Ruffing and Horney describe the method of calculation of the "Bush-era tax cuts" portion thus:

Through 2011, the estimated impacts come from adding up past estimates of all changes in tax laws -- chiefly the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the 2008 stimulus package, and a series of annual AMT patches -- enacted since 2001. Those estimates were based on the economic and technical assumptions used when CBO and the Joint Committee on Taxation (JCT) originally "scored" the legislation, but the numbers would not change materially using up-to-date assumptions. Most of the Bush tax cuts expire after December 2010 (partway through fiscal 2011). We added the cost of extending them, along with continuing AMT relief, from estimates prepared by CBO and JCT.[14] We did not assume extension of the temporary tax provisions enacted in ARRA. Together, the tax cuts account for $3.4 trillion of the deficits over the 2009-2019 period. Finally, we added the extra debt-service costs caused by the Bush-era tax cuts, amounting to $1.9 trillion over the period and an astonishing $350 billion in 2019 alone.

The CBPP article amalgamates several sets of tax provisions. Seeing the impact of extending individual provisions can be seen in this excerpt from Table 1-5 of the CBO's recent Budget and Economic Outlook (Jan. 26, 2010).

One can also see these numbers graphically in a nifty little interactive facility the CBO has put up here. Below, I've shown a snapshot of the CBO baseline deficit (black) and what happens when EGTRRA and JGTRRA are extended.

Note that the President's Budget does propose allowing the tax cuts on upper income households to lapse; the estimated increase in revenues shown in Table S-8 (page 164) of the Budget. The addition of revenues is estimated at $41.4 billion in FY2011, and $137.4 billion in FY2020.

Normally the establishment survey is regarded as the more reliable, though Tim Kane has argued that the household survey sometimes does a better job of recognizing turning points. We might look to some other labor market indicators to try to referee the current dispute. Automatic Data Processing constructs its own estimate based on the 22 million Americans whose payrolls it helps prepare, and their guess was that the economy shed 22,000 private sector jobs in January on a seasonally adjusted basis. Since BLS estimates that 8,000 government jobs were lost in January, ADP's estimate is about 10,000 more pessimistic than the BLS payroll figure. The Institute for Supply Management's survey of nonmanufacturing establishments found more managers reporting declines in employment than reported increases in employment in January. By contrast, their survey of manufacturing establishments found more managers reporting increases in employment than declines. Fair to say that the signals are mixed, but things may not be as bad as the BLS nonfarm payroll numbers suggest.

Earlier in the week we received reports on January auto sales that could also be described as no better than lukewarm. Americans purchased 6% more light vehicles last month than they had in January 2009. That might sound encouraging, unless you've forgotten that January 2009 was the worst month for car sales out of the last 6 years (on a seasonally unadjusted basis). Last week's good news was that January 2010 was only the third worst month out of the last 6 years, beating both January and February 2009. Nonetheless, that's the same basic arithmetic that gives rise to some hope for 2010 reported growth rates-- things were so awful last year that even a very bad month counts as an improvement.

Data source: Wardsauto.com

I also continue to follow with interest what's been happening to commodity prices, with both oil and copper now off 15% from their values of just a few weeks ago. I'm persuaded that speculation in China has been a big part of the story on both the way up and now on the way down. Greg Merrill calls attention to the estimate by the International Copper Study Group that China's apparent usage of copper grew by 43% in the first 10 months of 2009, while copper usage by the rest of the world fell by 18% over the same period. If stockpiling in China has indeed come to an end, that would explain the sharp fall in prices, and could portend more to come.

Source: Kitco

Source: ino.com

Finally, I have to pass along a story that Mike Shedlock highlighted from Bloomberg:

Non-performing loans in China have risen into the "trillions of renminbi" because of poor lending practices, an insolvency lawyer said.

"We work really closely with SASAC, the state-owned enterprise regulator in China, and there are literally trillions and trillions of renminbi of, frankly, defaulting loans already in China that no one is doing anything about," Neil McDonald, a Hong Kong-based business restructuring and insolvency partner with Lovells LLP, said at an Asia-Pacific Loan Market Association conference yesterday. "At some point there's going to be a reckoning for that."

China's government is tightening controls, including banks' reserve ratios, to prevent record lending from fueling inflation. The Shanghai office of the China Banking Regulatory Commission warned yesterday that a 10 percent fall in property values would treble the number of delinquent loans in the city. Liu Mingkang, chairman of the CBRC, said Jan. 4 that loans were channeled into stock and property speculation last year, which China has been taking measures to stop.

My bottom line: the scales tipped last week in the direction of near-term deflationary pressures, despite the strong 2009:Q4 U.S. GDP report and falling unemployment rate.

