Rather than revise my approach further, I’m going to post a working version of how I propose to estimate market NGDP expectations.
Here is what I have in mind
Take a vector
Representing the price of a set of assets. I propose that this set of assets is strongly correlated with the market’s implicit outlook on U.S. nominal GDP. This is not necessarily a perfect data set, we can imagine that events in East Asia or Europe could steer any single one of these prices for an extended period. Ideally, we’d also have an inflation indexed bond spread, though in this case, this would hinder the analysis as TIPS have only traded since 2003. We might also include a safe private sector bond index.
Take the first and second principal components of for t spanning 1989 to 2012, quarterly frequency. These components might contain much of the market’s near-term outlook, distilled into an index of meaningless scale.
I’ve not labeled the graphs, the black line is the first PC, the red line is the second.
Next, model these components along with lagged nominal GDP in the vector ,using a selection of potential VAR models. We might not be able to say, with any credibility, what the components actually mean, but we can try to forecast nominal GDP with them.
Call these models: . In this example I look at a ‘vector error correction model’ on three lags of using only the first principal component, four lags using only the first, and three lags using both components.
Fit these models to data sequentially, covering period 1 (1989Q1) to as little as 40 (1998Q1) or as much as 97 (2012Q4).
At first, fit model to date index positions 1 to 40, forecast NGDP with this model for period 41 through 45 (remembering that NGDP is lagged one period relative to the market components). Save the percent change in NGDP for periods t+1 to t+5, in the 57×1 vector
Repeat this process over the dataset, in essence simulating the result a forecaster would have had in each quarter of the data set after position 40 (the amount of data needed to give the model a moderately good fit).
Here are the resulting s from three s
That is run off quarterly averages. This looks about right to me, as far as the deviations from 5% approximating the effective stance of policy. Here is the system run at quasi daily frequency, the choppiness of NGDP data make this cumbersome.
You could think of lots of different ways to make the models somehow account for the fact that the principal components are probably distorted by international factors, or otherwise not reliably related to NGDP expectations.
I suggest setting up some sort of Bayesian model averaging or combination system, on a wide set of potential models. That, would be an undertaking.
On and BTW: Link to the quarterly NGDP expectations here.
It is hard to overstate how important Thatcher was in turning back the worst elements of the Western mixed economy. She saved Britain from itself, at least for a time, and was right about the Euro. Rest in peace.
I liken the ’87 crash to that sequence in Pulp Fiction where John Travolta accidentally shoots the man sitting in the back of Samuel L. Jackson’s car. Stick with me. The mistaken shot is the stock market crash (or maybe the rally before the crash), and Travolta and Jackson are the financial market participants. The two frantically seek shelter in Quentin Tarantino’s house, uncertain of how the situation can be resolved. They call Ving Rhames (representing Alan Greenspan) in a panic. Greenspan calmly answers by sending Harvey Keitel (monetary easing) and all is well…at least for a while.
This (not safe for work) clip from the film is at least what came to my mind when a macro professor explained the ’87 crash to me some years ago. Everyone freaked, Greenspan said he was on the problem, cut rates, and “confidence” was maintained. When people speak of financial market confidence, they really mean the implicit NGDP forecast hidden in market prices.
In January I posted about a method I was toying with for estimating the market’s underlying NGDP forecast. I have some results, and will post something soon. But before that, I’d like to share some principal component graphs I’ve made along the way, which support the Mr.Wolf interpretation of October 1987. You can click the graphs below for a closer look.
To start, lets look at the first principal component from: the ten year Treasury yield and logs of the S&P 500, West Texas Intermediate month ahead futures, the major currencies, trade weighted dollar index, and three month copper futures. These are somewhat arbitrarily chosen, just what I was able to get back to ’86 without hassling my Datastream source too much. The component was calculated from mid 1986 to early 2013, though in this first graph I focus on the ’87 crash. If you are new to principal components, think of this series as a sort of multidimensional midpoint of the five series, the scale has no meaning.
I’ve proposed that principal components like this are proportional to expected NGDP in some way. In the next post we’ll see that lagged values of these components are strongly correlated with NGDP. If the component really is a proxy for NGDP expectations (the true stance of monetary policy in the Market Monetarist model), then it would seem that expected NGDP certainly dipped abruptly on Black Monday, but not catastrophically so. Put simply, the ’87 crash didn’t much shake NGDP expectations.
Now let’s look at the market prices themselves. I’ll show fewer days of trading in these plots, because it becomes too messy to get a clear read on October ’87 if I show as much as I did in the graph above. Also, note that the dates are in YYYY-MM-DD format for these plots.
