For serious macroeconomists, the magnitude (or existence) of the output gap is a central factor for determining the appropriate policy actions (see for instance Weidner and Williams). In several recent posts, I've discussed the variety of approaches to estimating the output gap [0] [1]. A recent symposium on Projecting Potential Growth published by the Federal Reserve Bank of St. Louis is an excellent resource for anybody who wants to think seriously and carefully about the challenges in estimating this variable. In the lead article entitled "What Do We Know (And Not Know) About Potential Output?", the authors John Fernald and Susanto Basu write:

To keep the discussion manageable, we confine our discussion of potential output to neoclassical growth models with exogenous technical progress in the short and the long run; we also focus exclusively on the United States. We make two main points. First, in both the short and the long run, rapid technological change in producing equipment investment goods is important. This rapid change in the production technology for investment goods implies that the two-sector neoclassical model -- where one sector produces investment goods and the other produces consumption goods -- provides a better benchmark for measuring potential output than the one-sector growth model. Second, in the short run, the measure of potential output that matters for policymakers is likely to fluctuate substantially over time. Neither macroeconomic theory nor existing empirical evidence suggests that potential output is a smooth series. Policymakers, however, often appear to assume that, even in the short run, potential output is well approximated by a smooth trend. Our model and empirical work corroborate these two points and provide a framework to discuss other aspects of what we know, and do not know, about potential output.

It's important to understand that potential GDP as discussed by Fernald and Basu is not "a 'forecast' for output and its growth rate in the longer run (say, 10 years out)" which they refer to as a 'steady-state measure'..." -- this is the concept that conforms better with the CBO and OECD estimates of potential. For Fernald and Basu, and most of the others who work in this area...

[p]otential output is the rate of output the economy would have if there were no nominal rigidities but all other (real) frictions and shocks remained unchanged. In a flexible price real business cycle model, where prices adjust instantaneously, potential output is equivalent to actual, equilibrium output.

That last sentence clearly and simply explains why economists steeped in the RBC tradition eschew any macrostabilization policy. It's simply not necessary (see [2], [3]).

I do have a minor quibble here; in many New Keynesian models, monopolistically competitive behavior characterizes either or both product and factor markets. One could define output in the absence of nominal rigidities as that "natural output" and output in the absence of nominal rigidities and departures from competitive markets as "potential output". This is the terminology used in for instance Edge et al. (2007) and Justiniano and Primiceri (2008) (the latter discussed in this post). But one is free to define terms as one desires, as long as terms are clearly defined, and in any event, the "competitive markets" case is not typically considered in these types of exercises.

Fernald and Basu argue that a two sector model (incorporating differential rates of productivity growth for the consumption and investment goods producing sectors) with only technology shocks leads to a better fitting model of output than a single sector model. The main point here is not that technology shocks are the only important type of shocks perturbing the economy (although they argue they are the most important); rather their point is that allowing for two sectors and differential productivity growth can alter one's view about the evolution of the potential GDP, and hence of the output gap. In their DSGE, potential output is more variable than that obtained using a single sector model (closely related to the CBO and OECD production function approaches). Hence, the resulting implied output gaps exhibit smaller variability.

Implications of the crisis and recession

What about the practical concerns of where potential (or "natural") GDP is going? Fernald and Basu provide an extremely useful overview of some of the arguments -- some of which will be familiar to Econbrowser readers -- that potential GDP will move in a substantially altered trajectory in the wake of this crisis. Writing at the end of 2008:

Several arguments suggest that potential output growth might currently be running at a relatively rapid pace. First, and perhaps most importantly, TFP growth has been relatively rapid from the end of 2006 through the third quarter of 2008 (see Table 2). During this period output growth itself was relatively weak, and hours per worker were generally falling; hence, following the logic in Basu, Fernald, and Kimball (2006), factor utilization appears to have been falling as well. As a result, in both the consumption and the investment sectors, utilization-adjusted TFP (from Fernald, 2008) has grown at a more rapid pace than its post-1995 average. This fast pace has occurred despite the reallocations of resources away from housing and finance and the high level of financial stress.

Second, substantial declines in wealth are likely to increase desired labor supply. Most obviously, housing wealth has fallen and stock market values have plunged; but tax and expenditure policies aimed at stabilizing the economy could also suggest a higher present value of taxes. Declining wealth has a direct, positive effect on labor supply. In addition, as the logic of Campbell and Hercowitz (2006) would imply, rising financial stress could lead to increases in labor supply as workers need to acquire larger down payments for purchases of consumer durables. And if there is habit persistence in consumption, workers might also seek, at least temporarily, to work more hours to smooth the effects of shocks to gasoline and food prices.

Nevertheless, there are also reasons to be concerned that potential output growth is currently lower than its pace over the past decade or so. First, Phelps (2008) raises the possibility that because of a sectoral shift away from housing related activities and finance, potential output growth is temporarily low and the natural rate of unemployment is temporarily high. Although qualitatively suggestive, it is unclear that the sectoral shifts argument is quantitatively important. For example, Valletta and Cleary (2008) look at the (weighted) dispersion of employment growth across industries, a measure used by Lilien (1982). They find that as of the third quarter of 2008, "the degree of sectoral reallocation…remains low relative to past economic downturns." Valletta and Cleary (2008) also consider job vacancy data, which Abraham and Katz (1986) suggest could help distinguish between sectoral shifts and pure cyclical increases in unemployment and employment dispersion. The basic logic is that in a sectoral shifts story, expanding firms should have high vacancies that partially or completely offset the low vacancies in contracting firms. Valletta and Cleary find that the vacancy rate has been steadily falling since late 2006.