As discussed in the Employment Situation release, there are breaks in the population controls. Table B in the release indicate little impact on the unemployment rate. With respect to changes in civilian employment, the Dec to Jan change would have been larger than the one actually published.

Additional coverage: Izzo/WSJ RTE, Reddy/WSJ RTE, CR 1, CR 2, CR 3, Economist's View, Jeff Frankel.

First, has a doubling of exports ever occurred in the past forty or so years? The answer is yes!

Notice that nominal exports certainly doubled in the mid-1970s and early 1980's. Nominal exports also almost doubled by 1990 and 2008, approximately 5 to 6 years after peaks in the trade-weighted exchange rate. (Real exports seldom exceed a 50% increase).

Hence, the objective of doubling nominal exports is clearly possible. From a macro perspective, whether the doubling occurs depends upon (i) the price level of exports, (ii) the quantity of exports.

The price of exports

Clearly, the price of exports matters both directly (by affecting the price of each unit of exports) and indirectly (by affecting the quantity of exports) for nominal exports. First, we can examine the relationship of the price level to the exchange rate.

Here, the implied pass through is substantially higher than import pass-through [1], but in line with the estimate of 0.75 reported by Vigfusson, Sheets and Gagnon [link fixed, 2/5 9am] for the US.

Hence, sustained dollar depreciation could aid in hitting the target in a direct fashion.

The quantity response

The quantity of exports depends on (1) rest-of-world GDP, (2) the real exchange rate, and (3) US supply of exportables. (1) and (2) enter into standard elasticities approach equations; (3) has been included in studies such as Helkie and Hooper (1988), as well as more recent studies by me [2]. Omitting the supply side artificially imputes to rest-of-world growth the supply side if the two variables co-trend.

For the moment, consider the basic specification omitting the supply side, as discussed in this post from last October, but estimated over the 1973Q1-2009Q4 period:

Δ exp _t = θ ₀ + ρ exp _t-1 + θ ₁ y^* _t-1 + θ ₂ r _t-1 + σ ₁ Δ exp _t-1 + σ ₂ Δ y^* _t-1 + σ ₃ Δy ^*_t-2 + σ ₄ Δ r _t-1 + v _t

Where exp is real exports of goods and services, r is the real exchange rate, and y^* is the rest-of-world GDP. Note that the rest-of-world GDP variable is the export weighted real GDP calculated by the Federal Reserve Board, for 1970q2-07q4; the 2008q1-09q3 data I estimated using a regression of GDP on a current and four lags of industrial country industrial production, time trend, trend squared, and world GDP ex.-US.

(Data sources: BEA 2009q4 advance release for imports, exports, GDP; Federal Reserve Board for broad index of real dollar value; personal communication/Fed for rest-of-world export weighted GDP; and IMF International Financial Statistics for industrial country industrial production (nsa), and GDPs used to project rest-of-world GDP.)

The implied long run price elasticity is 0.82, and the long run income elasticity is 1.81. The price elasticity is higher than that obtained by DOLS in this paper, based on export data up to 2007, but the income elasticity is about the same. Hence, continued dollar depreciation would have a substantial direct impact on export quantity. But rapid rest-of-world growth could be even more important, given the high income elasticity. (The rest-of-world GDP variable is export-weighted, so this characterization pertains to US export markets.)

In my working paper, augmenting the basic specification with a supply variable (industrial production) halves the income elasticity. This complicates the issue; then one needs to know how the supply of exportables will evolve over time.

I am the first the confess that the measure I use for the supply of exportables is wanting. One could use a measure of the capital stock (as in Helkie and Hooper). But I think no measure is particularly satisfying, especially given the fact that over one-third of exports are in the form of services, and a full 15% are "private services", including business, professional and technical services.

Complications: Vertical Specialization, etc.

In a number of posts [3] [4] [5], I've argued that vertical specialization -- the use of imported inputs for subsequent exports -- is important in thinking about how trade flows respond to exchange rates and incomes. While it's likely that the degree of vertical specialization is less for the US than other, smaller, developed economies, it's plausible that it's been increasing over time. If this is so, then measured exports could be rising at a noticeably higher rate than the value-added component of exports. In other words, I'm positing an upward trend in gross exports to GDP that is not as marked as the value added in exports as a share of GDP. This upward trend helps make the goal of a doubling of gross nominal exports more feasible.

Of course, this effect relies upon a continuation of "product fragmentation" or "globalization". That process might have been slowed by rising energy prices, or rising transactions (including credit) costs, as discussed here and here.

Bottom Line

So, if you didn't know it already, achieving the goal of doubling nominal exports depends upon exchange rate pass through, the extent of exchange rate depreciation, the rate of rest-of-world GDP growth, and the evolution of export supply (of both goods and services).

