Across the developed markets, long bond yields are moving lower. Lower long yields typically represent lower expectations of NGDP. After all, if NGDP is expected to grow robustly, then either it will cause inflation and bonds will get killed, or it there will be high productivity growth, and stocks will likely do better.
Lower NGDP expectations must mean tighter policy in the short term. At least in my world view that is more or less the definition of tighter policy. Thus, when I see long bond yields move lower, I immediately ask, “who is tightening policy?”.
The answer seems to be everyone. China’s central bank is hard to read, but it appears happy to accept some level of slowdown to put a lid on rampant credit growth. The US is tapering, and good economic data out of Japan is causing people to rethink their expectations of the BOJ easing further. Finally, no one really thinks that the ECB will have the political will to do the kind of Japan level QE that the EZ desperately needs.
Now, despite all that, I don’t think that that is the primary driver of what is happening. I think that falling inflation in the short term (less than 2 years), has resulted in a passive tightening of policy, and that is what is crushing long yields. The real short term rate is the nominal bank rate (in the UK 0.5%) less inflation (annual change GDP deflator). The following graph therefore gives a sense of the “real” short term rate in the US.
So its pretty clear that the low inflation in the US has caused policy to tighten by almost a full percentage point since 2012. If you were to make an adjustment to this for the taper the effective tightening would be even greater. Sadly, I could not make the usually excellent Fred give me up to date series for the EZ GDP deflator – for some reason it ends in mid 2013. I strongly suspect the EZ is in an even worse position.
I think financial markets are waking up to the fact that low inflation might be here for a while, and that this has significant implications on where the “real” policy rate lies, even if there is no change in the expected path of the nominal rates. Remember, policy is expansionary *if and only if* the (real) natural short term interest rate is above the inflation adjusted Fed funds rate. Might we just have seen these cross over? If so, expect the US slowdown to continue, and Europe to go back over the cliff.
So I had a look at the FT’s coverage of the inflation report, and it brought up one of my pet peeves about the commentary on the crisis, namely, measures of economic slack.
The bank of England apparently thinks that there is around 1.5% of slack in the economy. My first pet hate is that “slack” is not adequately defined in this context. Does this mean that Carney thinks that RGDP will develop a new trend line that is only 1.5% higher than the current level and at around 2% a year? Or does this simply mean that at the current moment companies estimate that with their current personnel and facilities they could only increase production by 1.5%.
This is important because there are two types of “slack”, there is the measure of “could we do more right now”, and there is the measure “given greater demand could I deploy more employees, capital, and technology to increase supply”. I am pretty sure the BOE’s estimate is about the former, but the macroeconomically important version is the latter. In other words, the supply side constraints could be soft for a while, if technological improvements since 2008 have enabled greater production, but they just haven’t been deployed due to weak demand.
Lets take a quick look at the RGDP (constant prices):
Does this look like an economy with only 1.5% slack? Is it not possible that in the medium term we might recover nearly all of our lost productivity? Might we not find that as demand grows aggregate supply just continues to quietly grow so that the BOE’s measure remains stuck at 1.5% while GDP grows 4-5% a year for a number of years?
Stolen from an ONS publication, does this look like an economy with only 1.5% slack? Are you telling me that after 7 years of technological progress, the BOE expects slack in GDP to be exhausted before productivity per worker has even reached its 2007 high?
Are we really to expect that some (minor) institutional differences will mean that UK workers will not, over the medium term, enjoy the same advances that have allowed US productivity to grow 20% in the same period? The UK is structurally similar to the US, but the structural differences (might) mean that in the UK we get more hiring first, and productivity growth later, and in the US they get more productivity first, and then more hiring. That certainly seems more plausible to me than that the differences in our institutions mean that the UK will not benefit from the same advances of the US in the long run. In that case, the technology exists already for a 20% rise in productivity in UK workers.
The real problem here is that the BOE is giving a short term definition of slack, where it doesn’t assume anything about the future investment and employment and capital improvement programs of enterprises. It just asks about capacity utilisation right now. Which, immediately following a recession, is a sensible enough thing to do. The problem is, that here we have moved into the medium term. There has been technological progress in that time, and the fact that this is waiting in the wings means that we should not regard current utilisation as in anyway a meaningful indicator of “slack”.
I predict that productivity per worker will recover its century long trend line of 2% a year growth. In that case, “slack” in the economy is more like 15% than 1.5%. Capital spending, training workers on new technology, the rise of robotics and machine learning will do the heavy lifting over the next 3-5 years, and we can expect strong growth along side benign inflation until we approach this productivity trend line.
Articles about Housing Bubbles are ten a penny at the moment, so I thought it was about time for another salvo in my lonely war against the Bubble Obsessed. When I was lying awake last night, it occurred to me that there is not really enough thought about what constitutes “expensive” or “cheap” when it comes to housing. When talking about an item like bread, we can see that over time the price tends to fall slowly as technology and farming improves, but with occasional spikes when there is some type of supply shock which lowers supply. So it makes sense to talk about when bread is expensive by comparing it to recent history. Fashion items, on the other hand, derive part of their value from their exclusivity, so their price relative to wages stays fairly constant to target a given type of consumer.
Then there are financial assets like the stock market, which make new highs most years, because they are a claim on a fraction of a pie which is growing. Since the housing market also a claim on future earnings, via rent, it too should logically make new highs most years.
It is my contention that housing is more of a luxury good than a commodity, and thus I would expect people to have a reasonably stable preference about what fraction of their income they are prepared to spend on housing. Thus, house prices are expensive, only in so far as they grow more than the total spending (perhaps per capita) in an economy. This makes sense, if my wages grow over time, I would expect to try to move to a better house, and pay more rent. Since, on average, everyone’s wages grow over time, so must house prices. Running to stand still as it were.
The following shows the change in the house price index relative first to NGDP (=total spending), and secondly to the median wage.
The first thing to note is how amazingly stable both these measures are over time. Particularly house prices/median wages. It was basically flat for decades. On the housing/nominal spending measure, US housing has never been cheaper! The difference in trajectory is a measure of the fact that median wages have not risen in line with total spending due to declining labour share over the period. It is interesting that prices relative to median wages really did show a marked increase in the 2000s, but that is all but fully unwound, and I look forward to watching house prices going flat relative to median wages for many more decades.
I tried to recreate the same graph for the UK, but FRED seems to only have rental income. However, that is interesting in its own right, so lets look at rental prices vs NGDP and vs the median wage in the UK:
This data goes over a much shorter period than the US data above. However, its pretty clear that the cost of renting has been in a reasonably long term decline throughout the nineties. I look forward to watching the cost of renting resume its decade long decline.
Its also interesting that the crash has actually made housing more expensive since it caused wages to fall much faster than house prices. A salutory warning to the Bundesbank and Swedish who seem determined to make the case that you should try to put a lid on house prices by raising rates.
Anyway, the main point is clear – forget the media’s obsession. Housing is cheap by the most important measure – its cost relative to median wages.
Also, if you are a BOE Hawk determined to raise rates to put the break on the housing market, then have another look at the evidence. And then don’t.
PS:If someone can find the data for UK house prices in a handy format somewhere, I will redo the US graph for the UK.