, now has room to maneuver. The nonpartisan Congressional Budget Office estimated in August that the federal government will have a deficit of 3.2 percent of GDP for fiscal year 2016. This is much smaller than in recent years, including 2009’s deficit of 9.8 percent of GDP – the widest since World War II.

The shrinking deficit, as well as the government’s near-record-low borrowing costs, could provide enough breathing room to focus on targeted, efficient policies that promote long-term economic growth and shared prosperity, for instance, through investments in infrastructure.

The economy and American families need Congress to use this breathing room to create real economic security.

Author: Christian Weller, Professor of Public Policy and Public Affairs, University of Massachusetts Boston

What Was Behind the Boom and Bust in House Prices?

Interesting piece from the St. Louis Federal Reserve On the Economy Blog. House prices fell during the “great recession” in the US by 30% or more. Recent modelling shows that the main reason for the fall was that people’s beliefs about house prices had changed. It was less about a change in the demand for housing or availability of credit. In other words, if enough people think prices will rise, they will rise; but the reverse is also true.

In Australia, we still have more households believing home prices will rise in the next year, as explored in the latest Property Imperative, released yesterday. Thus, if the modelling is correct, this expectation becomes self fufilling.

The causes behind the boom and bust of house prices over the past decade or so are generally boiled down to three possible culprits:

Fundamental shocks, such as changes in the ability to build houses or in people’s desire to own houses

Credit market changes, such as looser lending restrictions allowing more people to purchase houses

Beliefs, or house prices increasing simply because people thought they would increase

Recent research points more strongly to one in particular: that people’s beliefs about house prices had changed.

Greg Kaplan, an economics professor at the University of Chicago, discussed this finding in his paper “Consumption and House Prices in the Great Recession: Model Meets Evidence,” presented at the St. Louis Advances in Research (STLAR) Conference on April 7-8

You can watch a video on this research here. Download a summary of the research here.

Fed Holds Rates Once Again

Whilst the Fed highlighted some further improvements in the US economy, and three board members wanted to lift, the decision was to hold. The markets liked the decision, reflecting on the fact that with the November Fed meeting abutting the US election, December is the likely next window.

Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of this year. Although the unemployment rate is little changed in recent months, job gains have been solid, on average. Household spending has been growing strongly but business fixed investment has remained soft. Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.

Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Jerome H. Powell; and Daniel K. Tarullo. Voting against the action were: Esther L. George, Loretta J. Mester, and Eric Rosengren, each of whom preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.

US Household Net Worth Rises

The latest (Q2 16) US Financial Accounts have been released, containing data on the flow of funds and levels of financial assets and liabilities. The data will increase the likelihood of a fed rate rise, offsetting the more negative news released yesterday.

The net worth of households and nonprofits rose to $89.1 trillion during the second quarter of 2016. The value of directly and indirectly held corporate equities increased $452 billion and the value of real estate rose $474 billion. The figure plots the contributions to the change in net worth of households and nonprofit organizations. The black line plots the total change in net worth, while the bars represent the changes in the main components of net worth: market value of directly and indirectly held corporate equity (dark blue), market value of real estate holdings (green), and other assets net of liabilities (light blue). Other assets include consumer durable goods, nonprofit organizations’ fixed assets, and financial assets other than corporate equity.

Household debt increased at an annual rate of 4.4 percent in the second quarter of 2016. Consumer credit grew 6.4 percent, while mortgage debt (excluding charge-offs) grew 2.5 percent at an annual rate.

Domestic nonfinancial debt outstanding was $46.3 trillion at the end of the second quarter of 2016, of which household debt was $14.5 trillion, nonfinancial business debt was $13.2 trillion, and total government debt was $18.6 trillion. The figure plots the 4-quarter moving average percent growth rate of debt outstanding for domestic nonfinancial sectors at a quarterly frequency. The growth rate of debt is calculated as the seasonally adjusted flow divided by the seasonally adjusted level in the previous period, multiplied by 100. In the Financial Accounts, debt equals the sum of debt securities and loans.

