Sunday, October 27, 2013

Whither Inflation? "Many Now Think Inflation Helps"

The New York Times reported on October 27, 2013, that "there is a growing concern inside and outside the Fed that inflation is not rising fast enough."  On one level, this apparent policy pivot on the part of the Fed is surprising, given the Fed's long held and overarching aversion to any snippet of inflation in the economy.  A second surprise is the idea that increasing inflation is a monetary policy tool available to our government to encourage economic growth.  Third, it is also surprising that the Fed is considering inflation as an input into the economy, as opposed to a measure a a result of other economic forces.

In 1966, Alan Greenspan, a recent Chairman of the Federal Reserve, contributed to Ayn Rand's newsletter "Objectivist", writing "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation."  In his 18 years at the helm of the Fed, Greenspan's policies were on the side of an inflation hawk.  Equally, although in a much different time, Paul Volcker was serenely focused on monetary supply and keeping inflation in check.  One of his major efforts as Chairman of the Fed was the taming of the high inflation experienced in the early 1980's, triggering a recession to cool economic activity.

Volcker has also expressed his opinion in the past few years, expressing his concerns over potentially inflationary Fed policies.  In November, 2010, he spoke in Singapore about his concerns over the potential emergence of inflation associated with quantitative easing policies being led by Ben Bernanke.

In 2011, Volcker wrote an Op-Ed in the New York Times,  further expanding on his concerns about reduced vigilance against inflation on the part of the Federal Reserve and the Obama administration.  He also recognized, however, the "desperation" that essentially all the fiscal and monetary tools have been exausted to no great effect, other than saving the economy from going off a cliff, but not leading to even a moderately robust recovery, writing:

"There is great and understandable disappointment about high unemployment and the absence of a robust economy, and even concern about the possibility of a renewed downturn. There is also a sense of desperation that both monetary and fiscal policy have almost exhausted their potential, given the size of the fiscal deficits and the already extremely low level of interest rates."

"Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work."

Our current economic circumstance in the United States is quite troubling, with millions out of work, and job creation and incomes at levels abysmally short of prior levels and what people need and expect.  The Obama administration did a remarkable job addressing the great recession, keeping the global economy and financial system from collectively going over the credit cliff.  As it is, we are remain reeling from the effects of severe credit correction, with a economy wide shoring up of balance sheets, with all the concomitant reduction in credit availability.  There are, however, more pernicious and troubling undercurrents which are slowly and inexorably sinking developed economies below the surface.

The undercurrents to which I refer are the sources of value within the economy, sources of value which have in the past ten years shifted away from the United States economy.  Since 1980, there has been a 40% reduction in the number of manufacturing jobs in the United States, one symptom of intense price pressures associated with globalization.  The increased cost of many commodities, including oil, leading up to the 2008 great recession, all contributed to putting economic pressures throughout the economy, from households to businesses.  Strangely, oil prices did pull back after the 2007 peak, but did rebound back up to over $100 per barrel in 2011.

The normal factors which drive inflation up have not been working their magic in recent years.  Wages have been stagnant and demand for goods and services has not strengthened since the recession.  Outsourcing manufacturing to other countries along with intense price competition across the economy, with underutilized capacity, has resulted in a price driven recovery, instead of demand driven.  Demand is just not rebounding.

On the credit side, interest rates have been extremely low, and the Fed has been injecting funds into the banking system through quantitative easing.  Normally, this vast injection of liquidity into the economy would result in a lowering of the barriers to making investments, essentially a lowering of the hurdle rates for capital allocation,which presumably would increase the aggregate number of capital projects approved.  If, however, there is no demand for goods and services, there is no fundamental reason for expanding capital projects.  In addition to the lack of fundamental demand, banks have increased their credit requirements, and have been shoring up their own balance sheets, with increased capital reserves, reducing risk exposure, and writing down and jettisoning under performing portions of their loan portfolios.  In the housing market, there has been a rebound of prices and sales of existing homes.  This rebound has resulted in increased prices for housing stock but has not caused an up swell in the prices for labor and materials associated with new construction.

In classical terms, the definition of the cause of inflation is when too many dollars are chasing too few goods and services.  This infers that the extent of the Fed's policies on lowering interest rates and providing liquidity to the banking system through the succession of quantitative easing, would normally of resulted in increased inflation.  In looking at inflation in the last 40 years, there is a very high correlation between United States inflation levels and the inflation adjusted price of crude oil, as seen in the chart below.



In every period of inflation, there occurs an increase in the price of oil.  Accordingly, it is an exogenous factor, oil pricing, that influences inflation.  In 2013, the price of oil was above $100 per barrel for most of the year.  Also in 2013, the global economy, especially in North America, Europe and emerging economies in Africa and South America have experienced lower growth rates than in 2011 and 2012.  The United States is looking at a GDP growth rate for 2013 of 1.5%, significantly lower than the 2.8% in 2012.  This reduced growth in the global and United States economy is putting downward pressure on oil demand and oil prices.