Note that the Administration's forecast (from the Troika process) was set (or "locked down") in early January, before the 2009Q4 advance GDP release. The CBO's forecast was finalized December 8th. Hence, I have generated the forecasted levels for 2009Q4 GDP from the forecasted 2009 Q4/Q4 growth rates. The actual advance release for 2009Q4 GDP is therefore higher than the forecasted.

Short term outlook

The Administration's discussion of the GDP forecasts from the Analytical Perspectives (Page 14) reads thus:

Real GDP.--The Administration projects the economic recovery that began in the second half of 2009 will continue in 2010 with real GDP growing at an annual rate of 3.0 percent (fourth quarter over fourth quarter). In 2011-2013, growth is projected to increase to around 4-1/4 per-cent annually as underutilized economic capacity returns to productive uses.

As shown in Chart 2-5, the Administration's projections for real GDP growth over the next five years imply a recovery that is a bit below the historical average. It is true that recent recoveries have been somewhat weaker, but the last two expansions were preceded by relatively mild recessions, which left less pent-up demand when conditions improved. Because of the depth of the recent recession, there is much more room for a rebound in spending and production than was true either in 1991 or 2001. On the other hand, continued weakness in the financial sector may limit the pace of the recovery. Thus, on net, the Administration is forecasting a recovery over the next five years that is slightly below historical averages.

Note that this average post-recession growth rate pertains to the previous ten recessions. If post-recession growth rates depend on the depth of recessions, then one could argue that the 3.8% forecast is too low ERP, 2009. Working the other direction is the fact that this recession was conjoined to a financial crisis.[1] [2]

The CBO's forecast for 2011 is noticeably more pessimistic than either the Blue Chip or Administration forecast. The CBO's forecasts of particularly sluggish growth are driven by the following three (familiar) points:

• Economic growth will probably be restrained by the aftermath of the financial and economic turmoil. Experience in the United States and in other countries suggests that recovery from recessions triggered by financial crises and large declines in asset prices tends to be protracted.
• Although aggressive action on the part of the Federal Reserve and the fiscal stimulus package enacted in early 2009 helped moderate the severity of the recession and shorten its duration, the support coming from those sources is expected to wane. In addition, under the assumption that current laws and policies remain unchanged -- an assumption that is reflected in CBO's forecast -- tax rates will increase in 2011, further hampering growth.
• Household spending is likely to be dampened by slow income growth, lost wealth, and constraints on households' ability to borrow. Investment spending will be slowed by the large number of vacant homes and offices.

In addition, CEA Chair Romer observes in a briefing on the budget:

Now, the forecast that the Congressional Budget Office released last week was considerably more pessimistic about both 2010 and 2011 than either of the administration forecasts or the Blue Chip consensus. And, actually as CBO noted in its release, they're required to make forecasts under the assumption that none of the Recovery Act provisions are extended; there's no new jobs bill enacted. And all of the 2001 and 2003 tax cuts expire at the end of the year.

CBO's report was careful to explain that under the assumption that some of these policies will be extended, its forecast would have looked much more similar to other forecasts.

Longer term outlook

Over the longer term, the deviation appears to be driven by differences in views regarding potential GDP growth. The Administration explains its views on page 16:

Longer-Term Growth. -- The Administration forecast does not attempt to project cyclical developments beyond the next few years. The long-run projection for real economic growth and unemployment assumes that they will maintain trend values in the years following the return to full employment. In the nonfarm business sector, productivity growth is assumed to grow at 2.3 percent per year, while nonfarm labor supply grows at a rate of around 0.7 percent per year, so nonfarm business output grows approximately 3.0 percent per year. Real GDP growth, reflecting the slower measured growth in activity outside the nonfarm business sector, proceeds at a rate of 2.5 percent. That is markedly slower than the average growth rate of real GDP since 1947 -- 3.3 percent per year. In the 21st Century, real GDP growth in the United States is likely to be permanently slower than it was in earlier eras because of the slowdown in labor force growth that is expected beginning with the retirement of the post-World War II "baby boom" generation.

According to the Administration, the Administation and CBO forecasts differ for the following reasons (page 16):

Real GDP Growth.--The Administration's real GDP projections are very similar to those of the Blue Chip consensus in 2010 while exceeding the consensus view in 2011. In its August 2009 projections (the most recent available) the Congressional Budget Office (CBO) projected long-run growth of 2.2 percent per year. Most of the difference between the Administration and CBO's long-run growth comes from a difference in the expected rate of growth of the labor force. Both forecasts assume that the labor force will grow more slowly than in the past because of population aging, but the Administration bases its population projections on the Census Bureau's projections, which tend to run higher than the CBO projections. The Administration also believes that labor force participation could be somewhat stronger in the future. The net difference in the two forecasts is only a few tenths of a percentage point.