Third, Bloom (2008) argues that uncertainty shocks are likely to lead to a sharp decline in output. As he puts it, there has been "a huge surge in uncertainty that is generating a rapid slow-down in activity, a collapse of banking preventing many of the few remaining firms and consumers that want to invest from doing so, and a shift in the political landscape locking in the damage through protectionism and anti-competitive policies" (p. 4). His argument is based on the model simulations in Bloom (2007), in which an increase in macro uncertainty causes firms to temporarily pause investment and hiring. In his model, productivity growth also falls temporarily because of reduced reallocation from lower to higher productivity establishments.

Fourth, the credit freeze could directly reduce productivity-improving reallocations, along the lines suggested by Bloom (2007), as well as Eisfeldt and Rampini (2006). Eisfeldt and Rampini argue that, empirically, capital reallocation is procyclical, whereas the benefits (reflecting cross-sectional dispersion of marginal products) are dountercyclical. These observations suggest that the informational and contractual frictions, including financing constraints, are higher in recessions. The situation as of late 2008 is one in which financing constraints are particularly severe, which is likely to reduce efficient reallocations of both capital and labor.

Fifth, there could be other effects from the seize-up of financial markets in 2008. Financial intermediation is an important intermediate input into production in all sectors. If it is complementary with other inputs (as in Jones, 2008), for example, you need access to the commercial paper market to finance working capital needs -- then it could lead to substantial disruptions of real operations.

Finally, the substantial volatility in commodity prices, especially oil, in recent years could affect potential output. That said, although oil is a crucial intermediate input into production, changes in oil prices do not have a clear-cut effect on TFP, measured as domestic value added relative to primary inputs of capital and labor. They might, nevertheless, influence equilibrium output by affecting equilibrium labor supply. Blanchard and Gali (2007) and Bodenstein, Erceg, and Guerrieri (2008), however, are two recent analyses in which, because of (standard) separable preferences, there is no effect on flexible price GDP or employment from changes in oil prices. So there is no a priori reason to expect fluctuations in oil prices to have a substantial effect on the level or growth rate of potential output.

A difficulty for all these arguments that potential output growth might be temporarily low is the observation already made, that productivity growth (especially after adjusting for utilization) has, in fact, been relatively rapid over the past seven quarters.

...

Given wealth effects on labor supply and strong recent productivity performance -- along with the failure of typical proxies for mismeasurement to explain the productivity performance -- there are reasons for optimism about the short-run pace of potential output growth. Nevertheless, the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been.

As an aside, I will observe that Jim might have a very different opinion on whether the change in oil prices would have an impact on potential GDP; see Hamilton, JPE 1988.

What does the output gap look like?

The discussion thus far has focused on the definition of output gap as the deviation of output from the natural level of output. While Fernald and Basu do not show their measure of actual output gaps as implied by their model, one can look to another paper (Edge et al. 2007) to see what a somewhat different DSGE produces an output gap (by the way, this segue highlights the fact that there are very many different types of DSGE's out there; gross characterizations are dangerous since there are many dimensions along which each model might differ).

From the Edge et al. (2007) paper, the authors observe:

Nonetheless, there are sharp differences between the FRB/US and DSGE model generated output gaps, partially reflecting differences in the economic concept captured by the two series. The DSGE model's output gap is a driver of inflation, which implies that the path of inflation has an important bearing on the resulting output-gap path. Two instances illustrating this dependence are the early 1990s, when inflation continued to decline even though a slow recovery was underway (the so-called opportunistic disinflation), and the late 1990s, when inflation remained contained despite the very strong economic growth. These episodes are reflected in the DSGE model's output gap estimate, as this gap remains negative in the early 1990s and for much of the late 1990s. A conceptually similar output gap - - albeit one from a reduced-form model of Laubach and Williams [2003] - -shows a similar pattern over the 1990s because of the behavior of inflation. The FRB/US output gap measure is, by contrast, less closely linked to inflation: Indeed, real marginal cost, equal to the inverse of the mark-up, is the key driving variable in the model's inflation equation. The FRB/US potential output series is a production function based measure that is built up from smoothed values of multifactor productivity and production inputs. This measure saw output rising above potential through the 1990s.

I must confess that from my own perspective, the "output gap" measure thus defined as the deviation from "natural output" has some counter-intuitive aspects, including the fact that output never exceeds potential during the dot-com boom era. But the late 1990's/early 2000's were a period of low inflation, and as noted, by construction the path of the "output gap" will be driven by that phenomenon. This drawback (in my opinion) doesn't mean that one would then want to drop the entire exercise of using New Keynesian DSGE's to infer output gaps. Rather, I'd want to see how sensitive these measures are to a number of modifications; as an open economy macro guy I'd probably want to see how including the external sector matters.

Exactly because this is such a complicated issue, the Symposium on Projecting Potential Growth is particularly useful as it reviews a variety of issues encountered in estimating the output gap and potential GDP, variously defined: how definite is the distinction between the production function and time series approach, how to account for data revisions and real time data, trying to measure potential in China.

Why isn't one approach unambiguously better?