Domestic nonfinancial debt growth was 4.4 percent at a seasonally adjusted annual rate in the second quarter of 2016, down from an annual rate of 5.4 percent in the previous quarter.

Nonfinancial business debt rose at an annual rate of 4.1 percent in the second quarter, down from an annual rate of 9.4 percent in the previous quarter.

State and local government debt rose at an annual rate of 2.2 percent in the second quarter of 2016, up from an annual growth rate of 0.8 percent in the previous quarter.

Federal government debt increased 5.0 percent at a seasonally adjusted annual rate in the second quarter of 2016.

Rate Hikes Will Be the Least of Market Worries – Moody’s

Moody’s says the Fed does not set interest rates in a vacuum. Indeed, the federal funds rate is shaped by a host of drivers that are hardly limited to labor market conditions.

Despite warnings from high-ranking Fed officials that ultra-low interest rates are not forever, recent soundings of business activity, as well as the nearness of November 8’s Presidential election, weigh against a hiking of the federal funds rate prior to the FOMC’s December 14 meeting. Moreover, recent data question whether 2016 will be home to even a single rate hike.

In a September 12 speech, Fed governor Lael Brainard presented a convincing case favoring an extended stay by exceptionally low benchmark interest rates. On several occasions, Governor Brainard challenged the wisdom of a preemptive rate hike that intends to thwart inflation before it takes hold. Given “the absence of accelerating inflationary pressures” and the limited scope for lowering of fed funds in the event recession risks rise, Brainard argues for the continuation of a highly accommodative monetary policy. Basically, the macroeconomic costs of mistakenly hiking rates too early are viewed as well exceeding the potential inflationary costs of waiting too long to confront inflation. The damage done by a premature rate hike may be harder to repair than the damage resulting from above-target price inflation.

However, there is an alternative view that views ultra-low interest rates as doing more harm than good because of how cheap money (i) boosts savings in order to compensate for negligible interest income and (ii) forces investors to purchase riskier assets offering higher, though volatile, returns.

Futures now sense 2016 will end without a rate hike

As measured by the CME Group’s FedWatch tool, fed funds futures assign an implied probability of only 12% to a hiking of fed funds at the September 21 meeting of the FOMC. Thereafter, the implied likelihood barely rises to 20% for the November 2 meeting and climbs no higher than 47% for the FOMC’s deliberations of December 14. For now, the futures market does not expect a single rate hike for 2016.

The latest declines by the implied probabilities of rate hikes at the FOMC’s remaining three meetings for 2016 stemmed from lower than expected August readings for retail sales and industrial production. Despite the latest indications of subpar business sales, US equities rallied. Moreover, an accompanying drop by the VIX index hinted a narrowing of the high-yield spread that recently widened from September 8’s 18-month low of 508 bp to September 14’s 538 bp. Nevertheless, at some point, the corporate earnings outlook will overrule the now predominant influence of Fed policy. Unless business sales soon accelerate sufficiently, market participants will begin to fret over the adequacy of earnings for 2016’s final quarter and all of 2017.

US Production Index Lower Than Expected

Latest figures from the US Federal Reserve shows that industrial production decreased 0.4 percent in August after rising 0.6 percent in July. The market reacted to this data, taking it as an indicator that a rate rise was less likely in the short term.

Manufacturing output declined 0.4 percent in August, reversing its increase in July; the level of the index in August is little changed from its level in March. Following two consecutive monthly increases, the index for utilities fell back 1.4 percent in August. Even so, the index was 1.7 percent above its year-earlier level, as hot temperatures this summer boosted the usage of air conditioning.

The output of mining moved up 1.0 percent in August, its fourth consecutive monthly increase following an extended downturn; the index, however, was still about 9 percent below its year-ago level. At 104.4 percent of its 2012 average, total industrial production in August was 1.1 percent lower than its year-earlier level. Capacity utilization for the industrial sector decreased 0.4 percentage point in August to 75.5 percent, a rate that is 4.5 percentage points below its long-run (1972–2015) average.