Since the newly released CBO estimates of potential GDP (which the Administration did not have available at the time of the writing of the Budget) are even lower than those from January 2009, this foregoing assessment still applies.

Additional discussion, see WaPo WSJ RTE, and Bozzo/AB.

Several state-run Chinese banks have ordered some branches to suspend new lending for the rest of this month, suggesting a coordinated effort by Beijing to manage state banks' torrid lending in the year's first few weeks.

A person with direct knowledge of the matter said Tuesday that Industrial & Commercial Bank of China Ltd., the country's biggest lender by assets, last Friday ordered its branches in Beijing not to issue any new loans for the rest of January.

China Citic Bank Corp. also suspended new lending in Shanghai last week because its local operations have already used up their monthly quota for new loans in the city, a Shanghai-based official at the medium-sized bank said Tuesday. The Citic Bank official added that both the bank's own headquarters and the People's Bank of China, the country's central bank, "have told us to control the pace of lending this year."

The moves by the two state-owned banks follow similar steps taken last week by state-run Bank of China Ltd.

I'm not sure how significant that is, but thought it made interesting reading side-by-side with earlier anecdotal accounts of Chinese speculative buying and a graph of what happened to commodity prices following the Chinese tightening.

Source: Kitco

Source: Kitco

Update 4pm 2/1/10: Since there is some confusion regarding the dates in the graph above, I've replotted the graph with dashed lines in Q4, and solid lines at Q1.

Update 7pm Pacific 2/1 Here are high frequency plots of the debt series.

Update 8:20am Pacific 2/2. In response to Eric Swanson's remark about using potential GDP, here is the relevant graph.

The signature event of this financial crisis was the "run," "panic," "flight to quality," or whatever you choose to call it, that started in late September of 2008 and receded over the winter. Short-term credit dried up, including the normally straightforward repurchase agreement, inter-bank lending, and commercial paper markets. If that panic had not occurred, it is likely that any economic contraction following the housing bust would have been no worse than the mild 2001 recession that followed the dot-com bust....

Why was there a financial panic? There were two obvious precipitating events: the failure of Lehman Brothers investment bank in the context of the Bear Stearns, Fannie Mae, Freddie Mac and AIG bailouts; and the chaotic days in Washington surrounding the passage of legislation establishing the Troubled Asset Relief Program (TARP).

Why would Lehman's failure cause a panic? Why, after seeing Lehman go to bankruptcy court, would people stop lending to, say, Citigroup, and demand much higher prices for its credit default swaps (insurance against Citi failure)? Nothing technical in the Lehman bankruptcy caused a panic. The usual "systemic" bankruptcy stories did not happen: We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses. Most of Lehman's operations were up and running in days under new owners. Lehman credit default swaps (CDSs) paid off. Sure, there was some mess-- repos in the United Kingdom got stuck in bankruptcy court, some money market funds "broke the buck" and had to borrow from the Fed-- but those issues are easy to fix and they do not explain why Lehman's failure would cause a widespread panic. What is more, Lehman's failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.

We are left with only one plausible explanation for why Lehman's failure could have had such wide-ranging effect: After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were "too big to fail" and would be bailed out. But when the government did not bail out Lehman, and in fact said it lacked the legal authority to do so, everyone reassessed that expectation. "Maybe the government will not, or cannot, bail out Citigroup?" Suddenly, it made perfect sense to run like mad....

Let us go back one step further. Why did Lehman fail-- along with Fannie Mae, Freddie Mac, AIG, Wamu, and very nearly Citigroup and Bank of America? Here is where I part company on the usual worries about bubbles, imbalances, silly mortgages, and so on.

The underlying decline in wealth from the housing bust was not that large.... Most estimates put subprime losses around $400 billion. The stock market absorbs losses like that in days. But it turned out that housing risks are spread very differently from stock market risks.

The difference is that mortgages were held in very fragile financial structures. An extreme example: many mortgages were pooled into securities, and the securities were held in special purpose vehicles (SPVs), funded by rolling over short term commercial paper with an off-the-books credit guarantee from a large bank. Less extreme: when Bear Stearns failed, it was holding a large portfolio of mortgage-backed securities (MBSs) funded at 30-to-1 leverage by overnight debt. In both cases, when the mortgages lose value, the debt-holders refuse to renew their loans and the whole thing blows up. In contrast, when your (and my) pension account loses value, we cannot run for the exits and try to make someone else hold the losses.

John raises a number of interesting points. But I must say that I put more weight than he does on "the usual worries about bubbles, imbalances, silly mortgages, and so on." The problem is not just the fragility of the system in 2008, but the huge flows of capital into these devices in the years leading up to the crisis. U.S. home mortgage debt grew much more quickly than income, with almost $8 trillion in gross new U.S. household mortgage debt issued between 2004 and 2006 alone.