As a sort of old fashioned person, I still have an attachment to the production function approach embodied in the CBO and OECD (as well as FRB/US) measures of potential GDP. In part, this is because these measures accord better with my priors. I also understand where the differences in projections can come from (what do you assume about demographic trends, about TFP growth, capital stock depreciation, etc.); in the DSGE-based approaches, the differences can arise from any number of sources, including "deep" parameter values, nature of shocks, and so forth. Figuring out what drives the differences, then, can be a challenging (although not necessarily unrewarding) enterprise.

That being said, it is useful to keep in mind the fact that even in the production function approach, potential GDP, and hence the output gap, is estimated [4]. To illustrate this, consider the OECD different vintages of output gaps running through 2007Q4, here. The resulting graph (including the latest CBO measure) is below:

There're a lot of big revisions, particularly in the latter '90s, going from the first release to the estimates reported one year afterward. However, the corresponding revisions between initial release and 1 year afterward have been smaller since 2001. And revisions between 1 year and 3 years after initial release have been pretty small throughout, which is comforting. See Chapter 3 from the latest OECD Economic Outlook for additional discussion of revisions to potential GDP, as well as this post.

Reflecting my training in econometrics, I also find the production function approach to have some plausibility because of the findings of Basistha and Nelson. They conclude that a state space model incorporating a forward looking Phillips curve yields an implied output gap not too dissimilar to what one would obtain from the CBO's production function approach.

Two last observations

There are many different "output gaps" being estimated and reported. Understand what each one is measuring before deciding to use one or the other.

Which one is the "best" one to use depends on the question being asked, and tradeoffs regarding estimation error.

Digression: For a nifty, alternative time series approach to measuring the output gap, see James Morley and Jeremy Piger's recent work here; their most updated estimates of the output gap are here.

Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.

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Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

 But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

• In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.


• This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.

In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

As BNP Paribas's senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.

Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.


• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).


• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

Retail Sales Fall An Annual 8%

Retail sales, excluding cars and fuel, fell by an annual 8 percent in August, the largest such decline registered since at least 2001. This follows a 6 percent in August. The year on year chart (see below) couldn't be clearer.



Sales were also down month on month (ie with respect to August), this time by a non seasonally adjusted 7%. In fact, on a seasonally adjusted basis retail sales peaked in February 2008, and have been trending down since. We still don't have the seasonally corrected data from Eurostat for September, but looking at the uncorrected data we do have from the Estonian statistics office, it does seem that retail sales were down again in Q3 over Q2.




Thus retail sales turned negative in March and the trend simply continues. The decrease in the retail sales of goods was most influenced by the stores selling manufactured goods where sales decreased by 12% compared to September 2007. Sales in non-specialized stores selling manufactured products and shops selling household goods and appliances, hardware and building materials were the worst hit.

Sales in grocery stores have, as might be expected, been rather more stable, with sales only down 3% . As had been the case in previous months, the decrease in food sales was largely influenced by the rise in food prices and the resulting decline in consumption.



Industrial Output Down 3.8%

Output adjusted for working days decreased an annual 3.8 percent, compared with a revised fall of 3.7 percent in August.

If we look at the seasonally and working day adjusted output index, then we can see that the level of output is now meandering downwards, and we now are way off the highs reached during last October and November. With this in mind we should expect the year-on-year percentage drops to start to decline after December, but it will then become much more interesting to follow the evolution of the absolute levels indicated by the general output index.

The main reason for the decline in output is evidently the lack of demand. The fall in manufacturing output was greatest in food, wood and building materials production. Food output was especially hit by the decrease in consumption resulting from this years large price increases. Although the rate of price increase has decelerated in recent months, food product prices are still up by 12% compared to September 2007.

The other area with big output drops is the manufacturing of wood and wood products, where the drop in sales in both domestic and external markets continues. The Estonian market is influenced by the construction slump, while in the external market Estonian manufactures are having a hard time due to the competitive environment and their own weaknesses in price competitiveness. Compared to September 2007, 22% less sawn timber and 9% less glue-laminated timber were produced. The largest drop (32%) was in the production of building materials which is directly connected with the decline in the construction market.

Some export-oriented industries have been continuing to expand - even in this difficult environment - especially enterprises involved in the manufacture of metal products, chemical products, and electrical machinery. Output was also up in the manufacture of machinery, radio and communication equipment, precision instruments and motor vehicles, since again a lot of the output is for export. The export share is 97% in the manufacture of radio and communication equipment and 91% in the manufacture of precision instruments.

Both Wages and Unemployment Still On The Rise


Wages continued to rise rapidly in the second quarter, up by 15.2%, even if this was the slowest pace of increse in more than two years, while the unemployment rate rose - to 3.1 percent in September - the highest level in more than three years.

Estonia's jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, according to data from the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015. This number is of course, incredibly low by any comparable international standard, and is hard to square with a country in the midst of a very deep rcession (even after all the ritual genuflections towards the labour marekt being a lagged indicator). In order to understand how this situation is possible it is important to take into consideration Estonia's special demography and migration history.



However, it is also true to say that unemployment does normally follow changes in economic output with a time lag, se we should expected it to rise considerably in the coming months and quarters. Indeed the unemployment rate as measured by the Estonian statistics office in quarterly labor surveys is nearer to 4 percent in the second quarter (and the EU harmonised rate which is based on the survey shows 4.2% for September in the Eurostat database), and may rise as high as 10% according to recent estimates from Erkki Raasuke, head of Baltic research for Swedbank AB (not that they have been getting too much right of late, but still).


