What Will the Fed Do?

The U.S Federal Reserve will hold its next two-day meeting this week, on September 16th and 17th. At the conclusion of the meetings, the Fed will announce whether it will raise interest rates (the Federal Funds Rate). The benchmark rate has been near zero (targeted between 0 and 0.25%) since December 2008. This is the Fed's primary tool for achieving its goals. Those goals are mandated by law:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
— https://www.chicagofed.org/publications/speeches/our-dual-mandate

This is commonly called the "dual mandate", to maximize employment while keeping prices stable (i.e. low inflation). Ignoring Hayek's warning of the folly of trying to plan something as complex as the world's largest economy, we can try to anticipate the Fed's action by evaluating how close they are to achieving their mandated goals.

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
— F. A. Hayek

Growth is positive, but is still below the long term average, and thus cannot be said to be up to long term potential. In short, there is room for the Fed to remain accommodating without violating their mandate.

Unemployment is low, and near the long term average, but is still above the low point of recent recoveries. In short, there is room for the Fed to remain accommodating without violating their mandate.

Prices are relatively stable, as inflation is low. Specifically, inflation remains below the Fed's informal inflation target of 2%. Recent data suggests inflation is likely to decline in the near term. In short, prices meet the Fed's definition of stability, and there is room for the Fed to remain accommodating without violating their mandate.

Interest rates, by any measure, remain moderate. There is room for the Fed to remain accommodating without violating their mandate, but there is also room for rates to rise.

This last point, the current level of rates, which appear quite low historically, is the most often cited reason why the Fed should hike rates. Rate hawks are focused on the absolute level of rates. However, in economics, it is usually the marginal impact of a change that matters most. A 0.25% hike in the Fed Funds Rate, would be an effective doubling. The impact on consumer rates would be approximately 8% (.25% on 3.25% Prime rate). That may not seem like much, but it far exceeds the rate of growth, the rate of wage growth, or the rate of productivity gains. The tightness of credit would be significantly impacted by a simple 0.25% rate hike, and this will put significant pressure on consumers and entrepreneurs.

When facing complex decisions, it can be instructive to consider the Outside View. What are other central banks doing?  It turns out the other central banks are all easing credit (lowering rates and expanding or considering quantitative easing). As Charlie Bilello notes, central banks are averaging 7 rate cuts per month so far in 2015. (Here's his eye opening table.)

One key way to try to read the Fed is to think like them. Many of the voting members of the FOMC believe the trade-off between unemployment and inflation as described in the Phillips Curve. With unemployment now back to normal, many Fed members are ready to hike rates to thwart the inflation that the Phillips Curve predicts. Although the Phillips Curve theory is quite flawed, we should be pleased with its failure. Unemployment has declined to a very low level without any resulting troublesome inflation. As Vlad Signorelli at Bretton Woods Research has suggested, the Phillips Curvers at the Fed should declare "mission accomplished" and take a victory lap rather than acting on their dogma.

We shall see on Thursday.


Keep it Real

You may have heard that the NASDAQ stock market index hit a new all-time high yesterday. The index set new records for both the intraday mark and the closing value. For many, this conjures up images of the NASDAQ "bubble" of the late 1990s. Don't be afraid dear reader. Nominal thinking can be quite misleading. If you fear the new highs, perhaps the below chart will calm you down. It plots the NASDAQ in real terms (i.e. priced in ounces of gold) since inception. Nothing to see here. 



On Trend

I have no meaningful opinion on how the stock market will perform in the near future. However, I'm not convinced the market is significantly out of norm on the high side. As the chart below shows, the S&P500 is currently right on it's long-term trend (log scale of SP500 index, scaled to begin at 1.0 on 1/3/1950, +/- one standard deviation)

Emerging Markets Investing

I generally endorse indexing, but there are some obvious problems. It matters how the index is constructed. Here's an example. The financial indexers have grouped several large, unrelated financial markets together and called them "Emerging Markets". Take a look at the last two years. The four major countries, Brazil (EWZ), Russia (RSX), India (PIN), and China (FXI) have very dispersed returns. The index (EEM) is simply the muddle average of these four. (Click for a more dispersed image). Note, other EM index funds are similar to EEM, in this aspect. The issue is that the four major markets are very diverse, and they respond to different macro-economic factors. 