Net U.S. home mortgage debt as a percentage of GDP, 1965-2009. Mortgage data: end of year numbers 1965-2008 and end of third quarter value for 2009, from Federal Reserve Board Flow of Funds, Table L2. Nominal GDP from BEA Table 1.1.5.

A graph of real home prices is remarkable not just for the dramatic descent since 2006 (which began two years before John picks up the story) but moreover for the meteoric rise between 2000 and 2005.

Shiller's real home price index, 1890-2009. Source: Irrational Exuberance, Princeton, 2005, by Robert Shiller.

My view is that there were very serious problems with the U.S. financial system prior to 2008. But I think John has correctly described part of the reason why the failure of Lehman was such an important event.

Rate of growth of real GDP (annual rates), 1947:Q2 to 2009:Q4. Shaded regions represent dates of recessions as declared by NBER.

Three-fifths of that Q4 GDP growth came from the fact that businesses were drawing down inventories more slowly than they had the quarter before. Firms sold $8.5 billion more goods (at a quarterly rate) in 2009:Q4 than they produced, and met those sales by drawing down inventories by $8.5 billion. This reduction in inventories counts as negative investment spending of -$8.5 billion at a quarterly rate (or -$34 B at the annual rate these numbers are typically reported) for purposes of calculating fourth-quarter GDP. Firms sold $34.8 billion more than they produced in 2009:Q3, which amounted to negative inventory investment of -$139 B at an annual rate for Q3. Since this component of investment spending went from -139 to -34, it counts as positive growth when you compare Q3 GDP with Q4 GDP. This mechanism alone contributed 3.4 percentage points to the 5.7% growth rate for real GDP reported for Q4.

To put it another way, if consumers, businesses, foreigners, and the government had all purchased exactly the same quantity of real goods and services in 2009:Q4 as they had in 2009:Q3, more of those sales would have come out of inventory drawdown in Q3 than in Q4, so even without any gain in final sales we would have had to produce more stuff in Q4 than Q3, specifically, 3.4% more stuff at an annual rate. In fact real final sales to consumers, businesses, foreigners, and the government were not stagnant, but grew at a 2.3% annual rate during the fourth quarter, and the two effects combined give us the 5.7% reported GDP growth.

Just because the production gains can be accounted for in terms of slower inventory drawdown doesn't mean they aren't real, and doesn't mean they can't continue. I noted in July that we might expect inventory restocking to add 1.6% to the annual GDP growth rate for each of the first four quarters of the economic recovery, and we haven't even yet begun that inventory restocking process. The question, though, is what we'll see for the other components of GDP. Exports grew more than imports in Q4, with the result that net exports contributed 0.5 percentage points to that 2.3% growth in real final sales. That's certainly a very welcome development and a critical step for correcting the imbalances that have been very troubling over the last decade.

Government spending made no contribution to Q4 growth, which again is a consequence of the algebra of growth rates-- since real government purchases in Q4 were about what they had been in Q3, they made zero contribution to the growth rate, which is based on the change between Q4 and Q3. Fixed investment contributed 0.4 percentage points and consumption 1.4 percentage points to the 2.3% growth in real final sales and to the 5.7% growth in real GDP. Those are better numbers for consumption and fixed investment than we'd been seeing in the first half of the year, but not the sort you'd expect if a normal strong recovery was now fully in play.

The new GDP numbers allow us to update the Econbrowser Recession Indicator Index for the preceding quarter (2009:Q3), which now stands at 37.6%. This is a pattern recognition algorithm for dating business cycle expansions and contractions that waits one quarter for data revisions and clear trend identification before making an assessment. The value of 37.6 means that the preponderance of evidence favors the inference that the recovery began in 2009:Q3. However, the index has not yet crossed the 33% threshold at which, according to our predetermined rule, we would declare the recession to be over. Once the threshold is crossed, we will use the full set of revised data available at that time to assign a most probable date for the beginning of the expansion. If the currently reported 5.7% growth holds up under data revisions, I would expect the algorithm to generate on April 30 a formal declaration that the recovery began with the weak growth of 2009:Q3.

The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date, with 2009:Q3 the last date shown on the graph. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Fed Funds Rate Outlook -- A Taylor Rule Perspective

With U.S. real GDP growth moving back into positive territory in the second half of 2009 following four consecutive quarters of negative growth (see Figure 1), the economic forecasting community appears to be increasingly optimistic about the U.S. economy's growth prospects for 2010-11....

...According to Bloomberg's latest survey of 57 economists (as reported on {ECFC}), the U.S. economy is expected to grow by 2.7% in 2010 and 2.9% in 2011 (see Figure 2). These projections represent a significant rebound from the 2.5% decline expected for 2009.

