So as of March, the 10 city is 40% lower than its May 2006 peak, in log terms (37%, in percent terms). The CME futures indicate that the 10 city index will be 52.7% lower by May 2010 (41% in percent terms). Compared to last September, the trough has moved up (the trough back then was slated to be in May 2011). However, one doesn't want to make too much of these long horizon indications, since the futures prices for these dates (November 2011 onward) have not changed since, for instance, the February 25 futures (shown in this post).

Of course, futures prices incorporate both expectations and risk preferences. In addition, these markets -- particularly at longer horizons -- are not likely to be particularly thick, so one has to be careful about using these prices as forecasts, even if one were to assume risk neutral agents. For an alternative, one can use the forecasts of the old OFHEO indices and convert to implied Case-Shiller (see this post for example).

More commentary at Calculated Risk.

Note that forecasted GDP (in the tan shaded area) is above the level implied by e-forecasting. E-forecasting's estimate is that GDP will be down by 9.9% (SAAR) in 2009Q1. If this more dire forecast proves accurate (Deutsche Bank predicts -8.0% SAAR), then -- as Brad Delong likes to say -- we'll need a bigger stimulus package.

See also Calculated Risk's discussion of the employment report: [1], [2], [3].

Side note: for those wanting to hear my take on the G-20 meetings, Minnesota Public Radio had an hour with me on the air yesterday (link here).

The global financial crisis is drying up the financing that firms depend on for trade. That's making the global recession nastier and deeper than it otherwise would be.

As with all kinds of credit these days, financial institutions are making less trade finance available and charging more for it. But the squeeze in trade stands out because it pinches otherwise healthy companies that should be driving a recovery in global commerce. Already, the World Bank predicts trade will contract next year for the first time since 1982.

The Deteriorating Trade Outlook

Here's the IMF's recent forecasts for exports -- from October and then November -- for world trade, disaggregated into advanced and developing country groupings.

These developments in trade financing suggest that the recent drop-off in US exports and imports might be due only in part to macroeconomic factors. In particular, I suspect that some of the precipitous decline in US non-oil imports is driven by difficulty in obtaining financing. Similarly, for US exports.

The article continues:

Despite better growth prospects in developing countries, many lenders are pulling back drastically from these regions. The institutions are cutting exposure to economies traditionally perceived as more risky in order to patch up holes in their balance sheets. Other big players in trade finance, such as Wachovia, have disappeared.

"For emerging markets, the deleveraging process is extensive, and dollar sources have dried up," says Hung Tran, an economist at the Institute of International Finance, a Washington association of international financial firms.

Dating back to ancient commercial hubs such as ninth-century Baghdad, trade finance is the collection of hard-currency credit lines, insurance policies and guarantees that allows firms in different countries to do business with each other. It's the oil that lubricates $14 trillion of global trade.

"The trade-finance business globally is under significant stress," says John Ahearn, the global head of trade finance at Citigroup, one of the world's biggest trade-finance sources. Some repricing is expected as the globe readjusts from a period where credit flowed too freely. "We are coming out of an incredibly benign credit environment when trust levels were too high," says Stuart Nivison, head of trade and supply chain at HSBC Holdings.

Even big lenders such as Citigroup and HSBC that have expanded international credit lines to some markets recently are hitting obstacles. A big part of these banks' business is setting up trade lines that are offloaded to smaller banks in a secondary market. These days, however, the smaller banks aren't buying.

Consider what's happening in Brazil, an emerging export power that sells the world everything from soy and beef to iron ore and jets. Brazilian companies need dollar-denominated credit to finance the sales. The cost of these credit lines -- the bread and butter of trade finance -- has soared, doubling in many cases. The phenomenon hits smaller firms the hardest: Some no longer qualify for the lines and others are squeezed out of shrinking market by credit-hungry giants like state oil company Petroleo Brasileiro.

...

At times, credit is available, but the higher cost of it exceeds the profit margins, so the deals collapse. That's especially the case in commodities transactions.

By the way, the spike up in the value of the dollar (represented in the downward movement in the USD exchange rate), while often mentioned in journalistic accounts, is unlikely to have had a big impact in the September and October figures, given the lags usually estimated in trade flow equations (for a discussion of lag lengths, see this paper [pdf]).

