By Richard Clarida
July 9, 2012
- Craving instant information gratification, many of us spend much time trying to forecast and analyze short-term changes in economic data.
- Looking at the trends in the levels of economic data over a period of five to seven years provides refreshing insight and perspective on the economy that are often distorted by the daily data noise.
- Specifically, trends in the Consumer Price Index, the U.S. Dollar Index and real GDP reveal important insights about the economy, markets and policy.
What is the Fed’s price level record under Chairman Ben Bernanke? Figure 1 shows the level of headline CPI.
Since Bernanke’s first meeting as Fed chairman in March 2006, the cumulative increase in the price level has been 14.7%, which works out to an average annual inflation rate of 2.3%. Had the Fed achieved exactly 2% headline inflation each month since March 2006, the price level would be 13% higher today, not 14.7%, so there has indeed been a cost of missing – even by a small amount each year – the goal of 2% headline inflation. But, you ask, surely since September 2007 when the Fed first cut the federal funds rate and embarked on what has been almost five years of easy money, inflation has been much higher? No, it has actually been lower at 2.1% per year since then. But what about Fed policy since the failure of Lehman in September 2008: the money printing, quantitative easing (QE) and Operation Twist that followed? Surely, inflation must have skyrocketed? No, in fact since Lehman, inflation has averaged only 1.4% per year. So say what you will about Fed policy these last five years, it has been many things but it has not led to runaway inflation. Nor, importantly, has it been deflationary.
Quiz: By how much has the dollar plummeted since September 2007 when the financial crisis began, the Fed started to ease rates and then balloon its balance sheet through quantitative easing and the economy began to slide into deep recession followed by a disappointing recovery? Answer: It hasn’t! Indeed, depending on which index you look at, the dollar has either appreciated slightly (as the DXY Index shows in Figure 2) or has depreciated only very modestly. For example, the Fed’s broad trade-weighted dollar index shows the dollar down less than 1% per year.
How can this be? With the policy rate cut to zero and the Fed printing (high-powered) money and tripling the size of its balance sheet, surely the dollar must have plummeted? Well it hasn’t, and here are two reasons. First, as discussed in several previous Global Perspectives, currency values everywhere and always reflect relative valuations. Yes, it’s true that the economy has been weak and the Fed has slashed interest rates and ballooned its balance sheet, but so have the European Central Bank, the Bank of England and the Bank of Japan, which have also confronted weak economies. With all the world’s central banks pursuing similar policies, the net impact on the dollar on average has been modest. Second, the timing of the Fed’s QE and Twist operations, which have tended to weaken the dollar for some time, as Figure 2 shows, has of course not been random. Rather, the Fed has pursued these operations when the economy was weakening, market anxiety was elevated (by Lehman in 2008 and by the eurozone crisis in 2010 and 2011), and the resulting flight-to-quality capital inflow to the U.S. had bid up the dollar. So say what you will about the dollar these past five years, it has been volatile but overall, it’s also been flat.
Looking at GDP
“The worst economy since the Great Depression:” How many times have we read this phrase? Well, it’s true but also misleading.
Instead of focusing on the Great Depression, we should compare the U.S. economy to previous postwar business cycles. Figure 3 presents these comparisons.
Two things stand out when we look at the level of GDP across these
different episodes. First, the current recovery is indeed the weakest in
postwar U.S. history, with the level of GDP just slightly above its
pre-crisis peak and well below its pre-crisis trend path. Second, if the
experience of other crisis/recession episodes is any guide – and I
think it is – the prospects for a return to the pre-crisis trend path
are not favorable.
So the next time GDP growth surprises on the upside, even by a lot, be thankful but don’t be relieved. We will need a number of such upside surprises to growth in the years to come for the economy to return to its pre-crisis trend path in GDP. And if GDP doesn’t return to its pre-crisis trend path, the implications for living standards and the U.S. fiscal balance are enormous. But that is a subject for a future installment.