Indeed, judging by expectations of the future course of U.S. short-term interest rates, the market appears to believe that the U.S. recovery will prove to be stronger than a typical post-crisis recovery. Expectations for higher short-term interest rates are reflected both in the Fed Funds futures market and in the consensus interest-rate projections of leading economists (as reported in Bloomberg's latest {BYFC} survey). As shown in Figure 4, the futures market is pricing in Fed rate hikes that will take the Funds rate to around 0.75% by year-end 2010 and to around 1.00% by February 2011. The forecasting community believes the Fed will be even more aggressive as they expect the Fed to hike the Fed Funds rate to 1.75% by mid-2011.

While it is certainly the case that the Fed will eventually have to push its policy rate higher, there is reason to believe that the policy-rate path predicted in Figure 4 might be overly aggressive. Indeed, as we demonstrate below, the market's projection for Fed rate hikes is not consistent with the path forecasted by conventional Taylor Rule models. If we input the Federal Reserve's forecasts for core inflation and unemployment into a variety of Taylor Rule-type models, we actually end up with a zero or negative Fed Funds rate projected for all of 2010 and, in a number of cases, for 2011 as well.

The futures (red line) and mean forecast of the survey (blue) are depicted in the figure below.

In order to directly evaluate the range of possibilities for the Fed Funds rate, assuming the Fed follows a Taylor rule, Rosenberg considers four variants of the Taylor rule using the Fed's own forecasts of core PCE and unemployment (using Okun's law to convert the output gap to an unemployment gap.

i_Taylor = (r _N + π ^* ) + [ α (π-π^* + β θ (U-U_N)]

where:

(y-y^*) = θ (U-U_N)

and i_Taylor is the target Fed funds rate according to the Taylor rule, r_N is the real natural rate of interest, π is the inflation rate (π ^* is the target inflation rate), U is the unemployment rate (U_N is the natural rate of unemployment). Note that the second equation is Okun's Law (in levels) θ < 0.

• Benchmark, set r_N=2%, π^* = 1.5%, U^* = 5.0%, α = 1.5, β = 0.5, θ=-2.
• Same as benchmark, but set β = 1.0.
• Same as benchmark, but set U^*=6.0%.
• Same as benchmark, but set U^*=6.0% and set β = 1.0.

(I've changed the notation a little from what's in the original article.) As summarized by Rosenberg:

Inputting the Federal Reserve's own forecasts for core PCE inflation and unemployment into Rules 1-4, none of these versions of the Taylor Rule would prescribe a policy rate above zero in 2010. In fact, only Rule 3 would prescribe a Fed Funds rate above zero in 2011, while the other three rules would prescribe a negative Fed Funds rate in 2011. Overall, the simulated policy rate paths suggest that Fed Fund rate hikes are not warranted in 2010, and a case could be made that no rate hikes should be forthcoming through at least the first half of 2011 as well.

The specific implied rates are reported in the table below, while the range of implied rates are delineated by the green lines in Figure 9.

One caveat: even with the variants, this is one specific formulation of the Taylor rule. In particular, it is static in the sense of using only contemporaneous data to generate the implied Fed funds rate, and is not forward looking in the sense of relying on deviations of future forecasted output and inflation. (It also does not incorporate a partial adjustment mechanism in the form of the lagged Fed funds rate.) Finally, the coefficients are imposed and not estimated.

However, I suspect that some of these modifications would not be consequential to the calculation. See for instance the implied values reported by Glenn Rudebusch back in May of last year, using an estimated Taylor rule (once again using contemporaneous values):

Following up this post last week on Lee et al., here is another analysis of consumption behavior, but this one is cross-country. From the abstract to "After the Crisis: Lower Consumption Growth but Narrower Global Imbalances?" by Ashoka Mody and Franziska Ohnsorge:

We estimate consumption dynamics in the G-7 economies, paying particular attention to the possibility of precautionary behavior in the face of uncertainty. We find that in the short run, continued income uncertainty will significantly dampen consumption growth. As such, consumption in the G-7 economies is unlikely to be the engine that revives global growth. Differences in the pace and timing of consumption moderation have implications for the evolution of global imbalances. With the U.S. experiencing a sharper rise in unemployment and, perhaps, more widespread loss of financial wealth than elsewhere in the G-7, the relative rise of the U.S. savings rate is helping narrow global imbalances. But with a likely earlier recovery in the U.S., this narrowing could be short-lived. Moreover, long-term differences -- in economic and financial volatility and in demographic structures --have been an important source of the imbalances and could soon reassert their prominence.

I had pretty much established in my own mind that the Hall finding that consumption follows a random walk didn't apply to the United States [1] [2], but I thought this paper was really interesting because it extended the finding to a broader set of countries.

