Barking up the wrong US data tree

A mentor and friend once gave me some valuable advice: "Some people survey the forest, other people study the trees, but all too many people in this world are content to hug the bark. So, Rich, whatever you do in your career, don't become a bark hugger!”
 
I'll confess that I've been guilty of some "bark hugging” these days as I've tried to forecast and analyse in real time the complex and confusing economic, financial and policy gyrations of the past five years. The questions we often ask are of course worth answering: Will core inflation next month rise 0.2 per cent or is there a risk of 0.3 per cent? Will the dollar depreciate after tonight's Federal Reserve board meeting? Will GDP growth next quarter be 2.1 per cent or 1.9 per cent? But many of us, I suspect, spend much time trying to answer questions like these precisely because they are narrow and have well-defined answers; questions like these satisfy our craving for instant information gratification.
 
However, there is a risk – especially these days when rules of thumb and empirical regularities for understanding the global economy no longer apply – that focusing exclusively on short-run fluctuations is distracting us from the important underlying trends that are all too easily obscured by the ups-and-downs of the daily data flow.
 
It's the levels, stupid

Bank of England Governor Mervyn King said it well recently to an audience preoccupied with daily data downloads, "It's the levels, stupid.” I, too, find it useful as I resist the urge to "hug the bark” and look at the five- to seven-year trends in levels of key economic indicators – not just the monthly or quarterly growth rates. Looking at the trend 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. I now look at three examples – the consumer price index, the US dollar index, which shows the dollar's foreign exchange value, and real GDP. 'Looking at the levels' this way reveals some important insights about the economy, markets and policy that would otherwise be obscured.
 
Looking at the price level

Forecasters and the financial press are all so focused on monthly inflation data – the rate of change in the CPI – and whether or not a central bank is hitting its inflation target that month that they often lose sight of the big issue: What is happening to the price level? This is important because even for an economy with a credible inflation-targeting central bank that is aiming for say, a 2 per cent inflation rate, the price level can wander away permanently from a trend path implied by the inflation target. This is because for inflation-targeting central banks, bygones are bygones. For example, an adverse supply shock that pushes up inflation and thus the price level is met with a policy that pushes inflation back down to – but not below – the target, thus accommodating a permanent increase in the price level.
 

 
 
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 per cent, which works out to an average annual inflation rate of 2.3 per cent. Had the Fed achieved exactly 2 per cent headline inflation each month since March 2006, the price level would be 13 per cent higher today, not 14.7 per cent, so there has indeed been a cost of missing – even by a small amount each year – the goal of 2 per cent 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 cent per year since then. But what about Fed policy since the failure of Lehman in September 2008: the money printing, quantitative easing and Operation Twist that followed? Surely, inflation must have skyrocketed? No, in fact since Lehman, inflation has averaged only 1.4 per cent 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.


 
Looking at the US dollar

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 cent 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, 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 US 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 US 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 US 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 favourable.

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 US fiscal balance are enormous. But that is a subject for a future article.

Richard Clarida is an executive vice president in PIMCO's New York office and PIMCO's global strategic advisor Pimco. © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.