Who Creates New Jobs?

The conventional answer to this question is "small businesses". As we discussed in this podcast, there is a more refined answer. In short, all net job growth can be attributed to new companies. Granted, most new companies start out small, but not all small companies are new. This research is a key insight from the Kauffman Foundation.
Any entity attempting to spur economic development should study the important new details about job creation and destruction released by the U.S. Census Bureau in recent years. The Business Dynamics Statistics have shattered conventional thinking about who creates jobs.  Between 1987 and 2005, startup companies (those which did not exist the prior year) added about 3% annually to the existing job pool.  Over the same time period, total job growth averaged 1.8% per year.  This means all existing companies, grouped as a whole, reduced the number of jobs by 1.2% per year.  Stunningly, all net job growth can be attributed to startup companies.  For example, in 2005 startups added 3.5million net new jobs, but the economy as a whole added only 2.5million net jobs.  As a group, existing businesses lost over 1million jobs that year. 

Here's a letter  I wrote on this topic to my local paper more than three years ago.

Research Dollars

An interesting note related to

this podcast

, is how it began. Dr. May penned

a blog post

arguing for more public funding of research and development. I emailed him to disagree, essentially arguing the US is way down the list on R&D funding but very high on lists of innovation and growth. It lead to a discussion in his office, which lead to my interview. 

In the podcast, I chose to focus more on his college and how they are making future innovators. I purposely chose not to debate public funding in the episode, as I thought the topics we did discuss had broader appeal. However, in the episode, Dr. May mentions that public research has been reduced the past several years (and may now be starting to rebound).  In private conversation with him outside the podcast, I challenged his take. 

I went to the Census.gov site and looked up federal spending on research and spending from the

National Science Foundation

. Here are a few charts from the data (click to see larger image).   

The below chart suggests total R&D spending did dip slightly after 2009.

Basic R&D at universities surged in 2009, then pulled back but remained on trend throughout.

Applied R&D spending also jumped in 2009, then pulled back, but remained on trend throughout.

Below we see that applied R&D at universities surged in the 2000s, so the recent decline is minor.

Lastly, consider the percentage of applied research and total research that flows to universities. 

Oppressive Government


In Durant's The Complete Story of Civilization he recounts a tale from the life of Confucius that marvelously equates voting and migration:
Returning to Lu, Confucius found his native province so disordered with civil strife that he removed to the neighboring state of T'si, accompanied by several of his pupils. Passing through rugged and deserted mountains on their way, they were surprised to find an old woman weeping beside a grave. Confucius sent Tsze-loo to inquire the cause of her grief. "My husband's father" she answered, "was killed here by a tiger, and my husband also, and now my son has met the same fate." When Confucius asked why she persisted in living in so dangerous a place, she replied; "There is no oppressive government here." 
"My children," said Confucius to his students, "remember this. Oppressive government is fiercer than a tiger."

Don't Pay the Teachers, Compensate Them

In complex issues, simplification is common but improper. On the issue of what teachers are paid, it is a gross over-simplification to focus on their salaries. Yet that is all anyone ever talks about. I try to point out this flaw in a recent letter.

Dear Editor:
Friday's MDJ reported on the level of salary for some Cobb County school teachers and compared those salaries to what is offered in other area school districts. Although I have sympathy for the idea we should pay our (Cobb) teachers more, there are three key concepts missing from this discussion.
First, the focus of the discussion centers on salary, instead of total compensation. A proper analysis would measure all the ways a teacher is compensated. This would include other monetary factors such as paid time off, insurance benefits, and, importantly, retirement compensation (pension, insurance, etc). This would also include non-monetary compensation, such as work environment (class size, safety, quality of students, facilities, quality of co-workers and supervisors, opportunities for advancement, etc.). And a proper comparison would take into account the cost of living. Just as a teacher in Wyoming can live an equivalent lifestyle on less compensation than one could accept in metro Atlanta, teachers in Cobb enjoy a lower cost of living than many surrounding areas.
Second, the analysis should include some comparison to other available jobs, not just teaching jobs. Could a recent graduate with an education degree earn more or less in other professions? And if the district's goal is the pay enough to hire the best, shouldn't it pay enough to be competitive with other industries?  Is the goal to hire the best math teacher or the best mathematician; the best science teacher or the best scientist?
Third, it appears the analysis treats all employees at a given level as identical. In many other professions, employers pay varying amounts even to rookie employees based on many factors. Perhaps if the system had flexibility to pay those with better resumes more money, the district could hire better employees without a significant increase in total cost. I understand there maybe collective agreements prohibiting this, but it should be acknowledged these practices are sub-optimal.
Russ Wood
West Cobb