Despite the fact that unemployment will undoubtedly rise further as the recession deepens, it is the very tighness of the labour market (which is, as I say, in part a product of Estonia's demography) which prevents wage increases slowing down more rapidly, and thus the entire Estonian price system adapting to the slowdown (this phenomenon is often called "sticky wages and prices", and as we can see, the degree of viscosity here is almost treacle like). So Estonia's low earlier fertility fuelled the initial wage craze which along with the credit boom got us to the present point, and now the same lack of strength in depth in the labour market blocks the downward adjustment. In both cases the net by-product is massive pressure on the Kroon-Euro peg as Estonia struggles to find export competitiveness.


Consumer Confidence Falls Again


Unsurprisingly Estonian consumer confidence fell again in October, hitting its lowest level in more than 9 years, a sure sign the that the economy is about to shrink again, as domestic demand continues to search for a bottom. The Tallinn-based Konjunktuuriinstituut consumer confidence index declined to minus 27, its lowest reading since June 1999, and down from minus 22 in September. The institute cited worsening expectations for personal and state finances as the key drivers behind the drop.

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

Both Standard & Poor's and Fitch Ratings have responded over the last month to mounting risks from the global credit crunch by downgrading or revising credit rating outlooks to negative for a number of CEE economies including the Baltic states, the Balkans, Hungary and Ukraine. Moody's Investors Service has also revised its outlook to negative for Latvia and downgraded Ukraine.

S&P and Fitch both downgraded long-term sovereign ratings to Latvia and Lithuania on Oct. 27, citing recession risks and the growing need for external financing, while Estonia, had its rating cut by Fitch and outlook revised to negative by S&P. Basically, the crunch is biting in terms of both the cost and the availability of credit. This tightening in credit conditions is not, of course, new in Estonia, and in many ways we could say that the credit conditions should never have been allowed to get so "loose" in the first place. As can be seen from the chart below, the year on year rate of increase in peaked at the end of 2006, and since then the slowdown in Estonian domestic demand has been driven by the slowdown in the availability of credit (strictness off the terms, documentational requirements etc). Evidently, if such criteria had been applied much earlier, and the rate of annual increase never approached 80% all this may well have been a much less dramatic process.







The Estonian central bank said last week revised it's forecast for the economy, which has already made the turn around from being the second-fastest growing one in the EU in 2006, to being one of the most rapidly contracting ones in 2008. According to the bank the Estonian economy may shrink 1.8 percent in whole-year 2008 and 2.2 percent in 2009. As we have noted above the economy sank by 0.8% q-o-q in Q2 and by 1% year on year.



The decrease in GDP in Q2 was mainly a result of weak domestic demand, but the drop in both imports and the rate of increase in the export of goods and services meant that the contribution from external trade was negative. About the only item which maintained some momentum was government spending - buoyed by the tax income from an earier and better epoch. Compared to Q2 2007, total domestic demand was down by 2.8% , largely as a result of adecrease in private consumption and capital investments ( down by 2.0% and 2.5%, respectively).



Private consumption decreased mainly due to the decrease in expenditures on transport and clothing and footwear. The growth of expenditures on food and non-alcoholic beverages decelerated. Capital investments decreased in both the financial and the household sector. Investments in manufacturing industry were almost stationary year on year. At the same time public sector construction investments accelerated.



The decrease in exports and imports since the second half of 2007 which had been noted in Q1 went even further in the 2nd quarter. Compared to the 2nd quarter of the previous year, exports of goods and services decreased by 4.9% and imports by 8.2% (at constant chain-linked prices).




Goods exports were down by 3.2% primarily due to the decrease in exports of refined petroleum products. At the same time, exports of basic metals and electrical machinery (electrical motors and appliances), which significantly influence export movements, increased. Exports of services decreased by 8.9% primarily due to the decrease in exports of services for railway cargo, airway passengers and cargo transport and trade related exports services. The decrease in imports of goods was influenced mainly by the decrease in imports of refined petroleum products and motor vehicles. While imports decreased faster than exports, the deficit of net exports in GDP has increased since the second half of 2007 and amounted to -4.6% of GDP in the 2nd quarter. In the 1st quarter the impact of net exports was -7.1% (so the negative impact slowed vis a vis Q1).

Fiscal Crunch Coming

Basically, as the economy slows, and government income increases even while counter cyclical spending policies add to expenses, the government is moving into tricky fiscal deficit territory. Mindful of this the Estonian government approved on September 25 a draft 2009 budget which attempted to balances overall finances, including local government and the social insurance funds. The budget, which is still to be finally approved by the Estonian parliament, will fall into a deficit and need to be covered from government reserves, according to former Prime Minister Vaehi in a recent interview with the Maaleht newspaper Maaleht.

A deficit of 10 billion krooni would equal 3.5 percent of the expected gross domestic product of 283 billion krooni forecast by finance ministry in August. SEB have forecast a deficit of 1 percent of GDP in Estonia's overall finances next year.

Falling tax revenue has forced the Estonian governemnt of Prime Minister Andrus Ansip to cut spending and seek out new financing in an attempt to maintain a balanced budget, formerly a linchpin of the country's fiscal policies. The Finance Ministry have already forecast the budget will fall into a deficit of 3.1 billion krooni, or 1.2 percent of gross domestic product this year, after running surpluses in each of the last 6 years.