The authors estimate over the 1984-2007 period:

Δ ln c _i,t = α ₀ + α ₁ c _i,t-1 + α ₂ Δ ln y _i,t + α ₃ Δ UER _i,t + α ₄ V _i,t + ε _i,t

where the dependent variable is the growth rate of real consumption, c is the consumption share of disposable income, Δ ln y is the growth rate of real disposable income, Δ UER is the change in the unemployment rate, and V is a proxy measure for volatility in the macro outlook (based on Carare and Mody's methodology, using the standard deviation of forecast errors form a FSVAR approach to generating expected detrended output).

The authors estimate several variants; in one set of results, these basic variables are augmented with demographic variables.

What are the implications for consumption and imbalances?

...U.S. consumption growth, which as noted has been in the 2-1/2 to 4 percent range for almost two decades, will remain weak. After a shrinking of consumption in 2009, consumption growth is projected at 1-3/4 percent in 2010. Elsewhere also, consumption growth will remain below precrisis levels through 2010. In terms of our model, this immediate weakness is being generated by the rise in unemployment, our assessment that GDP volatility (though reduced from its 2009 levels) will remain high in 2010, and by the destruction of financial wealth.

Writing in the context of the Great Depression, Keynes (1937) was quite clear that consumption was unlikely to lead a recovery. As long as, he argued, consumption bears some relatively stable relationship to income -- and particularly if the share of consumption is falling -- production for consumption that is not accompanied by investment will result in aggregate incomes that produce insufficient effective demand for consumption goods. But investment, he went on to note, was highly sensitive to a deep form of uncertainty. The factors that influence the rate of investment, he concluded, were "most unreliable" since they were "influenced by our views of the future about which we know so little" (p. 221). Thus, at a time when consumers are restrained by the uncertainties and fears that we have discussed in this paper, investors are likely to be all the more reluctant to step forward. Our claim that these processes may be working at the same time in all G-7 countries, though to varying degrees, implies that the synchronization puts a further dampener on the strength of the recovery.

Finally, global imbalances are narrower in 2009 because the U.S. has taken an earlier big hit on unemployment and possibly because more U.S. households held risky financial assets that have caused a more widely spread loss of financial wealth. In the countries on the other side of the global imbalances, the rise in unemployment has been slower due to the domestic structure of employer-employee relationships and public support to maintain employment. While U.S. unemployment is projected to rise further, that rise is expected to be relatively modest compared with the projected unemployment increase, especially in Germany. The German forecasts for consumption growth reflect that anticipated increase in unemployment. As such, if events were to develop in line with the projections, the implication is that the unwinding of the global imbalances could reverse quite quickly in 2010.

This is a careful analysis, so it bears close study. I have a slightly different perspective driven by my focus on the ongoing process of deleveraging going. Deleveraging is occuring in the household sector, but that is in part driven by the forces outlined in the Mody-Ohnsorge paper. But what is not directly included is the tightening up of lending standards, and increases in capital requirements. To the extent that the Mody-Ohnsorge models fit well over the 1984-2007 sample period, perhaps ease of financing is not an important determinant of consumption behavior (or is proxied by financial wealth variables). However, I tend to think otherwise (note -- I don't know how one could incorporate easily this ease-of-financing factor in the regression analysis).

Hence, I think it still possible -- although maybe not probable -- that US consumption growth will remain sufficiently muted to constrain the current account to GDP ratio. (And it's important to realize there is not a one-for-one relationship between consumption and the external balance. [3])

]]> http://www.econbrowser.com/archives/2010/01/g7_consumption.html http://www.econbrowser.com/archives/2010/01/g7_consumption.html deficits Menzie Chinn Wed, 27 Jan 2010 19:50:16 -0800 Here I offer some thoughts on President Obama's new proposal.

The challenge for policymakers is to formulate strategies for fiscal solvency-- what we often call "exit strategies"-- and communicate these strategies to the general public....

First, governments can reform their institutional fiscal framework to make it more likely that fiscal adjustment takes place when the time for action arrives. The precise framework will depend on country-specific circumstances. Possible reform options include fiscal responsibility laws, numerical fiscal rules (to take effect only when conditions normalize), fiscal councils tasked with monitoring fiscal developments, improvements in budgetary procedures, and increased fiscal transparency...

Second, various reforms in health and pension entitlements, though politically not easy, can be undertaken without jeopardizing economic recovery. These reforms will not have a large impact on the today's deficit, but can dramatically improve long-term fiscal trends and signal commitment to fiscal sustainability.

Here is the New York Times' description of the President's new proposal:

President Obama will call for a three-year freeze in spending on many domestic programs, and for increases no greater than inflation after that, an initiative intended to signal his seriousness about cutting the budget deficit, administration officials said Monday.

The officials said the proposal would be a major component both of Mr. Obama's State of the Union address on Wednesday and of the budget he will send to Congress on Monday for the fiscal year that begins in October.

