Dominant and contrarian visions of 2015

It's that time of the year when seemingly every economist in the private sector puts together an economic outlook for the year ahead. I'm not foolhardy enough to make predictions, or even to pretend my crystal ball is less cloudy than others'. I'm writing this post because I am bothered by the extreme prevalence of some "consensus views." For example: the narrative of divergence between the U.S. and the eurozone. Or the widely shared belief that Syriza will lead Greece out of the eurozone. 

I have put together a list of (what I see as) dominant views--it's not fair to call them "consensus"--, as well as possible alternative scenarios that don't get as much attention as they should. Time will tell.

	Dominant view	Contrarian view	Dark-horse view
U.S. dollar	Fed raises rates, and the U.S. economy outperforms that of the eurozone, Japan, and emerging markets, leading to a big appreciation of the U.S. dollar relative to most currencies.	Grexit and the failure of Abenomics add more fuel to the run-up of the dollar.	The eurozone's economy performs better in 2015 than in 2014, the ECB delivers little or no QE, and Japan's growth and inflation turn out higher than expected. The dollar depreciates from the level of late 2014.
Monetary policy	Divergence between Fed, on one side, and BoJ and ECB on the other. Tightening begins in the U.S., whereas ECB and BoJ commit to zero interest rates for the foreseeable future.	Rapid disinflation lifts real interest rates. The Fed turns more dovish, and policy rates rise less than anticipated, supporting asset prices.	Faster-than-expected growth, and recovering oil prices change the Fed's inflation outlook, prompting aggressive tightening.
Inflation	Inflation stays low in most countries. In the U.S., core inflation remains stable, then rises, as labor market tightens. Eurozone enters deflation, briefly, before base effect of low oil prices is phased out.	U.S. core inflation falls, scaring the Fed into postponing interest rate hikes. Eurozone falls into deflation, which proves to be more persistent than anticipated. "Japanization" narrative becomes mainstream.	Oil price rebound puts disinflation behind, at least for now.
U.S. bonds	Long-term interest rates rise, in anticipation of the Fed's tightening "in mid-2015". The yield curve flattens, due to low expectations for medium-term growth and inflation.	Slow growth and ultra-low inflation push long-term yields even lower.	Monetary policy tightening happens faster than expected. Growth surprises on the upside. Long-term yields rise sharply. The yield curve steepens despite Fed's tightening.
U.S. equities	Gradual withdrawal of Fed support + Pick-up in economic growth = Elevated profits and valuations persist --> Positive returns, but lower than in 2014.	The Fed is even more cautious than expected, and puts off interest rate hikes, perhaps due to ultra-low inflation. Investor enthusiasm turns into mania. IPOs and M&A activity bubble up. Valuations approach those of the late 1990s, raising the risk of a crash in the short term.	Fundamentals of 2009-2014 bull market prove fragile. Faster-than-expected monetary tightening crushes equities.
Oil	Plentiful supply and sluggish demand keep prices in $50-$80 range.	Disruptions to supply in MENA push prices back up to the $90-$120 range.	Recession in China pushes price under $50 for several months.
China	Soft landing, with bumps. "Lowflation" persists, pernicious deflation is avoided. Excess capacity is worked out slowly; government doesn't need to officially bail out the financial sector.	Slowdown escapes Beijing's control. Sharp recession and deflation set in, but government steps in to save the day, nationalizing several financial entities. Commodities plunge, several countries in Latin America enter recession, financial crises engulf a few EMs. Volatility spikes in all the world's main financial centers.	China's slowdown proves temporary. GDP growth rebounds north of 8%. Commodity prices rebound.
Japan	Fresh monetary stimulus succeeds at first. Yen depreciates, Japanese firms gain market share and increase profits. Core inflation remains positive, but eventually starts falling again, prompting the gov't to provide, eventually, more stimulus.	New round of monetary stimulus fails to keep inflation up. Deflation returns, spurring the gov't to provide new stimulus, soon.	Domestic demand, inflation expectations, inflation grow faster, setting off a "virtuous cycle" that leaves deflation behind forever. Abe's third arrow gets implemented, raising potential growth.
India	Lower commodity prices boost economy and improve fiscal position. Modi pushes through reforms, lifting potential growth and dampening core inflation. Equity bull market continues.	Global environment supports Indian growth, but Modi can't push reform as quickly as expected, due to internal political obstacles. Equities lose some steam, but there is no collapse.	Rupee sell-off triggered by rising U.S. interest rates, contagion from Russian crisis to other EMs, etc. Foreign exchange reserves shrink precipitously, financial crisis looms.
Russia	Recession deepens. External debt crisis looms, but is narrowly avoided.	Short-lived dip. Growth resumes thanks to rebound of oil price.	Persistently lower oil prices push Russia into full-blown external debt crisis. Banks fail. IMF comes to the rescue.
Greece	Syriza wins the Jan. 25 elections, or gets enough seats to form a coalition led by Syriza. Greece requests a debt restructuring (i.e. partial default), which the troika rejects. Grexit.	Syriza wins the Jan. 25 elections, but doesn't obtain majority. They call new elections. By then (March), Greeks get scared out of leaving the euro. Syriza loses votes in the second election. A coalition of moderate parties forms, and in the nick of time Greece commits to reform in exchange for more time and money from troika. Greece stays in.	Syriza gets crushed in the polls, and stays out of gov't. ND forms a coalition. Stability returns, for now.