Two Questions In Conclusion

Basically then, it is hard to call the exact impact of trade on Q3 data without having the September trade data in front of us, since although the July and August export numbers are well below the April and May ones, we also need to take into account the accompanying drop in imports (which helps net trade, and thus is GDP positive). On the other hand the general impression you should get from all the data is that we are in for another shocker in Q3. Which leaves us with two questions:

1/ Where do we go from here?
2/ Just how long will it be before we hit generalised price deflation?

Let's take the second one first. Possibly for many people the question will appear to be a ridiculous one, but it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. Now in the rate of increase from one month to another has been slowing, and in September the index was barely up over August (less than 0.5%, following a virtually stationary reading in August over July) so we should not be surprised to see the index hit a ceiling at some point, and then start to come down. Basic economic theory leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Estonian economy at current prices). Thus there is only one way for prices and wages to go: down. Although people may struggle with all this yet awhile before they accept the inevitable.



So what about the future of the economy in general? Well, let's take two quotes from the most recent Eesti Pank growth forecast. First, a recognition that they got it wrong in the past:

According to the base scenario of Eesti Pank's 2008 autumn forecast, Estonia's gross domestic product will decline by 1.8% in 2008 and by 2.1% in 2009. So far the economic correction has been more abrupt than expected primarily due to decreasing domestic demand. In addition to the cessation of the rapid real estate market expansion, also private consumption dropped in spring more than forecasted.

According to Eesti Pank's estimate, the economy should pick up again either at the end of 2009 or at the beginning of 2010. The average economic growth rate of 2010 will be 3%. Private consumption growth should recover in 2010 along with the revival of household confidence, whereas 2009 will be characterised by slowing wage growth and increasing unemployment.

The astonishing news to me was that the Fed has pledged to plow $540 billion into the money market, which is composed of very short-term debt, which is, as I already said, pretty astonishing since the total money market is about $3.5 trillion, and which has had (according to Doug Noland in his Credit Bubble Bulletin) “a y-t-d expansion of $423bn, or 16.8% annualized”. And in an odd bit of symmetry to the just-pledged $540 billion, he…

Global wheat production will likely be 4.4% less next year, Dan Basse, president of AgResource Co. in Chicago, told Bloomberg News. Basse believes the world’s corn and soybean crops will also see declines.

“The credit situation is worrying even the biggest and best farmers,” Brian Willot, a former University of Missouri commodity analyst who now grows soybeans in Brazil, told…

Food prices were down - by 2.2% - but this was mainly influenced by seasonal decreases in the price of fruit and vegetables and fruit. Bread, dairy products and cheese prices also fell. Fuel prices were down by 4.3%, as were motor vehicle prices.

The widespread presence of discounts meant that the prices of non-durable household goods, individual care goods, bicycles, sports and recreational equipment all decreased. Purchase of new cars became cheaper, as did the prices of data processing equipment, airline tickets, furniture and furnishings, carpets and floor coverings diminished.

Latvian retail sales we should remember were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group which were down by 9.4%. There was a slighly smaller decrease in food products, which were down by 6%. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%. In the face of such a decline in demand the more competition driven sectors have little alternative but to lower their prices.




On the other hand, prices in the non competition driven sectors continued to rise, and rent in municipal flats and houses, the cost of refuse collection and other publicly administered services were up, as were liquefied gas prices.

Alcoholic beverages, cereal products, meat and meat products, fish and fish products, eggs, oils and fats, sugar, sweets and non-alcoholic beverages all went up, as did clothes, textiles, household goods, and school textbooks.


Producer Prices Accelerate In August


Latvian industrial producer prices rose in August at a 13.1% annual rate, up frm the 12.4% annual rate registered in July. Month on month producer prices increased by 0.9%.

On an annual basis it has been the increase in the cost of energy components like electricity and gas, and the price of manufactured food products and beverages which have made the biggest impact on the overall level of producer prices,contributing 4.5 and 4.1 percentage points, respectively.

As can be seen in the chart below, Latvian producer prices are now up over 50% on the start of 2005, and with the Lat effectively tied in value to the euro (which is either used by, or a reference point for, nearly all Latvia's major external customers) this represents a huge loss of competitiveness for Latvian industry and service companies.





Energy Prices

In terms of the outlook for Latvian inflation moving forward we need to think about just when it will be that year on year crude oil turn negative, and when this does happen, what will this mean for Latvian inflation? An interesting question this one since it will really show us the "naked truth" about how resistant Latvian prices are to correcting themselves as the economy continues to languish in recession.


Oil prices have fallen substantially recently, even if with considerable volatility in the process. Last Friday, for example, , the first time oil had closed at over $100 in more than a week. Oil prices in fact shot up by more than $6 a barrel on Friday, with light, sweet crude for October delivery rising $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange, after earlier rising as high as $105.25. The increase followed the announcement of the sweeping US government financial rescue plan which emboldened investors to re-enter equiity and commodity the markets.

Crude thus climbed over $13 in the space of three days, but prices will more than likely resume their downward trend, at least in the short term, since demand for energy is likely to remain weak as the economic slowdown continues to bite in the US, Europe and Japan, while key emerging markets maintain tight monetary policy (although not Latvia unfortunately, since the Lat peg means there is no monetary policy to implement) in the battle to contain inflation (I am talking here of countries like Brazil and India). So, despite the coming and going, the trend in oil is decidedly down, and crude has now fallen around $43 — or over 30 percent — from its all-time trading record of $147.27 reached July 11.