If you read Sumner in 2010, you’ll quickly see the difference between ’87 and ’08/’09.
This graph of 20 day log differences shows us that oil traders were unimpressed with the stock market collapse. Oil prices didn’t fall until weeks later when stocks were rallying. Copper prices plunged on black Monday (that abrupt drop just before the 1987-10-26 date marker), but quickly rallied thereafter.
Next, the S&P 500 index along with the U.S. dollar index:
This is a fascinating graph. The dollar strengthened on Black Monday, but then quickly weakened as monetary policy eased. I had to double check the figures; I couldn’t believe the dollar fell 10% in a quarter, but it happened. This is the opposite of what we saw in late 2008 when the dollar soared.
The last constituent of the component is the five year yield:
The 5 year yield shot up before the crash, plunged back to August 1987 levels on Black Monday and then held steady for the rest of the year.
Lastly, here is a plot of the component in 2008-2009. This really needs to be mapped to an NGDP forecast to easily interpret (next post) but still gives a rough sense of how different the two market crashes were.
We already knew that market NGDP expectations held up in ’87 and plunged in 2008/2009. I view this more as a test of the principal component approach. This doesn’t mean the component is really mirroring NGDP expectations, but if I’d seen a sustained drop in the component after Black Monday, it would be back to the proverbial drawing board. Failure to reject is something.
Seems reality is too real for some folks. The authorities have shutdown Intrade.
This as a big step back, but not so surprising. As Hugh Hendry has said, governments can’t stand markets, because markets deal in the truth, no matter how unpalatable it may be. The market is like a physician who won’t sugarcoat your diagnosis.
The need to evade overreach by government is growing more acute. Seasteading, or buyout of Kaliningrad. We need a place innovators can flee to. ”Exit not voice”.
I’m not too worried about this fiscal cliff. My guess is that it won’t even lead to a recession, if we do ‘go over’, but rather a marked slowing in RGDP for a quarter or so. I think the economy would look as it did before QEII.
In a situation like this, the thing to do is to look at the markets to get a sense of what they foresee. However reading markets is not so straightforward in this situation. Unlike monetary policy, which is more or less neutral in its impact on the composition of aggregate demand (where the ‘money goes first’), fiscal policy is by definition nonneutral. If the government cuts the military’s equipment budget, then military contractors stand to lose more than others.
Because it is big corporations which stand to lose the most (or if you are an anoying libertarian, ‘their shareholders’) from the fiscal cliff, the stockmarket might be a less useful forecasting tool than bond yields or commodity prices. At least if your reference index is dominated by government-linked corporations.
Oil prices and bond yields don’t look like they are discounting a recession. Oil prices (West texas intermediate) have held in the mid to high $80s while TIPS spreads and bond yields have been fairly steady. As of Friday afternoon, December 28 WTI front month contracts were trading around $90 and the ten year bond yield is at 1.71%.
If we would say that there is a 40% chance of taking on the full fiscal cliff, and that markets are already discounting this, I would say that the full fiscal cliff would not have the sort of disasterous consequences some fear. At least this is what the markets say to me.
Some regions would be hard-hit, but the recovery would survive.
If you are an American citizen, and plan to vote tomorrow, I urge you to vote for Gary Johnson, Libertarian Party candidate for president.
Although I don’t agree with Johnson on everything (I’m a bit of a Malthusian), I do think that he is the best choice.
As I see it; a vote for Johnson tells the two big parties that Americans want more freedom, faster economic growth and less foreign intervention.
For folks on the left, It tells politicians that that you don’t want the NSA spying on innocent citizens and that you aren’t thrilled with the Orwellian NDAA. It says “I’m an adult and should be allowed to use or not use nonaddictive plants, with no reachable lethal dose”. For social conservatives, it is a loud and clear way to vent your anger at the overreaching blue states who impose their morality the on Christian-conservative parts of the country. For capitalists like myself, its a vote for faster growth, more technology, higher stock prices and private missions to Mars. In a country as big and diverse as America, the optimal framework is one which leaves a lot of decisions to local governments and local conditions, this is just what a more libertarian minded approach would give us.
If you live in a strongly Red or strongly Blue state, why not vote for Johnson? Remember, you’re vote doesn’t count unless you live in one of the 7 or 8 swing states.
If you are in a swing state, things get more complex, but you can still vote for Johnson without throwing your vote to whomever you hold to be the greater evil. Here is what I plan to do, because I vote in Pennsylvania this year, a state which matters.
