Presented to Local NABE Chapters Feb. 4, 2003Los Angeles Feb. 5, 2003San Francisco Feb. 6, 2003Silicon Valley Implications of Price Stability: Back to.
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Presented to Local NABE Presented to Local NABE ChaptersChapters
Feb. 4, 2003Feb. 4, 2003 Los AngelesLos Angeles
Feb. 5, 2003Feb. 5, 2003 San San FranciscoFrancisco
Feb. 6, 2003Feb. 6, 2003 Silicon Silicon ValleyValley
Implications of Price Implications of Price Stability: Back to the Stability: Back to the 1950s?1950s?
Harvey RosenblumSenior Vice President
and Director of ResearchFederal Reserve Bank of Dallas
Implications of Price Implications of Price Stability: Back to the Stability: Back to the 1950s?1950s?
OverviewOverview
On the brink of price stabilityOn the brink of price stability Deflation possible, but unlikelyDeflation possible, but unlikely Bank profit squeezeBank profit squeeze Changed role for FedChanged role for Fed
First, some definitionsFirst, some definitions
InflationInflation– Generally rising pricesGenerally rising prices
DisinflationDisinflation– Declining inflationDeclining inflation
DeflationDeflation– Generally falling pricesGenerally falling prices
Price stabilityPrice stability– Prices, Prices, on averageon average, neither , neither
rising nor fallingrising nor falling
Consumer price Consumer price inflation: 1950 - 2002inflation: 1950 - 2002
-5
0
5
10
15
'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00
12-mo. % change
Disinflation
PriceStabilityMid-50s
Inflation: Inflation: more recent more recent experienceexperience
0
2
4
6
8
10
12
14
16
1970 1980 1990 2002
12-mo. % change
Disinflation
RisingInflation
Q: Why do the ’80s & ’90s Q: Why do the ’80s & ’90s looklook different from the ’70s? different from the ’70s?A: Monetary policyA: Monetary policy
Microeconomic forcesMicroeconomic forces
Interrelated
GlobalizationGlobalizationNAFTANAFTADeregulationDeregulationImmigrationImmigrationTechnologyTechnologyCompetitionCompetitionProductivityProductivity
Monetary policy Monetary policy dial settingsdial settings 1970s1970s
– EasyEasy– EasierEasier
1980s and ’90s1980s and ’90s– TightTight– TighterTighter– Easy (1991-92 and 2001-02)Easy (1991-92 and 2001-02)
Monetary policyMonetary policydial settings dial settings (cont)
““Paul Volcker and Alan Greenspan Paul Volcker and Alan Greenspan set the real federal funds rate set the real federal funds rate three percentage points higher three percentage points higher than (Fed Chairmen) Arthur Burns than (Fed Chairmen) Arthur Burns and G. William Miller.”and G. William Miller.”
Romer and Romer (2002)Romer and Romer (2002)
Q: Does moneyQ: Does money growth matter? growth matter?
A: Yes, but not in the short-runA: Yes, but not in the short-run– Money growth and inflation closely Money growth and inflation closely
related over an eight- to ten-year related over an eight- to ten-year periodperiod
– BOTTOM LINEBOTTOM LINE: For short-run policy : For short-run policy making, money growth rates difficult making, money growth rates difficult to interpretto interpret
The Phillips CurveThe Phillips Curve
Declining unemployment implies Declining unemployment implies rising inflationary pressures, rising inflationary pressures, other things equalother things equal
The Phillips CurveThe Phillips Curve
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Inflation (percent)
Unemployment rate (percent)
1961-70
The Phillips CurveThe Phillips Curve
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Inflation (percent)
Unemployment rate (percent)
1974-83
1961-70
The Phillips CurveThe Phillips Curve
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Inflation (percent)
Unemployment rate (percent)
1974-83
1984-92
1961-70
The Phillips Curve The Phillips Curve slopes slopes upup in the in the 1990s!1990s!
0
2
4
6
8
10
12
0 2 4 6 8 10 12
Inflation (percent)
Unemployment rate (percent)
1974-83
1993-01
1984-92
1961-70
The Phillips CurveThe Phillips Curve
Declining unemployment implies Declining unemployment implies rising inflationary pressures, rising inflationary pressures, other other things equal things equal
But: But: Other things are never Other things are never equalequal
During the 1990s, microeconomic During the 1990s, microeconomic factors overpowered the factors overpowered the importance of lower unemploymentimportance of lower unemployment
NAFTANAFTA
NAFTA became law in 1994NAFTA became law in 1994– Strengthened investment incentivesStrengthened investment incentives– Gave sense of “permanence” to trade Gave sense of “permanence” to trade
relationshipsrelationships BOTTOM LINE:BOTTOM LINE:
– Encouraged industries to reorganizeEncouraged industries to reorganize Enabled least-cost solutions that include Enabled least-cost solutions that include
MexicoMexico Boosted effective labor forceBoosted effective labor force
NAFTA impacts new NAFTA impacts new vehicle prices?vehicle prices?
