Great Survey Paper on the Predictive Ability of the Term Spread

There is new paper by David Wheelock and Mark Wohar of the St. Louis Fed that surveys the literature on the relationship between the Treasury yield curve spread and future economic activity:

Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature
This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions.

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The Equation of Exchange Still Makes Sense

Over at Alphaville, Isabella Kaminska is fretting over what seems to be a breakdown in the equation of exchange:

So what’s wrong with Irving Fisher’s famous MV = PT equation? Why has throwing money at the problem not affected the relationship between money and income in the equation the way it supposedly should?

Drawing on a research note by Standard Chartered, Isabella concludes the answer must be with velocity. Let me reassure Isabella that the equation of exchange still holds and that there is more to story than just velocity. As I showed in an earlier post, the way to see this is to first note that M, the money supply, is the product of the monetary base, B, times the money multiplier, m:

M = Bm.

Now substitute this into the equation of exchange to get the following (I use PY instead of PT ):

BmV = PY

Now we have an identity that says the sources of nominal spending, PY, are the monetary base, the money multiplier, and velocity. Here, V = velocity or the average number of times a unit of money is spent, P = price level, Y = real GDP, and thus, PY = nominal GDP. This accounting identity allows us to think about what causes may have been behind the the dramatic decline in nominal spending, PY. Using MZM as the measure of M and monthly nominal GDP from Macroeconomic Advisers to construct velocity (i.e. V=PY/M), the three series on the left hand side of the expanded equation of exchange are graphed below in levels (click on figure to enlarge):

The last time we saw this figure was in September 2009. I noted then that the surge in the monetary base was largely offset by decline in the money multiplier leaving velocity as the main factor pulling down nominal GDP. This doesn't seem to have changed much, though velocity looks like it has bottomed out. I also noted then that the decline in the money multiplier probably reflects (i) the problems in the banking system that have led to a decline in financial intermediation as well as (ii) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. For the sake of completeness, the below figure graphs the the right-hand side of equation (2):

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Back to 2004

There have been approximately 7.2 million jobs lost--as measured by total nonfarm payrolls--in the United States since the start of the recession in December 2007. This is same number of jobs the U.S economy had back in March 2004. This staggering reversal in employment can be seen in the figure below (click on figure to enlarge):


The total 7.2 million jobs lost can be broken down into the following industries (click on figure to enlarge):


Note that the education and health care industries have actually gained jobs during this time. Finally, it is useful to take a look at the cumulative % change in jobs over time in this recession (click on figure to enlarge):


Interestingly, the natural resource and mining sector continues to grow through the first quarter of 2009 (though the rate of growth flattens and then begins to decline around mid-2008). After that, however, every industry sector other than education and health care either outright declines in employment growth or, in the case of government, slows down. I may be reading too much in the figure, but what I see is that the recession starts off as an Arnold Kling recalculation event but by mid-to-late 2008 it turns into a Scott Sumner aggregate demand collapse.

[Update: I made some edits to the dates]

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Measurement Errors Matter

(1) William Easterly shows how imprecise global economic measures--such as global poverty rates and purchasing power parity adjustments--can be. These very numbers have huge policy implications so we need to get them right. Until we do, though, Easterly cautions us about citing them.

(2) The monetary base does matter after all for macroeconomic activity. Most studies show that monetary aggregates, including the monetary base, have not had a robust short-term relationship with nominal spending, inflation, and the real economy since the early 1980s. In other words, what Friedman and Schwartz found in their classic study seems to have largely disappeared over the past 25 years or so. Several recent studies in prominent journals, however, say not so fast. These studies (e.g. here, here) show that if one looks at the monetary base held in the United States--the "domestic adjusted monetary base"--there is still a robust relationship. One of these studies even shows that Bennet McCallum's nominal income targeting rule could still be an effective policy option if the adjusted domestic monetary base were used.

(2) Bill Woolsey responds to this John Taylor interview on the Taylor Rule by taking a close look at its key components and notes that they imply the federal funds rate "for the entire period shows tremendous volatility. Perhaps the CBO estimate of potential output is off. Or, maybe the GDP deflator is the wrong measure of the price level." I would recommend taking a look at the Laubach and Williams output gap measure (Data here). It improves upon the CBO by allowing the growth rate of potential output to vary dramatically in the short run.

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