The observed co-movement is ascribable to the common factor of flight to safety and reduction in trade credits in the wake of the financial crisis (see some stunning pictures in Brad Setser's recent post).

China

Other coverage is in Globe and Mail, Journal of Commerce, Reuters, Bloomberg. Many of the articles focus on China, and we now have some feeling for the combined macro/finance impact: "According to Chinese customs figures, Chinese exports declined 2.2% and imports fell 17.9% in November, compared with a year earlier." (Volz in FEER.) This suggests to me that the more rapidly the supply of export credit can be restored (at least partially), the less significant the downturn in Chinese exports, and hence in the Chinese economy.

From Reuters:

Stunningly bad trade figures from China underlined the problem. China had been expected to show double digit growth in trade last month as compared to November 2007, but the data showed exports falling 2.2 percent from a year ago and imports down 17.9 percent.

"Global demand for Chinese products is vanishing," said Gene Ma, an economist at China Economic Monitor, a Beijing consultancy. "Secondly, the credit freeze in importing countries has made it hard for Chinese exporters to sell abroad. I heard some Chinese exporters had to cancel shipments as they were worried about getting paid by their buyers."

Chinese banks have been very nervous about accepting letters of credit from abroad, making it tougher for imports to China to get the needed financing. China and the U.S. pledged $20 billion to fund trade with developing countries last week, but that is a tiny balm for a huge market.

Some Disparate Observations

In some previous posts, I observed that globalization was a function of trade -- and other transaction -- costs [1], [2], [3]. That observation was focused on transportation costs, but it's clear (in retrospect) that one of the drivers of globalization was decreasing financing costs. With financing costlier for the foreseeable future, secular growth in trade flows may be even more muted than one would expect from the slowdown in global GDP.

There is a good news/bad news aspect to this conclusion. The bad news is that decreased international trade means a reduction (relative to counterfactual) in the gains from exploiting comparative advantage. This will show up in further reduced GDP.

The good news, such as it is, is that reduced import penetration in the developed economies will mitigate protectionist tendencies. In addition, higher transactions costs (due to higher financing costs) will likely act to reduce the marginal propensity to import, thereby boosting the Keynesian multiplier (as described by me, and Dani Rodrik) in a way that will not induce retaliation. Of course, the net effect is still likely to be toward greater protectionism.

Technorati Tags: imports, exports, trade credit, credit crunch, and protectionism.

"The data are pretty clear that we are not in a recession," Council of Economic Advisers Chairman Edward Lazear told a meeting of editors and reporters from the Wall Street Journal and Dow Jones Newswires.

...

"I would be very surprised if the NBER, looking back at this period, would date this as a recession," Mr. Lazear said. There are even indications that revised first-quarter estimates would be slightly stronger than 0.6%. "The optimists seem to have been closer to right on that than the pessimists," he said.

Just to reiterate, that quote is from May 2008.

Here's a picture of GDP and gross domestic income (as suggested by Jim in this post, and noted in the BCDC announcement).

I thought at the time Ed Lazear would regret those remarks. But Lazear's views were not unique. Here are some additional quotes of interest, hoisted from the comments sections in Econbrowser:

From March 2008, in response to my worries about 2008H2 growth:

While the financial market turmoil and dysfunctional credit markets are significant wild cards, interest rates are so low (and could be 2.25% this week!) that you have to think that growth later this year and into '09 should be positive, if not strong.

Yet another:

The Macroeconomic Advisers monthly real GDP index rose to a record high in December. It fell in October but rebounded in November and December.

Preliminary indicators suggest it rose again in January.

I get a sense that some academic economists are actually rooting for a recession, a way of punishing the country for having elected Bush.

...

In other words, looking at data too close to the candidate turning point can easily lead to subsequently embarrassing remarks. Nonetheless, the specific dating of the recession to December 2007 has spurred lots of queries about whether it matters, when (i) the recession is so much in evidence, and (ii) whether any greater importance should be accorded to a declaration by the NBER as opposed to any other group or individuals. Here are some thoughts on both questions, augmented with some retrospective views.