Market Groups

The indexes for all major market groups declined in August. The output of consumer goods decreased 0.2 percent as a result of a large drop in consumer energy products and a small decline in consumer non-energy nondurables. The output of consumer durables was unchanged; a gain in automotive products was offset by declines in all of its other components. Business equipment posted a decrease of 0.4 percent, as gains of 1 percent or more for transit equipment and for information processing equipment were outweighed by a cutback of nearly 2 percent for industrial and other equipment. The output of defense and space equipment declined 0.6 percent. The indexes for construction supplies and business supplies moved down 0.6 percent and 0.8 percent, respectively. The production of materials decreased 0.5 percent: Both durable and energy materials posted declines, while the output of nondurable materials was unchanged. The reduction in the index for durable materials reflected similarly sized losses across all its major categories.

Industry Groups

Manufacturing output declined 0.4 percent in August; the index was also 0.4 percent below its level of a year earlier. In August, the production of nondurables moved down 0.2 percent, and the indexes for durables and for other manufacturing (publishing and logging) fell 0.6 percent and 0.7 percent, respectively. Many durable goods industries posted declines of nearly 1 percent or more, with the largest drop, 1.9 percent, recorded by machinery. Within nondurables, gains for food, beverage, and tobacco products and for paper were more than offset by declines elsewhere; the largest decrease, 2.1 percent, was recorded by textile and product mills.

The index for mining moved up 1.0 percent in August, with a decline in coal mining outweighed by increases in the indexes for oil and gas extraction, for oil well drilling and servicing, and for metal ore and nonmetallic mineral mining.

Capacity utilization for manufacturing decreased 0.4 percentage point in August to 74.8 percent, a rate that is 3.7 percentage points below its long-run average. The operating rate for nondurables moved down 0.2 percentage point; the rates for durables and for other manufacturing (publishing and logging) each declined 0.5 percentage point. The operating rate for mining moved up 1.0 percentage point to 76.2 percent, while the rate for utilities decreased 1.3 percentage points to 80.4 percent.

The “New Normal” and US Rates

Recent volatile stock market movements are in reaction to the fear that central banks will begin to tighten monetary policy. Much attention is on the Federal Reserve. So, a significant speech from Fed Governor Lael Brainard is worth noting. She spoke at the Chicago Council on Global Affairs, Chicago, Illinois and outlined five factors in “the new normal”.

She concludes:

The five features of the current economic landscape that I have highlighted lean roughly in the same direction: In today’s new normal, the costs to the economy of greater-than-expected strength in demand are likely to be lower than the costs of significant unexpected weakness. In the case of unexpected strength, we have well-tried and tested tools and ample policy space in which to react. Moreover, because of Phillips curve flattening, the possibility of remaining labor market slack, the likely substantial response of the exchange rate and its depressing effect on inflation, the low neutral rate, and the fact that inflation expectations are well anchored to the upside, the response of inflation to unexpected strength in demand will likely be modest and gradual, requiring a correspondingly moderate policy response and implying relatively slight costs to the economy. In the face of an adverse shock, however, our conventional policy toolkit is more limited, and thus the risk of being unable to adequately respond to unexpected weakness is greater. The experience of the Japanese and euro-area economies suggest that prolonged weakness in demand is very difficult to correct, leading to economic costs that can be considerable.

This asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation. I believe this approach has served us well in recent months, helping to support continued gains in employment and progress on inflation. I look forward to assessing the evolution of the data in the months ahead for signs of further progress toward our goals, bearing in mind these considerations.

Watch her speech in full.

1. Inflation Has Been Undershooting, and the Phillips Curve Has Flattened
First, for the past several decades, policymakers relied on the empirical relationship between unemployment and inflation embodied in the Phillips curve as a key guidepost for monetary policy. The Phillips curve implied that as labor market slack diminished and the economy approached full employment, upward pressure on inflation would result. However, since 2012, inflation has tended to change relatively little–both absolutely and relative to earlier decades–as the unemployment rate has fallen considerably. At a time when the unemployment rate has fallen from 8.2 percent to 4.9 percent, inflation has undershot our 2 percent target now for 51 straight months. In other words, the Phillips curve appears to be flatter today than it was previously.

