Tuesday, September 21, 2010

Poverty and the Recession: Is The Worst Still Ahead?

Reports released over the last few days provide final dating for the 2007-2009 recession and data on U.S. poverty and income for 2009. How are they related? How did the recession affect poverty? Now that the recession is officially over, can we expect that the worse is behind us in terms of poverty and income?

The Census Bureau report showed the poverty rate rising from 13.2 percent in 2008 to 14.3 percent in 2009, the highest rate since the early 1980s. The figure that grabbed the headlines, however, was not the overall rate but that for working-age Americans, which climbed to 12.9 percent, its highest level since the Census Bureau's continuous data series began 35 years ago. The remarkable increase in working-age poverty is undoubtedly linked to the extreme rate of long-term unemployment, which has risen far above its levels of any previous recession. The economic distress of the working-age population is further indicated by the record numbers of people without heath insurance, also a subject of the Census Bureau report.

Is the worst behind us? Unfortunately, there is little reason to hope that it is. In recessions of the 1960s and 1970s, the peak rate of unemployment tended to coincide with the year in which the recession ended, but starting with the dual recessions of 1980-82, the picture changed. Since then, peak poverty has begun to lag farther and farther behind each recession.

The bottom line: We can expect even worse poverty data in 2010 and probably in 2011 as well.

Follow this link to download a free set of classroom-ready slides with charts and analysis based on the 2009 poverty report.

Saturday, September 18, 2010

US Inflation: What is the Trimmed Mean CPI and What Does It Tell Us?

On September 17, 2010, news headlines reported that the US Consumer Price Index for August had increased by 0.3 percent. Is this a good or bad number? Unfortunately, monthly CPI changes don't tell us much. What steps can we take to make inflation data more useful for interpreting and formulating economic policy?

The first step is to convert monthly data to annual rates.  If the July-to-August monthly change (which was 0.254 percent, before rounding) were to continue for a full year, the annual rate of inflation would be about 3.1 percent. Annual rates are almost universally used in discussions of economic theory and policy.

Month-to-month changes are highly volatile. To reveal the underlying inflation trend, the next step is to look at changes in the CPI from the same month a year ago rather than changes from a month ago. Since inflation was lower for most of the previous year than it was in August, the year-to-year figure that month was just 1.1 percent, much lower than the annualized monthly figure of 3.1 percent.

The next step takes into account the fact that some prices, like those for food and energy, lie largely beyond the influence of domestic monetary and fiscal policy. Those prices are set in world markets and are subject to influences ranging from world politics to weather to oil spills. To show inflation trends with volatile food and energy prices removed, the Labor Department publishes a core CPI series. The core CPI increased at just a 0.9 percent annual rate in August.

Finally, we might ask, why adjust only for food and energy prices? Why not exclude any prices that show unusual changes in a given month? The Cleveland Fed publishes just such a series, called the trimmed mean CPI. It excludes the most extreme 16% of price movements each month. Many economists see it as the clearest indicator of underlying inflation trends, an improvement over the core CPI. The trimmed-mean CPI and core CPI numbers were about the same for August, 2010, but the trimmed mean series shows a more pronounced trend toward lower inflation over the previous two years.

The bottom line: Monthly inflation figures can sometimes signal a turning point in inflation, but those turning points are just as often masked by random noise. At present, the core CPI and trimmed mean CPI show that US inflation is still on a downward trend. Expect the Fed to stick to its easy-money policy until the trend shows a clear upward turn.

Follow this link to download a free set of classroom-ready slides discussing the trimmed mean CPI and other CPI variants. You may also want to steer your students to the Cleveland Fed's nifty interactive tool for generating inflation charts using all sorts of different inflation measures.

Monday, September 13, 2010

More on Financial Reform and Basel III: Regulating Bank Liquidity

As an earlier post explained, the Basel III agreement, now under negotiation, will set international capital adequacy regulations for banks. It will also set regulations for bank liquidity, which are the subject of this post.

Banks need liquidity because they cannot always control the timing of their needs for funds. For example, depositors may make unexpected withdrawals, sources of wholesale funding may not be rolled over in a crisis, line-of-credit agreements may create demands for liquid assets to fund loans, and off-balance sheet obligations provide further liquidity needs.