GDP growth and the contribution of the change in inventories

The latest figures on economic growth released by the Bureau of Economic Analysis (BEA) are bad. Yes, GDP growth has surged to 5.7% in the fourth quarter of 2009. But the contributions of investment, government expenditures, and net exports are almost nigh. Personal consumption expenditures has added 1.4 percentage points to growth, down from 2 percentage points in the third quarter. (See Chart 1.) The largest contribution (3.4 points out of 5.7) comes from the change in private inventories, i.e. the variation in the stockpiles of goods that businesses store. An increase in inventories adds to GDP, because those are goods that are produced but not sold, and therefore not included in expenditures; a decrease in inventories, on the other hand, must be subtracted from growth, because those goods were already counted in GDP at the time they were produced.

Chart 1 (click to enlarge)

What is wrong with having more than half of our growth coming from inventories?

First of all, in the medium term we are probably going to see inventories decrease more, not less, on average. Current inventory levels, as measured by the sales-to-inventory ratio, are too high relative to their long-term trend. (See Chart 2.) True, inventories plummeted through 2009, but that was just a correction to the excess stockpiles accumulated during 2008. Taking the recent trend of the sales-to-inventory ratio as benchmark, we should now be closer to 1.2 than to the 1.28 where we actually are. In the near term, therefore, and on average, we should expect net declines in inventories.

Chart 2 (click to enlarge)

Secondly, (optimistic) observers may have claimed that the positive contribution of the change in inventories is a sign that businesses anticipate an increase in demand. In fact, the present behavior of inventories is just a reflection of the economic past: businesses are increasing stockpiles, or at least reducing them more slowly, because consumption expenditures have picked up over the past six months. In other words, businesses are best characterized as backward-looking creatures. There is a strong correlation between current changes in private inventories and the past increase in personal consumption expenditures (PCE). (See Chart 3.) In fact, using quarterly data, the correlation coefficient is around 0.7. The correlation between changes in inventories and future PCE growth, on the other hand, is only 0.4. Saying that increases in inventories forebode stronger demand in the near future is almost wishful thinking.

Chart 3 (click to enlarge)

Finally, and this is a lesser point, estimates of changes in inventories are unreliable. Remember, the figures released by the BEA last Thursday are only advance estimates: over the next two months the government will release two revisions: the preliminary estimate and the final estimate. The “final” estimate will be revised again a few months down the road. Based on recent experience, substantially lower or higher revised figures for changes in inventories should not surprise us. Since 2006, for example, the average difference between the advance estimate and the “finally final” estimate has been $13 billion; the average absolute difference has been $4 billion –in the fourth quarter the change in inventories was -33.5 billion.

Did the recession end in May?

It’s looking more and more as if the recession in the U.S. ended in May. To support that claim I have looked at initial unemployment insurance (UI) weekly claims and the pattern that that time series has followed in previous recessions. The four-week moving average of not seasonally adjusted weekly claims has peaked less than eight weeks before the end* of the each recession since 1970 (see chart).