2. Labor Market Slack Has Been Greater than Anticipated
Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done. It is true that today’s unemployment rate of 4.9 percent is only 0.1 percentage point from the median SEP participant’s estimate of the longer-run level of unemployment. However, the natural rate of unemployment is uncertain and can vary over time. Indeed, in the SEP, the central tendency of the projection for the longer-run natural rate of unemployment has come down significantly, from a range of 5.2 to 6.0 percent in June 2012 to 4.7 to 5.0 percent in June 2016–a reduction of 1/2 to 1 percentage point. We cannot rule out that estimates of the natural unemployment rate may move even lower.

3. Foreign Markets Matter, Especially because Financial Transmission is Strong
Third, disinflation pressure and weak demand from abroad will likely weigh on the U.S. outlook for some time, and fragility in global markets could again pose risks here at home. In Europe, recovery continues, but growth is slow and inflation is very low. Low growth and a flat yield curve are contributing to reduced profitability and a higher cost of equity financing for banks, which in turn could impair bank lending, one of the main transmission channels of monetary policy in the euro area’s bank-centric financial system. A low growth, low inflation environment also makes progress on fiscal sustainability difficult and leaves countries with high debt-to-gross domestic product (GDP) ratios vulnerable to adverse demand shocks. Against this backdrop, uncertainty about Britain’s future relationship with the European Union could damp business sentiment and investment in Europe.

4. The Neutral Rate Is Likely to Remain Very Low for Some Time
Fourth, perhaps most salient for monetary policy, it appears increasingly clear that the neutral rate of interest remains considerably and persistently lower than it was before the crisis. Over the current expansion, with a federal funds rate at, or near, zero and the additional support provided by asset purchases and reinvestment, GDP growth has averaged a very modest rate upward of 2 percent, and inflation has averaged only 1‑1/2 percent. Ten years ago, based on the underlying economic relationships that prevailed at the time, it would have seemed inconceivable that real activity and inflation would be so subdued given the stance of monetary policy. To reconcile these developments, it is difficult not to conclude that the current level of the federal funds rate is less accommodative today than it would have been 10 years ago. Put differently, the amount of aggregate demand associated with a given level of the interest rate is now much lower than before the crisis.

5. Policy Options Are Asymmetric
The four features just discussed that define the new normal make it likely that we will continue to grapple with a fifth new reality for some time: the ability of monetary policy to respond to shocks is asymmetric. With policy rates near the zero lower bound and likely to return there more frequently even if the economy only experiences shocks similar in magnitude to those experienced pre-crisis, due to the low level of the neutral rate, there is an asymmetry in the policy tools available to respond to adverse developments. Conventional changes in the federal funds rate, our most tested and best understood tool, cannot be used as readily to respond to downside shocks to aggregate demand as it can to upside shocks. While there are, of course, other policy options, these alternatives have constraints and uncertainties that are not present with conventional policy. From a risk-management perspective, therefore, the asymmetry in the conventional policy toolkit would lead me to expect policy to be tilted somewhat in favor of guarding against downside risks relative to preemptively raising rates to guard against upside risks.

Long-Run Economic Effects of Changes in the Age Dependency Ratio

A decrease in the labor force and an increase in the elderly population could slow economic growth, says economic research from the Federal Reserve Bank of St. Louis.

Important demographic changes in the developed world in recent years may have long-run economic consequences. As a result, such changes have started to play a more important role in the design of economic policies.

In a recent blog post, I analyzed changes in the age dependency ratio in the G-7 countries since 1990.¹ Thorough analysis of the evolution of this variable and its components is important because the young and old are likely to be more economically dependent on the rest of the population and changes in age composition may affect other areas of the economy.

Panel A of the figure plots the annual age dependency ratios for the G-7 countries from 1990 to 2012. The age dependency ratio is the sum of the young population (under age 15) and elderly population (age 65 and over) relative to the working-age population (ages 15 to 64). As the figure shows, dependency ratios have risen in all seven countries in the past 10 years. In some countries, however, the trend started earlier. In Japan, for instance, the increase started in the early 1990s. Changes in the age composition of the population—from increases and/or decreases in the young and elderly populations—drive the dependency ratios. As the figure shows, in all G-7 countries, the elderly populations (Panel B) have increased, while the working-age populations (Panel C) and young populations (Panel D) have decreased slightly or stayed flat. Among those countries, Japan’s age dependency ratio increased the most.