From Jude's essay, Karl Marx Revisited:

It is more than a convenience for modern economists to ignore the role of risk-taking and innovation. The profession's determination to convert Keynesian demand theory into an exact science ran afoul of Princeton mathematician John von Neumann, who in 1936 demonstrated that risk and innovation could not be converted into mathematical equations. To this day, the computers that drive economic policymaking in most of the West cannot handle questions relating to this basic ingredient of entrepreneurial capitalism. Taxation of either business profit or an increase in the value of capital assets (a capital gain) are dealt with in static, linear fashion, as if the risk-taker is largely unaffected by variations in reward.14
In Human Action, Ludwig von Mises's 1949 magnum opus, we find the first connection between confiscatory taxation of risk-taking as an instrument of the bourgeois oligarchs, much as the oligarchs employed the Smoot-Hawley tariff to thwart external competition. We quote at length this fascinating passage:
Confiscatory taxation results in checking economic progress and improvement not only by its effect on capital accumulation. It brings about a general trend toward stagnation and the preservation of business practices which could not last under the competitive conditions of the unhampered market economy...

Every ingenious man is free to start new business projects. He may be poor, his funds may be modest and most of them may be borrowed. But if he fills the wants of consumers in the best and cheapest way, he will succeed by way of "excessive" profits. He ploughs back the greater part of his profits into business, thus making it grow rapidly. It is the activity of such enterprising parvenus that provides the market economy with its "dynamism." These nouveaux riches are the harbingers of economic improvement. Their threatening competition forces the old firms and big corporations either to adjust their conduct to the best possible service of the public or to go out of business.

But today taxes often absorb the greater part of the newcomer's "excessive" profits. He cannot accumulate capital; he cannot expand his own business; he will never become big business and a match for the vested interests. The old firms do not need to fear his competition; they are sheltered by the tax collector. It is true, the income tax prevents them, too, from accumulating any capital. But what is more important for them is that it prevents the dangerous newcomer from accumulating any capital. They are virtually privileged by the tax system...

The interventionists complain that big business is getting too rigid and bureaucratic and that it is no longer possible for competent newcomers to challenge the vested interests of the old rich families. However, as far as their complaints are justified, they complain about things which are merely the result of their own policies. Profits are the driving force of the economy...He who serves the public best, makes the highest profits. In fighting profits governments deliberately sabotage the operation of the market economy.15

While von Mises is viewed by America's intellectual aristocracy as an extreme conservative in his economic views, there is a definite flavor of Marx in this passage. In fact, even though the two are at polar extremes, they merge in their hostility to the politically entrenched vested interests of the Big Business bourgeoisie. If they were alive today, they no doubt would have similar perspectives on the state of the world economy, which is, after all, what this essay is all about.


These are the people {blacks and the poor} who would benefit most by having tax rates and regulations which stand as barriers to new enterprise pushed aside.21 Professor Reuven Brenner of McGill University in Montreal made this point in a paper on taxation prepared early this month for the new government in Ottawa, 'Taxation in General, of Capital Gains In Particular." Brenner argues that a high capital gains tax produces "a static, frozen, stratified society," whereas a "lowered capital gains tax could facilitate increased movement within the distribution."
A tax that prevents or slows down such movement is a far more progressive tax than one which would impose, let us say, a 50 percent marginal tax rate on the rich, and a 10 percent marginal tax on the poor. For when the revenues from the 50 percent tax on the small number of richer people is redistributed among the large number of the poorer, that will not allow any of the poorer to become rich. They become somewhat less poor, but still stay at the bottom of the ladder. In contrast, when there are more chances of obtaining credit with a lowered capital gains tax, the talented poor have greater hopes of moving up, something that progressive taxation, no matter how generous can never give.