Because of this downward pressure on oil demand and prices, we are not likely going to see a rebound of oil prices until 2015, after oil prices have dipped below $60 per barrel and two things happen:  (1) the global economy perks back up, and (2) investment in oil drilling pulls back.  These two factors lead to a demand resurgence at the same time there has been a pull back in the more expensive drilling activities, which will result in a run up in oil prices.  At that time, in 2015, there will be a resurgence of inflation in the United States, and not before.

Caveat - there is a good chance that oil prices will continue to buoyed by global demand factors, given that the Asian economies have lower elasticity of demand to price than European and North American economies.  As such, there are likely to retain higher demand for oil in a variety of oil price regimes.  This may mean that the global economy is not as whipsawed as it has been in the past with oil demand and price swings creating global economic instability, and less likely cause of a resurgence in inflation in 2015.

Another perspective on the the impact of oil prices on our economy is to look at the relationship between oil price movements and the value of the dollar.  The basic premise of the analysis in this blog is that oil is an underlying factor, driving economic activity, influencing inflation and the value of the dollar.  The opposite perspective would carry if oil prices were lower, there had been a pull back in oil drilling activity, and there was an up swelling in global economic activity.  None of these conditions is true today, as such, we are not going to see a resurgence of inflation until 2015 at the earliest.  



Saturday, October 26, 2013

Predicting Employment - US Employment Will Not Achieve Pre-Recession Levels Until 2018

98% of annual employment in the United States in the past 30 years is explained by two factors: total US primary energy use in Btu's and crude oil prices in 2011 dollars per barrel.  To predict US employment going forward is simply a matter of forecasting total energy use and inflation adjusted petroleum prices.  I say simply almost as tongue in cheek, given uncertainties associated with predicting petroleum prices and energy consumption.  This approach does, however, begin to bracket the question.

The initial premise was to take a look at the correlation of aggregate energy consumption and employment.  The following chart shows that there is an amazing correlation between employment and energy use in the United States.  The energy consumption is based on primary energy use int he United States, expressed in quadrillion Btu's, including all forms of energy.  Certain observations can be drawn from the chart.  Over the period from around 1955 through 1971, energy use in the United States grew quite rapidly, and grew faster than employment.  The impact of the Arab oil embargo can be observed with a downdraft in aggregate energy, followed by another rise and steep drop in 1979.  Both of these drops in demand were a result of steep rises in oil prices.

Since 1981, the movements of energy use and employment moved much more in lockstep, with an almost uncanny correlation in the period of 2007 through 2011.

Another observation that appears uncanny is that both energy and employment tripled in the period from 1949 through 2011.  Energy use rose from 32 quads in 1949 to 97 quads in 2011.  Employment rose from 44 million in 1949 to 131 million in 2011.

The most troubling observation about this data is that our energy use as a nation appears to have stopped moving upward, hitting a peak of 101.3 quadrillion Btu's in 2007, with 2013 primary energy use around 97 quads, or 4% below the 2007 peak.  At a very basic level, we may not achieve pre-recession employment levels until such time that energy use has moved up by 5%.  Indeed, the trajectory of growth in primary energy consumption has stagnated since 2000, with current energy use of around 97 quads below the 2000 level of 98.8 quads.  As such, the inference is that we may have hit a new period in the US economy, with low growth in energy consumption, with a corresponding period of low growth in employment.

To further my understanding of the relationship between energy and employment, I performed a regression analysis of US employment from 1982 through 2011 expressed in millions, against primary energy consumption in quadrillion Btu's, and inflation adjusted crude oil prices expressed in constant 2011 dollars per barrel.  I arrived at an equation which explains 98% of employment levels in the United States.  I applied the equation first to historical energy use and oil price data, to see how it fit with actual employment levels in the past 30 years.  I then applied the equation to develop a forecast of employment, based on EIA's forecast primary energy use, and fixing crude oil prices at $96 per barrel in 2011 dollars.  The results of these analyses can be seen in the chart below.  

Based on EIA's forecast of primary energy use, the regression analysis tells us that employment levels in the United States will not achieve pre-recession levels until 2018.

The data also tells us that employment is going to grow by 0.4% per year over the next 20 years.  Unless something changes drastically, this means that the people of the United States will be suffering extended underemployment for decades to come.