Click on the chart to enlarge.

The lead time was eight weeks in the 1973-75 recession, seven weeks in two recessions (1980 and 1981-82), six in 1970, five in 2001, and zero in 1991. The moving average declined essentially monotonically after each of those identified peaks.

During the current recession, the moving average saw a peak on the week that ended on April 4, 2009. That would put the end of the recession somewhere between April and May (zero to eight weeks later). And if the past is any indication, most likely in May.

The usual caveat applies: the pattern-recognition method is based on only six episodes of recession, and six is a very small number to make any claim on the significance of this finding. Moreover, each episode is spaced by several years from each other, so the hypothetical relationship between UI claims and the business cycle may have changed since last time.

I can’t help, nonetheless, to find some solace in that chart.

*Here I take the NBER dating of the business cycles. The NBER, however, provides the month in which a business cycle trough occurs, not the week. I take the liberty of dating the end of each recession on the last week of the month when the NBER identifies a business cycle trough.

When the heat is not in the core

Prices rose 2.4 percent in the year to September 2007, using the monthly price index for personal consumption expenditures (PCE); the reading was 0.6 percentage points higher than in August. Core inflation on the other hand, which doesn’t include the prices of food and energy, was 1.8 percent in the year to September 2007, and the reading stayed unchanged from the previous month.

Over the entire history of the two time series, the average difference between core and overall inflation has been close to nil (0.12 percentage points between 1960 and 2007). But the gap between the two does not necessarily have to be small and indeed has not been small for prolonged periods, sometimes lasting several years. (See chart 1.)


Most recently, between November of 2002 and August of 2006, overall inflation stayed above core inflation for 46 consecutive months. The average (and median) difference was 0.7 percentage points, a large one considering that core inflation ranged between 1.3 and 2.5 percent. (See chart 2.)


Most central banks including the Federal Reserve follow core prices, which means that many times their gauge of inflation is below the increase in the cost of living. Whether the Fed likes the prices of food and energy or not, wages are implicitly pegged to overall, not core inflation.

Suppose that the Fed has a target core inflation rate of two percent. If the public expects an overall inflation of, say, three percent next year, wages will increase accordingly, and so will nominal consumption expenditures. Monetary theory tells us that this will push actual overall inflation up to around three percent. Unless the prices of food and energy change relative to the rest of the prices, core inflation will also be around 3 percent, above the Fed’s target.


Conducting monetary policy by tracking core inflation is tantamount to assuming that the average gap between core and overall prices won’t get too far for too long (and that workers and employers have the same expectations). The US experience between 2002 and 2007 indicates otherwise (see chart 2). Given that economic conditions during those years have been “normal” --as opposed to the extraordinary oil shocks of the 1970s and early 1980s-- the premise that food and energy prices won’t stray too far from core prices doesn’t seem adequate as the default hypothesis for the rest of the century (barred a major technological breakthrough).

The main reason why central banks track core inflation, rather than overall inflation, is that the prices of foodstuffs and energy are notoriously volatile. Short-run changes in the price of those goods reflect variations in weather conditions, geopolitical climate, commodity markets, and discoveries of new oil reserves, for example. Central banks assume that those phenomena have a zero-mean effect on inflation in the long-run, so their effect on prices in the short-run can be safely ignored.

There is no question that inflation should be stripped out of its most volatile components. But it’s worth exploring alternatives to what we now know as core inflation. One possibility would be to use the prices of all goods and services, but then adjust their weights to reflect their volatility –prices with high volatility and low correlation with overall inflation would receive low weights. Those weights would evolve as new data are incorporated to the time series.

Another possibility is to leave out all goods and services with volatilities above a certain threshold. Those goods would not necessarily be food and energy, and would not necessarily be the same every month or every quarter. The Federal Reserve banks in Dallas and Cleveland have been calculating a trimmed index of inflation for a while. (Robert Rich and Charles Steindel of the Federal Reserve Bank of New York explore three alternatives to “ex-food-and-energy” inflation.)

A more radical approach would consist of targeting wages or labor costs directly, instead of the price of goods. (Knzn, over at “Economics and…” has been advocating this policy. Start by reading this post and this one.)

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