As I would like to vote for Johnson, but do prefer one of the two main candidates, I am making an agreement with a friend who likes the Johnson ticket but ultimately prefers the other viable candidate. We both swear to vote for Johnson, thereby offsetting the impact of our votes on the eventual outcome. I urge swing state readers to do this if you can arrange it by tomorrow night.
A leading reason I question the Keynesian fear of rapid government spending cuts, is that there are lots of quasi-exogenous downshifts in GDP components that don’t lead to recession, at least when you have your own central bank, or dominate the ECB (Germany). For example, the great recession undercut exports in (nearly?) all countries, but [edit:the drop in exports] had no predictable impact on NGDP and thus the business cycle. This suggests that some other force was steering NGDP (could it be monetary policy?) and as a result, that the U.S. might be able to print its way through the fiscal cliff if need be. After all, when we are talking about the ‘output gap’, a drop in spending is a drop in spending, be it from the lost wages of a laid off worker in an export industry or government.
Take a look at this graph:
The graph shows the share of exports in nominal GDP for a selection of economies which held up well (Australia, Poland and Israel) in the great recession or at least recovered quickly thereafter (Germany, Sweden). It is striking that exports never recovered to the prerecession share of NGDP in Israel and Australia, countries which did not even go into recession in 2008-2009. This means that the economy was able to shift quickly from exports to domestic consumption, presumably because the central banks were essentially level targeting. Given that Australia was mostly exporting commodities, and Israel, a set of diverse high tech goods (if memory serves), it seems unlikely that exporters simply began selling to the domestic market. Rather, other industries picked up the slack.
This ‘real shock’ aspect of an export collapse makes me even more confident that the economy can easily handle a rapid fiscal tightening. A drop in export demand is a real shock, you lose part of your ability to realize comparative advantage. If the iron ore market tanks, then Australia can’t just ramp up production at the Vegemite factory and quickly make an equivalently valuable quantity of output (this sentence shows how tenuous real output measures are). However, if you layoff government funded nurses and weapons engineers (the as the U.S. may do soon), they can easily get jobs in the private sector, so long as the Fed level targets NGDP, keeps the flow of economy-wide spending rising at a steady rate.
In all likelihood, the fiscal cliff would lead to a marked slowing in NGDP growth, and maybe even a short recession, given the timidity the Fed has showed us these last 4 years. So we are back to asking congress to play the role of AD manager.
I was tearing through twisty country roads today, listening to the Joe Rogan Experience podcast. Joe’s latest guest is the reporter Amber Lyon. Lyon is quasi well known for showing the world some of the shady things CNN was doing to hide the ends the Bahrain government is taking to quell the insurrection. I found myself disagreeing with many of the conversation threads but was struck by an idea the guest put forward.
Lyon said that reporters shouldn’t vote. Not so much because the system is rotten, but because then the reporter has a ‘dog in the fight’ and cannot be objective. This sounds wise to me, and leads me to wonder: why should it not also hold for economists? We would like to think we are perfectly mailable, able to compartmentalize our lives. I don’t think that is how humans work though. We are animals after all; programed by evolution to choose sides, to be in a tribe. So perhaps economic practitioners who write for the public or teach—sell themselves as objective—should stop voting.
I’m glad that I haven’t shown y’all the negative posts I’ve written and not published in recent months, because QEIII makes me super stoked. More stoked than I have been since nearly getting a job with an enzyme maker. QEIII is going to put hair on the economy’s chest and I want to be long equities and out of treasuries and that boring old dollar.
In general, I believe that a loose form of the efficient markets hypothesis holds, and that policy makers shouldn’t try and out guess traders. This said, markets are at least briefly inefficient (someone needs to trade them to efficiency after all) and I think that today was a great buying opportunity. I personally went from 100% USD on Monday to 50% long certain companies on Wednesday, before going 100% long after learning that QEIII would be open ended.
Open endedness is the key and I think market’s probably underreacted to the statement. If QE becomes like a new Fed Funds rate, then we could be back to 5-6% NGDP growth for a while and the economy could turn heads in the speed of its recovery. This is of course a big if, and I will pay to express by bullish view in the markets. Can’t wait to see what happens in coming weeks.
Also, it goes without saying that you should check out Lars and Scott today for their insightful readings. I look forward to the responses of other market monetarists over the weekend, though I generally dread reading the interpretations of the “push down long rates !!!” crowd. Monetary policy is not about interest rates.
P.S. Here are some plots which show the awesome power of monetary policy