First, to the question of whether it matters that there's a declaration. Here, I turn to Jeffrey Frankel, who is on the NBER BCDC, but is speaking on his own behalf:

We sometimes hear the question "Who needs the NBER Committee anyway?" This question most often comes in one of two forms:

(a) Everyone in the real world has known that the economy has been in a recession for some time. In past cycles, media reports have sometimes taken the line "Ivy Tower Eggheads Finally Figure Out What Everybody Else Has Known All Along." The implicit critique is that the committee takes too long after the event -- typically almost a year -- to make its declaration. One short answer is that our job is to be definitive, authoritative, but not fast. We don’t want to have to revise our dating of the peaks and troughs later, in part because it would sow confusion among those who rely on them (from econometric researchers to political speechwriters). GDP and other official statistics are often revised after the fact, for example. We leave it to others -- pundits, forecasters, consulting companies, financial newsletters, and so on -- to try to get there first. We deliberately get there last.

(b) The other form taken by the question "Who needs the NBER committee?" runs as follows: "The rule of thumb is simple: two consecutive negative quarters of GDP growth. Why complicate things?" The Frequently Asked Questions segment of the BCDC announcement answers this in detail. For now, observe simply that questions (a) and (b) are inconsistent with each other. As of December 1, 2008, the US economy has not yet experienced two consecutive negative quarters. So an argument that we should wait for two consecutive quarters (critique b) is the opposite of the critique that we should have acknowledged a recession before now (critique a).

Taking Frankel's points into account, we can then move to the second question, whether it matters that NBER BCDC makes the determination. Think back to the two-quarter rule of thumb. Why is it a "rule of thumb"? Because the data are revised over time -- most importantly GDP -- the two quarter (sometimes defined as a "technical recession") is heavily reliant upon the series that is most subject to revision. I've discussed the importance of revisions numerous times in this context: [1], [2], [3], [4], [5].

Another motivation is to recall that the NBER is a research group, and not a policy group, trying to identify for historical purposes the ebb and flow of activity. In any case, we want to place the responsibility for identifying peaks and troughs in economic activity in the hands of a disinterested group, and not in -- say -- the government. (I'll add that it's an auspicious group: "Robert Hall, Stanford University (chair); Martin Feldstein, Harvard University and NBER President Emeritus; Jeffrey Frankel, Harvard University; Robert Gordon, Northwestern University; James Poterba, MIT and NBER President; David Romer, University of California, Berkeley; and Victor Zarnowitz, the Conference Board. Christina Romer of the University of California, Berkeley, resigned from the committee on November 25, 2008, and did not participate in its deliberations of November 28.")

(For those wondering why NBER gets to declare the recession dates, one hint is that it was NBER researchers Burns and Mitchell (1946) who developed the lens through which "cycles" experienced in industrial economies were perceived. For the inquisitive, here is a link to the volume which summarized that research: Burns, Arthur F. and Wesley C. Mitchell, Measuring Business Cycles (NBER, 1946).)

This is why I think so much of the commentary, saying that this was all obvious, not only demonstrates a distressing level of ignorance, but also a juvenile approach to discourse (see e.g., here). Yes, it was pretty obvious that we were in a recession, but when it began is something that could have been placed at any number of dates. We will have a similar debate when we starting thinking about dating the trough.

I think it's also of interest to look back at whether we should be so surprised. I'll focus on the debate that occupied our attention months ago: whether the yield spread had predictive power for future economic activity. Well, now we can conclude the answer was yes. The inversion in August 2006 predates the recession's beginning by about 16 months.

Now, what we don't know is how well the prediction holds cross-country. This graph from a March 2007 post suggests it will work for Europe (we'll have to see what CEPR says, although current forecasts seem pretty definitive).

Here's a cross-country snapshot from an October 2007 post.

Australia and the UK seemed to be conforming to the prediction from the yield curve. Canada so far has failed to experience negative growth, and so might be thought to also conform to the prediction of yield curve -- at least so far.

Technorati Tags: yield spread, GDP, gross domestic income, recession, term premium, data revisions, NBER, and Business Cycle Dating Committee.

This statement is indeed accurate if one focuses on real GDP. I present the log of real GDP in Chained 2000$, normalized to 0 at the NBER-defined trough in 2001Q4. I also present for reference log GDP in the previous two expansions, normalized to 0 in the previous troughs in 1991Q1 and 1982Q4. (For those interested in output gaps, the mean WSJ forecast predicts output will be 2.7% below CBO's estimate of potential output by end-2008, in log terms.)