So we are now hitting prices which were reached on the way up in the middle of February, but how long will it be before we are below the same price y-o-y? Then annual inflation rates will start to notice what is called the "high base effect", and it will be interesting to examine the precise differences between those countries where secondary effects have made their presence felt (like Latvia unfortunately), and those where core inflation has basically remained low.

Latvian Wages Continue To Rise

At the same time Latvian wages, and despite the recessionary backdrop, continue their steady upward march, at a rate which is well above consumer price inflation plus productivity. Compared to the second quarter of 2007, gross hourly wages in Latvia were up by 26.1%, according to the most recent data from the Central Statistical Bureau.



The statistics office noted that the seasonally adjusted rate of increase has been reducing since 4th quarter of 2007, but this is very small consolation for a process that is effectively blowing a massive hole in the side of the Latvian economy's ability to compete internationally. And indeed they also point out that compared to the second quarter of 2007 the most rapid increases in hourly labour costs have been in economic activities like education – up 30.5%, hotels and restaurants – up 29.3%, mining and quarrying – up 27.7%, construction – up 27.4%, and trade – up 27.3%.


Unemployment Rises While Employment Stagnates

On the other hand unemplyment has started to rise, slightly, and according to the labour board there were 56333 people unemployed in August - nudging up the unemployment rate to 5.2%. To put things in perspective, the number of unemployed is still below that registered in August 2007 (57940), when the economy was, to all appearances, still booming.



Employment, on the other hand, has been more or less stagnant over the last 3 quarters, although year on year rates of employment increase have been healthy (an average of 4% during the last three quarters) and total emplyment has not started to decline in any notable form.





Household Indebtedness


Internal demand, as we have noted, has collapsed, and the Latvian economy is in recession.




So what is the answer to this mystery? How can employment be stable, real wages rising considerably, and yet the economy slumping. Well, the answer isn't too difficult to find, it revolves around household borrowing, and the rate of increase in household debt. If we look at the chart below, we can see that the Latvian "boom" was being fuelled by truly massive y-o-y rates of increase in household borrowing. So the high rates of growth were not due to large productivity gains pushing a supply side expansion, but due to rapid increases in domestic consumption fuelled by growing debt, a process which pushed the Latvian labour market (given Latvia's unusual demography) way beyond capacity limits, and stocked-up a huge inflation bonfire.

As we can see in the above chart, this all really became "one big party" after mid 2005. Now I say Latvia has no available monetary policy, but this isn't entirely the case. Had the Latvian central bank imposed very strict credit restrictions starting in 2005 (and not in the spring of 2007), and had the Latvian government operated a large (liquidity and demand draining) fiscal surplus of 5% of GDP or so starting in 2005, then maybe much of the worst of the distress which is now about to come could have been avoided.

But it is always easy to be right after the event, and I am not claiming to have had any better idea than anyone else at that point. Certainly even the IMF staff economists (who seem to me to be normally much more on the ball than their Brussels and Frankfurt equivalents) only started pushing the idea of fiscal surpluses strongly rather late in the day, and I am sure if we could rerun all this they would have acted differently. But then, you know, the owl minerva only flies after dusk, and all that.

But, as we can see, once the credit restrictions were put in place to some extent, the rate of increase in new credit did slow, and what is so remarkable is how quickly the whole economy itself slowed as this increase in credit lost steam. We are still seeing a year on year rate of increase in household credit of around 25%, and yet the economy is contracting, so what happens if credit stops growing is anyone's guess.

So what is the future? Well basically, given what we have just seen about the debt side of the equation, I think we can safely say you can forget about Latvian domestic demand as a driver of growth. And since government spending is not going to be the answer given the impending liabilities which will be hitting the Latvian state from the ageing population phenomenon (health, pension costs etc), exports would seem to be the only way out. But this is where, after all that inflation, we hit a snag.


As can be seen in the chart below, Latvian exports, far from having risen to the role which falls upon them, have rather weakened over the last six months or so.




True, in year on year terms, they have been rising, but the rate of increase has been slowing steadily, even if - due largely I think to an especially weak month in June and a low base effect in July 2007 - they did rebound a bit in July. The weakness in Latvian exports as a growth driver has been rather masked by the much more dramatic decline in imports, which have moved strongly into negative y-o-y territory despite the high level of oil costs, and this has obviouly been a headline GDP growth positive (that is GDP would have been worse had imports not shrunk so considerably). The decline in imports has also prevented the trade deficit from deteriorating further.



But of course, if exports are now to drive growth (and if Latvians are to start paying back all that foreign debt they have been accumulating) then what is needed is a surplus not a deficit. Well, Latvia needs to start selling more abroad, whatever, however, and I think that in order to do this, Latvian relative prices now need a very substantial adjustment, which either means very substantial internal price deflation, or that horrible and unmentionable "D" word. If people sit back with their arms folded and simply wait to see what happens (out of idle curiousity, perhaps?), then the former will inevitably happen, but the thing is the process could become so violent that it provokes the second inevitably in its wake, which raises the question as to whether it might not be better in the longer run to grasp the bull by the horns, and go down the second road now and dircetly. Whatever happens, none of the possible solutions for the current predicament are going to be easy.

Taking January to July as a whole gross wages were up 8.1% , while net wages increased by 7.2% (year on year) . Taking the private sector alone, gross monthly wages rose by 8.3% year on year in July, down from an 8.7% rate in June, while in the public sector the rate of increase slowed much more significantly, to 7.1% from 12.7% in June. The decline in the gross monthly wage in the private sector follows the recent trend, since year on year growth has been consistently below 9.0%.

