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Fed of 1970s shows capacity clues may mislead

Bank of England, London
Bank of England, London

The decision of central banks to focus more on economic slack as a barometer of when inflation will become a problem could backfire, if history is any guide.

The Federal Reserve, Bank of England and European Central Bank have started using the level of spare capacity in their economies as a way to foretell when they will start reversing easy monetary policies.

The more capacity, the bigger the output gap between actual and potential economic growth and the longer officials can keep interest rates low because price pressures will be sluggish.

“While this sounds plausible, past experience suggests that central banks tend to hike rates too slowly, with corresponding risks for price inflation,” Christoph Balz and Bernd Weidensteiner, economists at Commerzbank AG in Frankfurt, said in a March 21 report.

The problem is that output gaps are hard to estimate and better done in hindsight.

To demonstrate that, the Commerzbank economists looked at what the Fed would have estimated for the output gap in the early 1970s, given the data they had available from the prior three decades.

The initial impression was of an output gap of minus 1 percent for 1974, which would have encouraged the U.S. central bank to be “moderately expansionary,” said Balz and Weidensteiner.

In reality, the economy was later shown to have been slightly over-stretched in 1974.

Repeating the exercise for 1983, the output gap the Fed would have calculated at the time was minus 1 percent, versus the minus 4 percent it proved to be.

“In other words, a more restrictive policy would have been appropriate in 1974, but in 1983 a more expansionary policy was required,” said Commerzbank. “This demonstrates the uncertainty prevailing when monetary policy conclusions are drawn from the current data set.”

With the Fed’s new lines of communication aimed at damping expectations of rate hikes, the risk is the Fed “will again probably raise rates too late and too cautiously,” said the economists. This time the “greater danger” may be that loose monetary policy fans inflation in asset prices.

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Sovereign ratings are often out of kilter with economic fundamentals, undermining the ability of ratings companies to monitor the $50 trillion of outstanding public debt, according to UniCredit SpA.

In a study of the ratings of Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, UniCredit economists led by Erik F. Nielsen said economies in Europe’s so-called periphery, such as Portugal and Spain, are rated on average five levels below what their economic performances suggest.

Brazil, India, Indonesia, Turkey and South Africa -- the so-called fragile five emerging markets -- are rated on average almost two levels higher then the underlying economic conditions imply.

“History is littered with countries being over- and under- rated by the ratings agencies with -- at times -- dramatic consequences,” Nielsen and colleagues wrote in the March 26 report.

The economists suggested credit rating companies be forced to increase transparency and better explain their decisions.

The global financial crisis may not have killed off the Great Moderation.

From 1984 to 2007, volatility in consumption, investment and economic growth fell across the developed world, leading to suggestions that boom-bust cycles were a thing of the past, Goldman Sachs Group Inc. economists Charlie Himmelberg and Julian Richers said in a March 26 report.

The crisis and subsequent global recession upended that theory, but the Goldman economists suggest the world has perhaps already returned to calmer times.

They note that swings in U.S. private-sector employment growth over the past three years are already at their lowest in more than 50 years.

Economies also are showing signs of shifting toward less-cyclical sectors, such as services, and away from manufacturing.

“We suspect that, more likely than not, the Great Moderation is back,” said Himmelberg and Richers, adding that clampdowns by regulators may reduce access to the credit that can drive volatility.

The environment should support more risky investments, especially in corporate debt and equities, the economists said.

The threat is that low volatility may lull investors into a false sense of security, leading them to take on excess risk.

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Democratization of a country increases its economic output by about 20 percent in 30 years, according to a study co-authored by the writers of “Why Nations Fail: The Origins of Power, Prosperity and Poverty.”

Democracy encourages economic reform, increases human capital investment such as primary schooling, raises the capacity of public services like health care and reduces social unrest, according to the study’s authors, who included Daron Acemoglu of Massachusetts Institute of Technology and James A. Robinson of Harvard University. Both are in Cambridge, Mass.

“We find little support for the view that democracy is a constraint on economic growth for less developed countries,” they said in the report, published this week by the National Bureau of Economic Research.

The study is a rejoinder to economists such as Harvard University professor Robert Barro, who argued in 1997 that “democracy is not the key to economic growth.”

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Workers are staying in the labor market longer in the U.S. and U.K. to make up for lost incomes.

An index constructed by Fathom Consulting, a London-based economics company run by former Bank of England economists, shows inflation-adjusted annuity income is still below the levels of 2000.

Annuity income is the income life-insurance companies pay out as a form of financial protection and so serves as a proxy for retirement income.

Since 2000, the participation rate of those older than 55 years has risen about eight percentage points in the U.S., while the rate of those over 50 years has climbed six points in the U.K.

Fathom noted the potential income of retirees has already been hit in the past 14 years by the Internet stock crash and then the global financial crisis, which led to low interest rates and falling housing prices.

The study also found the U.K. labor force participation rate is higher than that of the U.S. for the first time since the 1970s. This leaves Fed policy makers more time before they need to tighten monetary policy, according to the study.

Indian women who have more education or income than their husbands have a higher likelihood of experiencing domestic violence than other females.

So says a study published this week by Abigail Weitzman, a graduate student at New York University.

Using India’s National Family Health Survey, which was conducted between 2005 and 2006, she found women with more education faced 1.4 times the risk of being violated by their intimate partner and 1.54 times the threat of frequent violence.

Women who were the sole breadwinners faced 2.44 times the risk of frequent violence than unemployed women.

Weitzman suggested programs that encourage women to work, such as by providing microfinance, should also consider offering legal and psychological counseling.

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The mispricing of bets on tennis players at Wimbledon exposes the limitation of humans in processing information.

That’s the result of a study of wagers taken by Betfair Group Plc before and during men’s singles games at Wimbledon in 2011 and 2012 by Alasdair Brown, a professor at the University of East Anglia.

Focusing on the differences in probability implied by the markets for match wins and those for set victories, he found bets are often mispriced once the game has begun because people struggle to process large amounts of information under time pressure.

The level of mispricing is 10 times greater when information is arriving compared with periods when there is no developing information, such as before a tennis match. The finding suggests to Brown that constraints on the ability of people to process information leads to the mispricing of assets.

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