Several recent studies² suggest that high dependency ratios may have the following long-term economic
consequences:

Saving rates: As workers get close to retirement, they tend to increase their savings through pension plans, healthcare insurance, etc. Also, if younger workers anticipate changes in demographic trends, they could start saving more for the future (by investing more in private pension plans, postponing consumption decisions, or investing in private health insurance). Increased savings could have long-term economic consequences, such as a decrease in long-term interest rates. Eventually, as the elderly start retiring and birth rates start decreasing—as appears to be the recent trend—savings would start decreasing and long-term interest rates would rise. Thus, recent demographic changes could affect saving rates and long-term interest rates.

Investment rates: If savings decrease, there could be fewer funds to finance investment projects, which could decrease investment in physical capital. Decreased investment could reduce long-term economic growth.

Housing markets: A growing labor force would increase house prices. A recent article in The Economist finds that since 1960, house prices in a sample of 10 countries fell by 0.2 percent per year as the age dependency ratio increased. Because the demographic composition of the labor force contributes strongly to the trend in house prices, fewer young people, together with a large increase in the elderly population, would likely result in less investment in the housing market.

Consumption patterns: An increase in the elderly population could shift consumption from certain goods toward healthcare services and leisure.

In summary, the decrease in the labor force, due to an increase in the elderly population and a decrease in the fertility rate, could translate into lower economic growth. Long-term problems in the developed world caused by an increase in the age dependency ratio could be alleviated by either increasing productivity (to avoid an economic slow-down from a shrinking labor force) or increasing the labor force participation of the elderly (e.g., by increasing the retirement age, as several European countries have done recently, or reducing taxes on the labor income of elderly workers). These economic policies, however, would not reverse the recent demographic trends.

Notes

¹ Santacreu, Ana Maria. “How Are Populations Shifting within Developed Countries?” Federal Reserve Bank of St. Louis On The Economy Blog, August 11, 2016; https://www.stlouisfed.org/on-the-economy/2016/aug….

² Economist. “Vanishing Workers.” July 2016, 420(8999), p. 58, http://www.economist.com/news/finance-and-economic…. Karp, Nathaniel and Nash-Stacey, Boyd. “Slow Productivity Growth: Cracking the Code.” BBVA Research U.S. Economic Watch, August 4, 2016; https://www.bbvaresearch.com/wp-content/uploads/20….

The Timing of Labeling a Bank “Too Big to Fail” Matters

From the St. Louis Fed On The Economy Blog.

When banks that are considered “too big to fail” (TBTF) are on the verge of failure and are subsequently saved by the government, many argue that the government is bailing out stock and bond holders at taxpayer expense. However, exactly who gets bailed out may be unclear. An Economic Synopses essay argues that it depends on when the institution is labeled TBTF.

Director of Research Christopher Waller noted that current stock and bond holders of failing banks get bailed out if the institutions are unexpectedly declared TBTF at the moment they are about to default. This is because markets haven’t had time to incorporate the TBTF news into asset prices.

However, it’s when banks are considered TBTF prior to default that the issue of who gets bailed out becomes murkier. Waller quoted authors of a 2004 book Ron Feldman and Gary Stern about the problem: “‘The roots of the TBTF problem lie in creditors’ expectations … and the source of the problem is a lack of credibility’ that the government will let them fail.”¹ Waller wrote: “It is exactly this timing that makes it difficult to determine who benefits from TBTF.”

A TBTF Announcement and Reaction

Waller gave an example of a bank (which he simply called bank A) that had been declared TBTF by the government. In response, the prices of the bank’s stocks and bonds would rise to reflect this new information. Subsequent offerings would also have higher prices, again due to the TBTF designation (and corresponding lack of default risk).