In general the central bank will probably welcome the general trend downwards, since wage increases beyond productivity obviously constitute inflationary pressures. There are however still two interesting questions to which we do not really know the answer. The first of these is that it is very hard to assess the impact of any wage "whitening" on the pubished numbers. The second is why it is that even though private sector ex-bonus wages increased by an annual 9.3% in July (over 8.9% in June) bonus payments remained so low. Companies were obviously scaling back on bonus payments in July, and looking at the weak performance in industrial output in the export sector in July might we find the explanation for this? We could also ask ourselves whether this is simply a one of "bad month", or whether, as the Western European economies slow this is actually an indication of what we may see in the future.

Inflation Slowing

Hungarian inflation slowed in August as oil and food costs, which have buoyed consumer-price growth over the past year, started to ease back. The annual rate fell to 6.5 percent from 6.7 percent in July. Month on month, consumer prices fell 0.3 percent over July.



Decreasing global energy and food prices have raised expectations that the inflation rate will now gradually fall back toward the central bank's 3 percent target. Food prices, which jumped 2.2 percent on a monthly basis last September as inflation began to quicken globally, fell by the most in three years in August. They were down 1.5 percent, dropping for a third month. A 9.9 percent increase in household natural gas prices on July 1 added 0.3 percent to the August figure and prevented inflation from slowing further. Oil prices, which have fallen over 30 percent since mid-July, also point in the direction of a furtherdrop in the inflation rate.



The strengthening of the forint, which gained 11 percent against the euro in the past six months has helped contain prices. The price of durable goods fell for a fifth month in August. Hungary's central bank has kept the two-week deposit rate at 8.5 percent for three months, double the rate in the euro region, after following a one percentage point rise to curb inflation and underpin the forint.

Employment Remains (more or less) Stagnant

One thing the Hungarian economy is NOT doing to any great extent is creating employment. The number of employees in companies employing at least 5 people and the public sector combined dropped by 0.5% year on year in July to hit 2.755 million. This followed a 0.9% annual drop in June. This process is only natural as the Hungarian population declines, but of course it does mean that the only real way the Hungarian economy can grow is by increasing productivity, and that in June something like the first 1% of productivity improvement was eaten up by diminished employment. Clearly the answer to this is to increase labour force participation rates, and this sounds fine in theory, but we are a long way from seeing it happen in practice.

The distribution of the labour force is changing, however, since the number of employees in the private sector rose by 0.3% year on year in July but decreased by 3.5% in the public sector. On the other hand, and to put all of this in some perspective, there are now over 100,000 fewer employees in the private sector than there were in June 2003.

Food prices were down - by 2.2% - but this was mainly influenced by seasonal decreases in the price of fruit and vegetables and fruit. Bread, dairy products and cheese prices also fell. Fuel prices were down by 4.3%, as were motor vehicle prices.

The widespread presence of discounts meant that the prices of non-durable household goods, individual care goods, bicycles, sports and recreational equipment all decreased. Purchase of new cars became cheaper, as did the prices of data processing equipment, airline tickets, furniture and furnishings, carpets and floor coverings diminished.

Latvian retail sales we should remember were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group which were down by 9.4%. There was a slighly smaller decrease in food products, which were down by 6%. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%. In the face of such a decline in demand the more competition driven sectors have little alternative but to lower their prices.




On the other hand, prices in the non competition driven sectors continued to rise, and rent in municipal flats and houses, the cost of refuse collection and other publicly administered services were up, as were liquefied gas prices.

Alcoholic beverages, cereal products, meat and meat products, fish and fish products, eggs, oils and fats, sugar, sweets and non-alcoholic beverages all went up, as did clothes, textiles, household goods, and school textbooks.


Producer Prices Accelerate In August


Latvian industrial producer prices rose in August at a 13.1% annual rate, up frm the 12.4% annual rate registered in July. Month on month producer prices increased by 0.9%.

On an annual basis it has been the increase in the cost of energy components like electricity and gas, and the price of manufactured food products and beverages which have made the biggest impact on the overall level of producer prices,contributing 4.5 and 4.1 percentage points, respectively.

As can be seen in the chart below, Latvian producer prices are now up over 50% on the start of 2005, and with the Lat effectively tied in value to the euro (which is either used by, or a reference point for, nearly all Latvia's major external customers) this represents a huge loss of competitiveness for Latvian industry and service companies.





Energy Prices

In terms of the outlook for Latvian inflation moving forward we need to think about just when it will be that year on year crude oil turn negative, and when this does happen, what will this mean for Latvian inflation? An interesting question this one since it will really show us the "naked truth" about how resistant Latvian prices are to correcting themselves as the economy continues to languish in recession.


Oil prices have fallen substantially recently, even if with considerable volatility in the process. Last Friday, for example, , the first time oil had closed at over $100 in more than a week. Oil prices in fact shot up by more than $6 a barrel on Friday, with light, sweet crude for October delivery rising $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange, after earlier rising as high as $105.25. The increase followed the announcement of the sweeping US government financial rescue plan which emboldened investors to re-enter equiity and commodity the markets.

Crude thus climbed over $13 in the space of three days, but prices will more than likely resume their downward trend, at least in the short term, since demand for energy is likely to remain weak as the economic slowdown continues to bite in the US, Europe and Japan, while key emerging markets maintain tight monetary policy (although not Latvia unfortunately, since the Lat peg means there is no monetary policy to implement) in the battle to contain inflation (I am talking here of countries like Brazil and India). So, despite the coming and going, the trend in oil is decidedly down, and crude has now fallen around $43 — or over 30 percent — from its all-time trading record of $147.27 reached July 11.