-3
-2
-1
0
1
2
3
4
5
1990 1992 1994 1996 1998 2000 2002
New VehicleInflation
12-mo. % changeNAFTA begins
ImmigrationImmigration
New immigrants filled 5 million New immigrants filled 5 million jobs in 1990s jobs in 1990s
Legal immigrants accounted for Legal immigrants accounted for 40 percent labor force growth40 percent labor force growth
BOTTOM LINEBOTTOM LINE: Without : Without immigration, inflation pressures immigration, inflation pressures would have been severe.would have been severe.
DeregulationDeregulation
John Duca’s researchJohn Duca’s research– Deceleration of prices and wages Deceleration of prices and wages
most evident in sectors experiencing most evident in sectors experiencing deregulation and/or increased deregulation and/or increased foreign competitionforeign competition
TechnologyTechnology
““A four-billion-fold increase in the A four-billion-fold increase in the world’s raw automated world’s raw automated computational power in 40 years, computational power in 40 years, an average growth rate of 56 an average growth rate of 56 percent per year.”percent per year.”
DeLong and Summers (2001)DeLong and Summers (2001)
‘‘Nuf saidNuf said
CompetitionCompetition
Pricing power “disappeared” in the Pricing power “disappeared” in the ’90s’90s
Firms adopt new technology Firms adopt new technology because they have because they have NO OTHER NO OTHER CHOICECHOICE
Inflation paradigmInflation paradigmshifted in the ’90sshifted in the ’90s
1970s and early ’80s 1990s
Cost push Cost compression
cost price cost productivity
Pricing power Absence of pricing power
Inelastic labor supply Immigration & virtual
immigration
Adopting technology a choice Adopting technology an
imperative
Regulated oligopoly markets Deregulated,
contestable markets
with globalization
Disinflation Disinflation momentummomentum Might have attained price Might have attained price
stability by 2004stability by 2004
Today’s inflation Today’s inflation tug-of-wartug-of-war
Homeland securityHomeland security Federal deficitsFederal deficits War on two frontsWar on two fronts NationalizationNationalization
– Airport securityAirport security Re-regulation (Patriot Act)Re-regulation (Patriot Act) Globalization stallsGlobalization stalls
– Increased protectionismIncreased protectionism Restricted immigrationRestricted immigration
Post 9-11 inflation forcesPost 9-11 inflation forces
Today’s inflation Today’s inflation tug-of-war tug-of-war (cont)
Monetary policyMonetary policy Microeconomic factorsMicroeconomic factors
– Globalization/NAFTAGlobalization/NAFTA– Demographics/ Demographics/
immigrationimmigration– DeregulationDeregulation– TechnologyTechnology– ProductivityProductivity– CompetitionCompetition
1990s disinflation forces1990s disinflation forces Homeland securityHomeland security Federal deficitsFederal deficits War on two frontsWar on two fronts NationalizationNationalization
– Airport securityAirport security Re-regulation (Patriot Re-regulation (Patriot
Act)Act) Globalization stallsGlobalization stalls
– Increased protectionismIncreased protectionism Restricted immigrationRestricted immigration
Post 9-11 inflation forcesPost 9-11 inflation forces
BOTTOM LINE:1. Price stability postponed2. Deflation on hold
Q: On the brink of Q: On the brink of price price stability? stability? “I don’t know at what point welcome
disinflation might morph into unwelcome deflation. I don’t think we are there yet.”
Pres. Bob McTeer, Dallas FedNABE Annual Meeting, September 2002
A: YesA: Yes
Price stability: Price stability: SignpostsSignposts Mortgage rates in the low 4sMortgage rates in the low 4s Fed changes target Fed funds Fed changes target Fed funds
rate by one-eighth pointrate by one-eighth point Commonly-used inflation indices Commonly-used inflation indices
around 1 percentaround 1 percent Flat and low yield curveFlat and low yield curve
A basic principle of A basic principle of economics and financeeconomics and finance Long-run inflation expectations Long-run inflation expectations
embodied in long-term interest embodied in long-term interest ratesrates
Bond yields follow Bond yields follow inflation, with a laginflation, with a lag
0
2
4
6
8
10
12
14
16
18
62 66 70 74 78 82 86 90 94 98 02
Percent
10-year T-Bond
Inflation
Mortgage rate in low Mortgage rate in low 4s signpost of price 4s signpost of price stabilitystability
2
4
6
8
10
12
14
16
18
20
'50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00
Percent
Price Stability
IFIF the U.S. gets the U.S. getsto price stabilityto price stability Implications forImplications for
– BanksBanks– Money market fundsMoney market funds– The FedThe Fed
A basic principle of A basic principle of economics and financeeconomics and finance Long-run inflation expectations Long-run inflation expectations
embodied in long-term interest embodied in long-term interest ratesrates
What does this meanWhat does this meanfor interest rates?for interest rates?
What does this meanWhat does this meanfor interest rates?for interest rates?
0
2
4
6
8
10
12
14
16
18
1-Year 3-Year 5-Year 10-Year
Percent
Nov 2002Near price stability
What does this meanWhat does this meanfor interest rates?for interest rates?