Investors who buy this bank’s stocks or bonds after the announcement, however, wouldn’t necessarily see a benefit. Waller noted that the TBTF status should be fully incorporated into asset prices, assuming financial markets are efficient. He wrote: “In short, new buyers are paying for the TBTF insurance via higher equity and bond prices. They do not receive a windfall from the TBTF status assigned to bank A.”

What If the Bank Is Allowed to Fail?

Waller also addressed what would happen if the bank was still allowed to fail after the TBTF designation was given. He wrote that initial bond and stock holders who sold after the announcement would not care, as they already received the insurance premium and would not be affected by the failure.

The current holders, however, would have paid a premium for the insurance, only to lose their investments anyway. Waller wrote: “Hence, it is not surprising that they would be upset by the government’s action. Who wouldn’t be upset after paying for insurance that didn’t pay off when it should have?”

Conclusion

Waller wrote: “To summarize, the value of being designated TBTF is capitalized into the price of a firm’s equities and its bonds. TBTF provides a windfall capital gain to shareholders and creditors at the time of the designation. But after that, new buyers of equities and debt are paying for that status. Consequently, determining who gets ‘bailed out’ when an institution is TBTF is a more complicated task than it appears.”

Notes and References

¹ Feldman, Ron; and Stern, Gary. Too Big to Fail: The Hazards of Bank Bailouts. Washington, D.C.: Brookings Institution Press, 2004.

Fed Leaves September Rate Hike Option Live

Monetary policy is alive and well, according to the FED, and interest rate rises are on the cards in the US. Chair Janet L. Yellen spoke at “Designing Resilient Monetary Policy Frameworks for the Future,” a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, her speech was entitled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future.”

The AU/US dollar moved in reaction to the speech.

In a nutshell, monetary policy remains relevant, and given the current economic indicators, there appears scope for rate rises later this year, possibly as soon as September. Her comments on how rate adjustments have been simulated are worth reading. It also means that we may see some falls in asset prices as the rises bite, across stocks and property.

A recent paper takes a different approach to assessing the FOMC’s ability to respond to future recessions by using simulations of the FRB/US model. This analysis begins by asking how the economy would respond to a set of highly adverse shocks if policymakers followed a fairly aggressive policy rule, hypothetically assuming that they can cut the federal funds rate without limit. It then imposes the zero lower bound and asks whether some combination of forward guidance and asset purchases would be sufficient to generate economic conditions at least as good as those that occur under the hypothetical unconstrained policy. In general, the study concludes that, even if the average level of the federal funds rate in the future is only 3 percent, these new tools should be sufficient unless the recession were to be unusually severe and persistent. Figure 2 in your handout illustrates this point.

It shows simulated paths for interest rates, the unemployment rate, and inflation under three different monetary policy responses–the aggressive rule in the absence of the zero lower bound constraint, the constrained aggressive rule, and the constrained aggressive rule combined with $2 trillion in asset purchases and guidance that the federal funds rate will depart from the rule by staying lower for longer. As the blue dashed line shows, the federal funds rate would fall far below zero if policy were unconstrained, thereby causing long-term interest rates to fall sharply. But despite the lower bound, asset purchases and forward guidance can push long-term interest rates even lower on average than in the unconstrained case (especially when adjusted for inflation) by reducing term premiums and increasing the downward pressure on the expected average value of future short-term interest rates. Thus, the use of such tools could result in even better outcomes for unemployment and inflation on average.

Of course, this analysis could be too optimistic. For one, the FRB/US simulations may overstate the effectiveness of forward guidance and asset purchases, particularly in an environment where long-term interest rates are also likely to be unusually low.²² In addition, policymakers could have less ability to cut short-term interest rates in the future than the simulations assume. By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving.²³ If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate.²⁴ Moreover, relying too heavily on these nontraditional tools could have unintended consequences. For example, if future policymakers responded to a severe recession by announcing their intention to keep the federal funds rate near zero for a very long time after the economy had substantially recovered and followed through on that guidance, then they might inadvertently encourage excessive risk-taking and so undermine financial stability.

Finally, the simulation analysis certainly overstates the FOMC’s current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly–although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.

Conclusion
Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.