The graph clearly indicates that GDP is now substantially below (4%, in log terms) where it was at this time in the previous expansion. It is 12% below the corresponding level in the 1982-00 expansion.

I also plot the implied level of GDP assuming the mean forecast from the WSJ survey for GDP is realized. In that case, by 2009Q2, output will be 7% below the corresponding level in the previous expansion.

While the mean forecast is of interest, so too is the dispersion in forecasts. In the figure below, I plot the mean forecast, and the highest and lowest forecasts (using as the reference for highest and lowest the 2008 Q4/Q4 growth rate), from James F. Smith of Western Carolina University and Parsec Financial Management (2.82%), and Paul Ashworth of Capital Economics (0.24%), respectively.

The mean forecast projects a bump up in growth in 2009Q1. The high forecast by James Smith projects rapid growth all the way through the forecast period. Of course, Smith in the November 2007 survey provided the highest forecast of the surveyed economists for every quarter from 2007Q4-2008Q4, as well as the highest for 2008 Q4/Q4. (In March 2008, Smith also had the highest forecast for 2008Q1 growth, at 2.6%, and tied for highest Q4/Q4 growth, at 3.5%.) The lowest Q4/Q4 forecast comes from Paul Ashworth; he forecasts a 0.24% growth rate for 2008.

In Figure 3, I present a histogram of the 2008 Q4/Q4 growth rates, as implied by the q/q growth rates reported by the respondents to the survey. Smith is the single observation in the top bin. Ashworth is one of four respondents in the bottom bin. Highlighting the skewed nature of the distribution, Smith is more than 2 standard deviations from mean, while Ashworth is about 1.4 standard deviations below mean.

If we take the most optimistic forecaster's view, then by 2009Q2, GDP will be only 4.8% below the corresponding point in the previous expansion. Taking the pessimistic view, it will be 8.3% below.

These forecasts were conducted in the first week of July. Hence, they predate the surprise jump in CPI inflation. Higher than anticipated inflation could have a variety of offsetting impacts. First, it could signal greater demand pressures, so GDP forecasts would be revised upward. On the other hand, taking into account the Fed’s reaction function, one might think that monetary policy would therefore be tighter than otherwise, and hence output -- at least several quarters out -- would be lower than previously projected.

Today, additional information was released, for industrial production. Here the picture is mixed. Both industrial production and manufacturing production (recall industrial production includes output from utilities which can be influenced by weather factors, even when seasonally adjusted) rose slightly (I think "edged up" is the phrase).

Note that by the metric of the Nation’s factories, utilities and mines, the economy is not growing, over a 3 month moving period.

Finally, both Macroeconomic Advisers and e-Forecasting released estimates of monthly GDP today (May for MA, and June for e-Forecasting). These series are presented in Figure 4. At this point we have a substantial disjuncture between the implications arising from the two organizations' assessments. E-Forecasting’s figures indicate that in 2008Q2 GDP has declined 0.6% q/q on an annualized basis, while MA is predicting a 2.9% q/q growth rate, taking into account the April and May estimates and a forecasted 0.6% growth (annualized) in June.

Without knowing more about the track records of each of the estimates of GDP, I'm reluctant to say which one better tracks the state of the economy (or, less ambitiously, track the state of the advance GDP release…) . Any informed commentary or references from readers welcome.

What is true is that over the 1992-current period, an estimated error correction model assuming cointegrating between the two series (with long run unitary elasticity) indicates that the MA series reverts more strongly to conditional mean than does the e-Forecasting series. In a statistical sense, then, one might think the last observations of the e-Forecasting series are more likely to be closer to the underlying trend represented by both series (recalling that both series are calibrated to match the quarterly actual GDP series reported by BEA). In an informal sense, I think of this statistical result as meaning that the MA series bounces around more than the e-Forecasting series. This is not a conclusion with economic content, though, as it doesn't say which series better represents the economy's state. It might be the case that economic output does jump around a lot, month to month.

Technorati Tags: potential GDP, recession, output+gap, industrial+production, forecasts.