0
2
4
6
8
10
12
14
16
18
1-Year 3-Year 5-Year 10-Year
Percent
May 1975
Nov 2002
Rising inflation
What does this meanWhat does this meanfor interest rates?for interest rates?
0
2
4
6
8
10
12
14
16
18
1-Year 3-Year 5-Year 10-Year
Percent
Sept 1981
May 1975
Nov 2002
High inflation
with tight monetary policy
What does this meanWhat does this meanfor interest rates?for interest rates?
0
2
4
6
8
10
12
14
16
18
1-Year 3-Year 5-Year 10-Year
Percent
Sept 1981
May 1975
Nov 2002
May 1955Price stability
Back to the 1950s?Back to the 1950s?
Mickey Mantle and Yogi Berra
Bank net interest Bank net interest margins margins
1
1.5
2
2.5
3
3.5
4
1953 1955 1957 1959 1995 1997 1999 2001
Percent ’53-’59 and ’95-’01
Return on assets (ROA)Return on assets (ROA)
0.4
0.6
0.8
1
1.2
1.4
1.6
1953 1955 1957 1959 1995 1997 1999 2001
Percent ’53-’59 and ’95-’01
Return on equity (ROE)Return on equity (ROE)
7
8
9
10
11
12
13
14
1953 1955 1957 1959 1995 1997 1999 2001
Percent ’53-’59 and ’95-’01
0
10
20
30
40
50
60
70
80
1934 1942 1950 1958 1966 1974 1982 1990 1998
Percent
Interest Expense
Salary & Benefits
Percent of total Percent of total expenseexpense
Price stability:Price stability:bottom line for banksbottom line for banks Reduced profitability (in the short-Reduced profitability (in the short-
run)run) Interest expense less importantInterest expense less important Salary/benefit expense control Salary/benefit expense control
more crucial than evermore crucial than ever Add “price-stability risk” to credit Add “price-stability risk” to credit
risk, interest rate risk and other risk, interest rate risk and other critical riskscritical risks
Money innovationsMoney innovations
Money Market Mutual Funds (MMFs)Money Market Mutual Funds (MMFs)– Early 1970sEarly 1970s– Offered by mutual fundsOffered by mutual funds
Money Market Deposit Accounts Money Market Deposit Accounts (MMDAs)(MMDAs)– Early 1980sEarly 1980s– Offered by banksOffered by banks
Over two-fifths of money supplyOver two-fifths of money supply
Money market fundsMoney market fundsa marriage of:a marriage of: RegulationRegulation
– Deposit interest rate ceilingsDeposit interest rate ceilings TechnologyTechnology
– Toll-free telephone numbersToll-free telephone numbers InflationInflation
M2 and its componentsM2 and its components
0
1000
2000
3000
4000
5000
6000
'60 '65 '70 '75 '80 '85 '90 '95 '00
$ billions
currencyFed money
M2 and its componentsM2 and its components
0
1000
2000
3000
4000
5000
6000
'60 '65 '70 '75 '80 '85 '90 '95 '00
$ billions
currency
checking
savings
CDs Old bankmoney
Fed money
M2 and its componentsM2 and its components
0
1000
2000
3000
4000
5000
6000
'60 '65 '70 '75 '80 '85 '90 '95 '00
$ billions
currency
checking
savings
CDs
MMDAs
New bankmoney
Old bankmoney
Fed money
M2 and its componentsM2 and its components
0
1000
2000
3000
4000
5000
6000
'60 '65 '70 '75 '80 '85 '90 '95 '00
$ billions
currency
checking
savings
CDs
MMDAs
MMFs
New bankmoney
Old bankmoney
Mutual fundmoney
Fed money
The Fed has The Fed has outsourced money outsourced money productionproduction
% of M2% of M2
Fed Money:Fed Money: CurrencyCurrency 1111
Bank Money: Bank Money:
CheckingChecking
SavingsSavings
CDsCDs4646
MMDAsMMDAs 2626
Mutual Fund Mutual Fund Money:Money:
MMFsMMFs 1717 43
Implications of Implications of sustained price sustained price stability for MMFsstability for MMFs Money funds shrink when rates Money funds shrink when rates
sinksink Shake-out in MMF industryShake-out in MMF industry Disruption of M2 statisticsDisruption of M2 statistics Disruption of business financeDisruption of business finance
– 32% of MMFs’ assets invested in 32% of MMFs’ assets invested in commercial papercommercial paper
– 45% of outstanding commercial 45% of outstanding commercial paper held by MMFspaper held by MMFs
Implications of Implications of sustained price sustained price stability for the Fedstability for the Fed Fed goal: Fed goal: Maintain Maintain price stabilityprice stability Change rates in smaller Change rates in smaller
incrementsincrements Respond aggressively to potential Respond aggressively to potential
deflationdeflation Fewer headlines for the FedFewer headlines for the Fed
Implications ofImplications ofprice stabilityprice stability
Conclusions Conclusions On the brink of price stabilityOn the brink of price stability Bank profit squeezeBank profit squeeze Mutual funds shake-outMutual funds shake-out Changed role for FedChanged role for Fed
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