The freeze would cover the agencies and programs for which Congress allocates specific budgets each year, including air traffic control, farm subsidies, education, nutrition and national parks.

But it would exempt security-related budgets for the Pentagon, foreign aid, the Veterans Administration and homeland security, as well as the entitlement programs that make up the biggest and fastest-growing part of the federal budget: Medicare, Medicaid and Social Security.

That sounds like a cosmetic and explicitly short-term approach to the budget problem, and therefore exactly the opposite of what we should be doing. The concern should not be the 2011 deficit, but the deficits in 2015 and beyond. But I see that others have found ways to put this more eloquently, so I outsource to my cyber colleagues:

Brad DeLong: this is a perfect example of the fundamental unseriousness of Barack Obama and his administration: rather than make proposals that will actually tackle the long-term deficit in a serious way-- either through future tax increases triggered by excessive deficits or through future entitlement spending caps triggered by excessive deficits-- he comes up with a proposal that does short-term harm to the economy as an alternative to tackling the deficit in any serious and significant way.

Paul Krugman: It's bad economics, depressing demand when the economy is still suffering from mass unemployment.... It's bad long-run fiscal policy, shifting attention away from the essential need to reform health care and focusing on small change instead.

King Banaian thinks the near-term fiscal contraction will in fact be insignificant:

The president is proposing a partial budget freeze that saves $250 billion over a decade.... That comes out to about 0.6% reduction in spending over a decade, and in the early years about $10-15 billion per year.

But in an update, Brad DeLong opines:

If it really is as small a deal as it now looks, it is not a budgetary and economic disaster-- it is a rhetorical, political, and messaging disaster.

This paper builds a model of two types of Chinese exports, those processed and assembled laregely from imported inputs ("processed" exports) and "non-processed" exports. Based on this model, the sensitivity of Chinese exports to exchange rate changes is empirically examined. Unlike previous work, the estimation period includes the net real appreciation of the renminbi that has occurred over the past three years. The results show that greater exchange rate appreciation dampens export growth, both for non-processed and processed exports, with the estimated cumulative price elasticity being substantially greater than unity. When the source of the increase in the Chinese real exchange rate is appreciations against the currencies of other emerging Asian trading partners, the e¤ect on processing exports is positive but insignificant, while the effect on non-processing exports is significantly negative. By contrast, when the source of the increase in the Chinese real exchange rate is appreciation against China's advanced-economy trading partners, the effects on both types of exports are negative. These results are consistent with the predictions of the theoretical model. Counterfactual simulations based on the estimated model strongly suggest that if the trade-weighted real renminbi had appreciated at an annual rate of 10 percent per quarter since mid-2005, Chinese real exports would have been roughly 30 percent lower today. Thus greater exchange rate flexibility could contribute to lowering China's huge trade surplus through restraining growth of exports.

The paper uses up-to-date data (through 2009Q2), and specifications analogous to those used in Cheung, Chinn and Fujii, but using cumulative FDI as the supply shift variable, and estimated in first differences (in Cheung et al., we use DOLS).

The results indicate that real exchange rate appreciations have contemporaneous and lagged negative e¤ects on real export growth, while foreign consumption growth has positive e¤ects. The growth of the FDI capital stock has first a positive e¤ect and then a small, but significant, negative one later on export growth. The long- run solution of the statistical model, also presented in table 1, shows that a one percentage point increase in the annual rate of appreciation of the real exchange rate would have a cumulative negative effect on real export growth of 1.8 percentage points, which is statistically signi…cant. A one percentage point increase in foreign consumption growth would increase export growth by 5.9 percentage points, which is also statistically signi…cant, and appears to be an implausibly large effect. Also, a 1 percentage point increase in the growth rate of the FDI capital stock raises export growth by a cumulative and statistically significant 0.3 percentage points. This suggests significant supply-side factors at work in the determination of the equilibrium growth rate of exports. All the estimated e¤ects are in line with theory. The estimated model also indicates a large and signi…cant e¤ect on export growth associated with China's entry into WTO.

Regressions based on disaggregated (processing, non-processing) trade are also estimated. Using some of these estimates, the author conducts a simulation, assuming a 10% annualized appreciation in the real effective rate since mid-2005 (to 2009Q2), instead of the actually observed 5.5% rate. This would have meant a RMB 20% stronger than actually observed as of December. Holding all else constant, exports then would take the counterfactual path illustrated in Figure 12.

In contrast to the results in Cheung et al., there is a substantial impact on exports. According to Figure 12, the gap is about 100 billion (2004$), on a quarterly basis. We found a 50 billion (2000$) impact for a 20% revaluation on an annual basis. Using an alternative error correction model, we obtain a somewhat larger 90 billion dollar impact -- but this is still substantially below the estimates Ahmed obtains.