A week ago, Macroeconomic Advisers released their estimate of April GDP, while e-Forecasting released their estimate of May GDP. These two series are depicted in Figure 1.

Recall that the NBER BCDC examines four other variables to gauge economic activity: payroll employment, industrial production, real manufacturing and trade sales, and real personal income less transfers [1]. To see how GDP has moved differently from these other measures of economic activity, see this post. Rather than providing a welter of series, I’ve tried to summarize the movement in these four variables by generating an index that is the first principal component of the four underlying series (all logged). This is the blue line in Figure 1.

Loosely speaking, the first principal component is the linear combination of the underlying variables that has the maximum variance. In a four variable grouping, four principal components would explain all the variance of the grouping. The first principal component in this case accounts for about 96% of the total variance. (The loadings are about equal.)

What's clear from this plot is that Macroeconomic Advisers' measure of GDP peaked in January 2008, and e-Forecasting's in March. (By the way, this jagged pattern in the Macroeconomic Advisers series is partly why the quarterly changes in the official BEA measure will not necessarily register a negative change q/q even if there is a 3 month changes in monthly GDP; see Jeff Frankel's discussion.) The first principal component peaks earlier than both the GDP measures, in October of 2007, although there is a second peak that is close to the first, in January 2008. The drop from the peak is "only" 5.4% in log terms.

This summary measure ends in March because of the unavailability of manufacturing and trade sales for April. What is reported is retail and foods sales. While not conceptually similar to the former, the two series move together (in levels, at medium frequencies). The slope coefficient of a regression of log manufacturing and trade sales against log retail sales is 1.11, and an adjusted R² of 0.98. Using this alternative measure, one obtains the alternate first principal component depicted in Figure 2.

This alternative summary measure alos records a decline, in this case since the peak of November 2007: 3.7 percent.

All this is to say, GDP is an important indicator. But it's not the only indicator of "economic activity". Something to keep in mind when you read statements such as: [2]

The definition of a "recession" is very clear and straightforward: Two consecutive quarters of negative growth. We have not yet had one consecutive quarter of negative growth.

No, not quite so clear...especially after keeping in mind the possibility of revisions. [3]

Technorati Tags: payroll employment, recession, industrial production, personal income, sales.

Figure 1 depicts the time series for year-on-year nonresidential investment growth, and residential investment growth lagged four quarters. There's an obvious correlation, but clearly it's not a particularly strong one. There are periods where business fixed investment levitates above residential growth, such as the latter part of the 1980s (due to the dollar's depreciation), and during the 1990s, as well as the most recent few quarters. The relationship can be summarized using a OLS regression of 4-quarter growth on 4-quarter growth rates.

d(nresinv)_t = 0.035 + 0.311 d(resinv)_t-1 + u_t

Adj. R² 0.37, SER = 0.054, smpl 1967q1-08q1, bold face denotes statistical significance at 1% MSL.

Using quarter-on-quarter growth rates yields a similar result (i.e., the cumulative coefficients on four lags of changes in residential investment sum to 0.33, as opposed to the 0.311 coefficient above).

What does this predict for year-on-year business fixed investment growth in 2009Q1? That's shown in Figure 2.

The regression indicates a 3.8% 4 quarter decline (in log terms) in 2009q1. It's unclear to me how this fits in with other forecasts. The q4/q4 prediction I obtain of -2.9% is somewhat less than the 0.3% (non-log terms) decline forecasted by the participants of the Chicago Fed Automotive Outlook symposium [1].

An alternative approach would be to try to explain investment using variables that theory says might be important. As discussed in this post on the investment disconnect, corporate profits is one candidate. In Figure 3, I plot 4 quarter changes in nonresidential investment and in real corporate profits.

This relationship,

d(nresinv)_t = 0.034 + 0.317 d(cprofits)_t-1 + u_t

Adj. R² 0.29, SER = 0.058, smpl 1967q1-08q1, bold face denotes statistical significance at 1% MSL.

predicts that the 4 quarter change in nonresidential investment will be about 0.3 ppts. in 2009q1.

In either case -- using a lead-lag relationship [2], or one based upon a version of a cash-flow model -- investment growth will be slowing down over the next year.

Technorati Tags: nonresidential investment, residential investment, corporate profits.