So we are now hitting prices which were reached on the way up in the middle of February, but how long will it be before we are below the same price y-o-y? Then annual inflation rates will start to notice what is called the "high base effect", and it will be interesting to examine the precise differences between those countries where secondary effects have made their presence felt (like Latvia unfortunately), and those where core inflation has basically remained low.

Latvian Wages Continue To Rise

At the same time Latvian wages, and despite the recessionary backdrop, continue their steady upward march, at a rate which is well above consumer price inflation plus productivity. Compared to the second quarter of 2007, gross hourly wages in Latvia were up by 26.1%, according to the most recent data from the Central Statistical Bureau.



The statistics office noted that the seasonally adjusted rate of increase has been reducing since 4th quarter of 2007, but this is very small consolation for a process that is effectively blowing a massive hole in the side of the Latvian economy's ability to compete internationally. And indeed they also point out that compared to the second quarter of 2007 the most rapid increases in hourly labour costs have been in economic activities like education – up 30.5%, hotels and restaurants – up 29.3%, mining and quarrying – up 27.7%, construction – up 27.4%, and trade – up 27.3%.


Unemployment Rises While Employment Stagnates

On the other hand unemplyment has started to rise, slightly, and according to the labour board there were 56333 people unemployed in August - nudging up the unemployment rate to 5.2%. To put things in perspective, the number of unemployed is still below that registered in August 2007 (57940), when the economy was, to all appearances, still booming.



Employment, on the other hand, has been more or less stagnant over the last 3 quarters, although year on year rates of employment increase have been healthy (an average of 4% during the last three quarters) and total emplyment has not started to decline in any notable form.





Household Indebtedness


Internal demand, as we have noted, has collapsed, and the Latvian economy is in recession.




So what is the answer to this mystery? How can employment be stable, real wages rising considerably, and yet the economy slumping. Well, the answer isn't too difficult to find, it revolves around household borrowing, and the rate of increase in household debt. If we look at the chart below, we can see that the Latvian "boom" was being fuelled by truly massive y-o-y rates of increase in household borrowing. So the high rates of growth were not due to large productivity gains pushing a supply side expansion, but due to rapid increases in domestic consumption fuelled by growing debt, a process which pushed the Latvian labour market (given Latvia's unusual demography) way beyond capacity limits, and stocked-up a huge inflation bonfire.

As we can see in the above chart, this all really became "one big party" after mid 2005. Now I say Latvia has no available monetary policy, but this isn't entirely the case. Had the Latvian central bank imposed very strict credit restrictions starting in 2005 (and not in the spring of 2007), and had the Latvian government operated a large (liquidity and demand draining) fiscal surplus of 5% of GDP or so starting in 2005, then maybe much of the worst of the distress which is now about to come could have been avoided.

But it is always easy to be right after the event, and I am not claiming to have had any better idea than anyone else at that point. Certainly even the IMF staff economists (who seem to me to be normally much more on the ball than their Brussels and Frankfurt equivalents) only started pushing the idea of fiscal surpluses strongly rather late in the day, and I am sure if we could rerun all this they would have acted differently. But then, you know, the owl minerva only flies after dusk, and all that.

But, as we can see, once the credit restrictions were put in place to some extent, the rate of increase in new credit did slow, and what is so remarkable is how quickly the whole economy itself slowed as this increase in credit lost steam. We are still seeing a year on year rate of increase in household credit of around 25%, and yet the economy is contracting, so what happens if credit stops growing is anyone's guess.

So what is the future? Well basically, given what we have just seen about the debt side of the equation, I think we can safely say you can forget about Latvian domestic demand as a driver of growth. And since government spending is not going to be the answer given the impending liabilities which will be hitting the Latvian state from the ageing population phenomenon (health, pension costs etc), exports would seem to be the only way out. But this is where, after all that inflation, we hit a snag.


As can be seen in the chart below, Latvian exports, far from having risen to the role which falls upon them, have rather weakened over the last six months or so.




True, in year on year terms, they have been rising, but the rate of increase has been slowing steadily, even if - due largely I think to an especially weak month in June and a low base effect in July 2007 - they did rebound a bit in July. The weakness in Latvian exports as a growth driver has been rather masked by the much more dramatic decline in imports, which have moved strongly into negative y-o-y territory despite the high level of oil costs, and this has obviouly been a headline GDP growth positive (that is GDP would have been worse had imports not shrunk so considerably). The decline in imports has also prevented the trade deficit from deteriorating further.



But of course, if exports are now to drive growth (and if Latvians are to start paying back all that foreign debt they have been accumulating) then what is needed is a surplus not a deficit. Well, Latvia needs to start selling more abroad, whatever, however, and I think that in order to do this, Latvian relative prices now need a very substantial adjustment, which either means very substantial internal price deflation, or that horrible and unmentionable "D" word. If people sit back with their arms folded and simply wait to see what happens (out of idle curiousity, perhaps?), then the former will inevitably happen, but the thing is the process could become so violent that it provokes the second inevitably in its wake, which raises the question as to whether it might not be better in the longer run to grasp the bull by the horns, and go down the second road now and dircetly. Whatever happens, none of the possible solutions for the current predicament are going to be easy.