Bank runs are the classic form of liquidity crisis. Although deposit insurance mitigates runs on retail deposits in most advanced countries, insurance does not extend to large depositors or wholesale funding. As runs deplete a bank's liquid reserves, it can be forced to sell less liquid assets at "fire-sale" prices below book value. Doing so erodes its capital and may lead to insolvency.

During a crisis, a liquidity spiral may develop that spreads problems from weaker to stronger banks. Early in the crisis, a few weak banks are forced to dump assets to cover deposit losses, collateral calls, or other liquidity needs. Falling asset prices weaken the balance sheets of other banks, and force them, too, to sell assets are fire-sale prices. Soon even healthy banks are subject to stress. In the fall of 2008, just such a liquidity spiral helped spread the financial crisis throughout the globe from its origins in the U.S. subprime mortgage market.

Regulations to moderate liquidity risk can apply to both the asset and liability sides of bank balance sheets. Asset side regulations can require minimum cash reserves, including reserve deposits at central banks, and can also encourage holding of additional liquid assets like short-term government bonds. Liability-side regulations can limit banks' reliance on volatile wholesale funding while encouraging use of stable funding like capital and insured retail deposits.

The Basel III negotiations, now underway, include discussion of two major liquidity regulation initiatives. One is a proposal for a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, hopefully long enough to permit recapitalization or orderly wind-up. Another proposal calls for a net stable funding ratio based on a ratio of available stable funding to required stable funding. The former is a weighted average of liabilities, with stable sources of funding like retail deposits and capital having high weights, and the latter is a weighted average of assets, with the most liquid assets having low weights.

The Basel III agreements are supposed to be completed by the end of 2010. They are the object of tough negotiations among national governments and fierce lobbying by banking interests. A preliminary meeting in July already resulted in some watering down of the initial proposals, including an agreement to postpone implementation of the net stable funding ratio during several years of observation. The final form of the Basel III agreements is certain to be a significant factor in shaping the timing and severity of the next banking crisis.

Follow this link to download a free set of classroom-ready slides explaining the need to regulate bank liquidity and discussing the Basel III proposals. These slides are best used together with those attached to my earlier post on Basel III and bank capital, which provides additional information on the Basel agreements in general.

Thursday, September 2, 2010

Bernanke Confronts "Too Big to Fail"

In recent testimony before the Financial Crisis Inquiry Commission, Fed Chairman Ben Bernanke confronted the "too-big-to-fail" problem head on. "If the crisis has a single lesson," he said, "it is that the too-big-to-fail problem must be resolved."

How did the US banking system get into this position? It used to be known as a system of small banks, and there are still nearly 4,000 community banks with assets under $100 million. However, most of the growth of banking in recent years has come from large, multi-bank holding companies. According to FDIC data, the 105 banks with more than $100 billion in assets hold 78 percent of all bank assets. Even more striking, just four banks, each with $1 trillion or more in assets, control 58% of all bank assets.

A bank is too big to fail if its failure would threaten the function of the whole banking system via losses to uninsured depositors, losses to counterparties on complex transactions, and general fear of dealing with all banks when even the largest are seen as vulnerable. When banks become aware that they are protected from to failure, they become subject to the problem of moral hazard. Knowing they will be bailed out when they get in trouble, they take too many risks. Confident of bailouts, investors, in turn, supply capital to the biggest banks at favorable rates, so the big grow ever bigger.

What can be done? One solution would be to break up the biggest banks into smaller institutions. Such measures were discussed, but rejected, during recent discussions of financial reform. Instead, the 2010 Dodd-Frank Act took a different approach. It attempted to eliminate moral hazard by instituting a new resolution mechanism for complex banking organizations that would allow even the largest institutions to be wound up without bailouts of management, shareholders, or counterparties.

Will it work? It all depends on credibility. "Simple declarations that the government will not assist firms in the future . . . will not be credible on their own," Bernanke said in his recent remarks. Declarations of intent need to be backed up not just by Dodd-Frank type resolution mechanisms, but by other measures as well, such as the stronger capital requirements expected under the forthcoming Basel III agreements.

Ultimately, though, we will not know if the new measures will work until they are tested. We will find out only when the next crisis strikes.

Follow this link to download a free set of classroom-ready slides discussing the too-big-to-fail problem.