Wednesday, October 23, 2013

Carbon Tax: A Few Thoughts on Implications for Economic Growth and Clean Energy Investment Policies

(Written in response to article on thebreakthrough.org site: "Should We Swap Energy Subsidies for a Carbon Tax?")  
A carbon tax will impact the economy, with the directionality and extent conditional upon alternatives available to energy consumers, and the allocation of carbon tax receipts by the government.  In addition, increased taxation reduces the velocity of money in the economy, which reduces economic activity.     
The impact of a carbon tax on energy consumers depends on available alternatives and opportunities for switching.  In the short term, a carbon tax would have a negative effect on the economy, diverting financial resources away from household budgets, reducing discretionary spending, and reducing profits for businesses.  The effect of a tax on gasoline for consumers, for example, results in reduced driving, or reducing other expenditures.  Wealthy consumers can offset increased gasoline costs by purchasing a hybrid car, overcoming the increase in gasoline taxes.
Over time, leveraging market forces to identify and source lower carbon alternatives can be the most effective means to obtain the greatest return on deployed capital and resources.  If there are no lower cost forms of energy available, or capital for improving efficiency is limited, then the overall effect of a carbon tax will be reduced economic activity. 
A carbon tax is regressive, as economically disadvantaged people do not have the capital and resources to acquire lower cost alternatives, resulting in their otherwise being stuck with a higher cost life.  This points to the need for the government to dampen the negative impacts of the carbon tax. 
The choice of what the government does with carbon tax receipts is critical, informed by the potential economic pratfalls associated with instituting the carbon tax.  Overcoming the dampening effect of a carbon tax is accomplished by making lower cost energy resources available as well as loosening up capital resources to accelerate investments in improving energy efficiency and productivity.  A 5% carbon tax, for example, can be overcome by a 7% improvement in energy efficiency, for example, with the added 2% to cover capital costs. 
A 5% carbon tax may encourage certain switching behaviors, but as an incentive, is not sufficient to encourage investment in alternative energy technologies that have larger price/performance gaps.  For example, there was a time when wind turbines were three times more expansive than what is needed to compete on the grid.  A 5% carbon tax would really not be enough to encourage investment to bridge a 200% price/performance.  Hence, there is a reason for governments to participate implement policies targeting closing the price/performance gap on emerging clean energy technologies.  Wind and solar technologies, for example, have both benefited from favorable financial policies on the part of governments.  As such, in certain markets around the world, both wind and solar power technologies are achieving grid parity economies.  These cost reductions have been achieved by the government priming market demand, resulting in scale economies and continuous movement down the learning curve. 
In summary, it is not a question of swapping energy subsidies for a carbon tax.  It is recommended to have both policies, with receipts from a carbon tax providing energy subsidies to encourage lower cost alternatives, encouragement of investments in energy efficiency and productivity, as well as addressing regressive nature of the tax. 

Monday, October 21, 2013

Dollar Will Continue to Strengthen With Softening Global Economy and Continued Weak Demand for Oil

As seen in the accompanying chart, the recent decline in oil prices correlates well with recent surge in the value of the dollar.  The trade weighted dollar index hit a low of 94 in July 2011, and has recently surged to a high of 103 in September 2013, an increase in value of 9.6%.  Over that same period of time, Brent crude spot oil prices hit a peak of $126 per barrel in April, 2012, and have since fallen to a low of $100 in October, 2013, representing a 20.6% decline in cost.  On initial observation, the current directional trend appears to be a continuing strengthening of the dollar and a continued decline in oil prices.

Factors resulting in a general tempering of the global demand for oil exogenous to the US economy include recent tempering of the Chinese economy, a cool down of India's economy, and a  general sluggishness across the globe of what were previously economies exhibiting higher growth rates.

According to the Bureau of Economic Analysis, the US economy grew by 2.8% in 2012.  The Conference Board forecasts a rather tepid growth of 1.5% in the US economy in 2013.  This level of growth is corroborated by a third quarter 2013 survey of 41 forecasters by the Federal Reserve Bank of Philadelphia, with a consensus forecast of 1.5% GDP growth for 2013.

The International Monetary Fund recently reduced its forecast for global growth in 2013 and 2014, pointing out that "Emerging market and developing economy growth rates are now down some three percentage points from 2010 levels, with Brazil, China and India accounting for two thirds of the decline."

These declines in global economic growth rates contribute to a reduced expectation for oil market pressures, and a corresponding reduction in oil prices.  It may just be that these reductions in market pressures for oil are an important contributing factor in the recent run-up in the value of the dollar. With a continued expected sluggishness if not softening of the global economy, we are likely to see continued reduction in oil prices and an increase in the value of the dollar.




Monday, October 14, 2013

China Surpasses the United States as the World's Largest Oil Importer

According to EIA's monthly Short Term Energy and Winter Fuels Outlook, China surpassed the United States in September, 2013 as the world's largest importer of petroleum.





Tuesday, October 1, 2013

Worldwide Installed Capacity of Wind Power To Blow Past Nuclear

Frequently, nuclear is held out as a carbon-free scalable technology, which it definitely is.  It may seem to some, however, that there is an implied differentiation that frequently accompanies these statements, implying that technologies such as wind and solar are not scalable, and hence less feasible when compared to nuclear.  Without getting into the details, I would like to share the following chart, which shows the global installed capacity of nuclear power and wind power.

What the chart shows, empirically, is that whether or not wind is scalable compared to nuclear, it will surpass nuclear as a major global power source, perhaps as soon as within the next two years.  Perhaps this implies that wind is a scalable power technology, although what is likely meant by scalable is very large central plants.  Being a distributed or diffuse power source does not seem to stand in the way of unprecedented growth of windpower.