The easiest thing to do is to pull down the CBO's measure (interpolated to quarterly frequency). This yields the following picture (in logs):

Two observations: (i) recessions do not necessarily coincide with negative output gaps (although they do seem to coincide with the beginning of periods of negative output gaps); and (ii) recoveries do not always coincide with positive output gaps.

This is obvious when one thinks about it, given the NBER BCDC definition of a recession as the following:

A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

That is a recession is the description of the first derivative of output taking on a negative value, while an output gap is a description of output relative to the output level consistent with the "normal" utilization of factors of production (also "full-employment"). For details of how CBO calculates potential GDP, see this document.

Looking at the last ten years provides another insight.

The US economy only barely made it close to full-employment in the expansion of 2001-2007/8/?, and is now declining again. I think I had realized this (especially in the course of various past debates over the surge in tax receipts, which I think has now been resolved -- see [1], [2] for a recollection.)

As I noted in the beginning of this post, I was finding it difficult to discern the most appropriate measure, so I will share the other measures I have investigated as indicators of potential (or "trend") GDP (which can then be used to calculate corresponding measures of the output gap): (1) the Hodrick-Prescott filter; (2) the Band Pass filter; and the quadratic time trend.

The Hodrick-Prescott filter is a ubiquitous two-sided filter used in time series macroeconometrics and elsewhere (I've even seen it used in the analysis of temperature data! [3]). Essentially, the HP filter calculates a trend that minimizes the weighted sum of squared deviations from trend, and squared changes in the the growth rate of the trend. This weighting is controlled by a parameter which is usually set at 1600 for quarterly data. As a public service, I'll note there are serious hazards associated with this filter, especially when trying to correlate various macro series that have been put through the same filter [4].

There is an additional problem (which is often ignored), namely that the HP filter is two-sided, so that running the filter up to the end point of data will tend to result in the trend being too close to the last data point (in our case, the output gap will be pulled to zero).

There are several band pass filters; the one most commonly used in the macroeconometric literature is the Baxter-King version.

Band pass filters are called this because (in the frequency domain) they pass through any cyclical components within a particular frequency band, and elimates the others. In the time domain, this means fluctuations that are shorter or longer than a specific length are ignored. In the business cycle area, then, in order to use this filter, one would have to have a prior on how long a "typical" business cycle is. More on both the HP and BP filters can be found in Tim Cogley's entry for the New Palgrave Dictionary of Economics [5].

The final means of identifying the output gap is to the simplest (at least in implementation) -- take the deviation from an estimated quadratic trend in time. This is not an uncommon procedure, but if you are pretty confident there is a unit root in log GDP, you might feel a little queasy about doing this [6]. But for completeness' sake, I'll show what happens when you do this as well.

Note that in order to circumvent the two-sided filter aspect of the HP filter, I have done a standard fix, which is to use an ARIMA(1,1,1) on log GDP over the 1980-08q1 period to dynamically forecast out 12 quarters, and then apply the HP filter to this "extended" series. I could have done a similar procedure for the BP filter, but opted to use the Christiano and Fitzgerald (2003) one-sided asymmetric version of the band pass filter to estimate the trend series.

First, the good news. Using the band pass filter, one finds that the output gap is still positive, at less than one percentage point of GDP in 2008q1. The HP filter indicates an essentially zero output gap. The quadratic trend indicates something similar to what the CBO indicates -- something close to a 2 percentage point negative output gap in 2008q1, versus 1.5 percentage points for CBO.

I don't want to say that there is one best version. Variations in the sample period, and the parameters used in each filter, will change the results. And of course, data revisions will mean the real-time output gaps will differ from the final revised output gaps we estimate today using either mechanical or judgmental approaches. For a pessimistic view regarding real time use, see Orphanides and van Norden (2004) [pdf].

Nonetheless, the distinction between the rate of change in economic output, and where output levels will gravitate to (and at what pace) is a useful one. And I think it will become of greater usefulness as the slowdown ends, if and when growth resumes. In particular, I'm thinking of whether the pattern of smaller -- but more persistent -- ups and downs continues (the half life of a deviation from potential has risen from 8 quarters in the 1970-90q1 period to 11.6 quarters in the 1990q2-2008q1 period).

Technorati Tags: potential GDP, recession, output+gap, full employment output, trend.