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With stocks hitting some post global economic meltdown highs last week , James Hamilton took a look at the "long term fundamentals" that seem to be driving the rise. And it while it appears there are a lot of reasons to be bullish about the US economy for later this year, that does not necessarily mean that the market will continue to rise. From EconBrowser : On the one hand, I'm expecting the real economy to be doing better in the second half of the year than it is right now, and inflation and interest rates to remain low through the end of the year. All of that should be bullish for stocks. But the question is, how much of that good news is already priced in? Below is an update of one of the graphs from Yale Professor Robert Shiller's very long-term data set to which I've often referred. The green line is a price-earnings ratio on the S&P500 or earlier counterparts. So as not to overstate the impact of temporary spikes up or down in earnings, Shiller relates the current inflation-adjusted stock price to the previous ten-year-average of inflation-adjusted earnings. That backward-looking P/E currently stands at 22.8, well above its average value of 16.5 in data going back to 1880. If the ratio of prices to historical dividends is unusually high right now, and if you expect the ratio to revert to more typical values, it suggests that you should expect a lower capital gain on stocks you buy today compared to what you would have earned if you bought at a time when the P/E was at or below its historical average. The blue line in the graph below shows the annual rate of return you would have earned by buying stocks at any indicated date and holding on to them for the next decade. That line stops in January 2003, because we don't yet know what the 10-year return of a stock purchased in February 2003 will turn out to be, and we certainly don't know what the 10-year return on a stock purchased in February 2013 is going to be. But what we do know is that in the historical record, you did indeed tend to earn a lower return on stocks if you bought them at a time like today when the P/E is relatively high. Read the full post here .

In an effort to determine whether consumption of oil in the U.S. will continue to decline, James Hamilton took a look at fuel efficiency. The average miles-per-gallon for cars in America has been rising. Assuming that current efficiency standards are not dropped, then average mpg will continue to rise as older models head for the scrap heap. Hamilton sketches out the projection at EconBrowser : Hamilton: Given the history of the average mileage of new vehicles sold each year (the blue line in the figure above) and an assumed fraction of cars of each age still on the road implied by the exponential distribution, I calculated the current average fuel economy of the existing fleet to be 27 mpg-- this is essentially just a geometric weighted average of the most recent values for the blue line in the graph above. If new cars offer 33 mpg, the average fuel economy of the existing fleet will continue to rise with time even if nothing else changes. For example, if the fuel efficiency of new cars sold in 2013 is no better than it was in 2012, the average fuel economy of the typical car on the road will improve to 27.6 mpg next year as more 33 mpg cars replace some of the less fuel-efficient models currently on the road. If there are no further improvements in fuel efficiency over the next decade, I calculate that the average car on the road would be getting 30.5 mpg by 2020. However, current Corporate Average Fuel Economy (CAFE) rules call for increasing mileage standards over this decade. MIT Professor Christopher Knittel estimates that technological progress would allow average miles per gallon to grow by about 2% per year with constant vehicle size and horsepower, and torque, and faster if we gradually move to smaller cars. In Scenario 2 in the graph above, I assume that the average miles per gallon of newly sold vehicles increases by 2.5% per year. That would result in slightly better mileage each year than anticipated to result from current CAFE standards. Under this scenario, the average efficiency for existing cars would rise to 27.7 mpg in 2013 and 32.8 by 2020, when the average new car sold in 2020 is assumed to get 40.5 mpg as measured by the NHTSA (translating into a presumed EPA sticker mileage of perhaps 30 mpg). The next question is how much a reduction in consumption this would translate into. First suppose that the total number of miles driven never goes up from 2012 levels. That would mean a ratio of gallons consumed in 2013 to gallons consumed in 2012 of (27.0/27.6) = 0.978 or a 2.2% reduction under Scenario 1 and a 2.4% reduction under Scenario 2. By 2020 we would have an 11.4% reduction under Scenario 1 and a 17.8% reduction under Scenario 2. Read the full post here .

On Thursday, the New York Fed announced that, after nearly four years, it had sold off all the securities in the Maiden Lane III portfolio , which had been set up to rescue AIG. And they did so at a profit of "approximately $6.6 billion." At Econbrowser , James Hamilton has taken this occasion to "review the various measures that the Fed implemented over the last 5 years." Hamilton: I was surprised to see that the Fed ended up making a profit on AIG-- my understanding had been that the Fed's strategy had been to mark these down at a loss over time. I was unable to discover the details of how this ended up favorably for the Fed. Thursday's statement indicates that more information will be provided on November 23. But the fact that the Fed ended up making a profit from these transactions is an important detail. The key uncertainty for policy makers at the time (just as it is the key dilemma for the ECB at the moment) was determining whether the crisis is one of illiquidity or insolvency. If the problem is just that assets are temporarily undervalued as a result of the financial panic (i.e., the assets are temporarily illiquid), the central bank can solve the problem by stepping in as a lender of last resort. If instead the problem is that the assets are correctly valued (i.e., the borrowers are fundamentally insolvent), all the central bank can do is transfer these losses from existing creditors to the taxpayer (possibly in the form of an inflation tax). A key indication that the central bank did exactly the right thing is if, as a result of their stepping in, the long-run value of the asset is restored, in which case the Fed would end up making a profit out of the transaction. Some have criticized the Fed's emergency lending on the grounds that the Fed took all these extraordinary actions and yet the economy still performed very badly in 2008:Q4 - 2009:Q2. I think this misses the point. I don't believe that it was ever within the Fed's (or anyone else's power) to bring the economy quickly back to full employment. Instead, the purpose of the Fed's emergency lending was to prevent a very bad situation from becoming even worse than it needed to be. The evidence we now have suggests that the Fed indeed accomplished exactly this. See for example the recent post-mortems by Adrian and Schaumburg on the CPFF and the PDCF. But let me now return to the first graph (below) to briefly discuss what I see as a very different strategy that the Fed has been following since winding down these emergency lending programs. The Fed replaced the emergency lending with significant growth in its holdings of U.S. Treasury securities, debt issued by Fannie Mae and Freddie Mac, and mortgage-backed securities guaranteed by Fannie and Freddie. These are fundamentally very different from the aggressive lending in the fall of 2008 in that they involved no new transfer of private risk to the taxpayers. The reason is that, before the Fed bought any agency debt or MBS, the U.S. Treasury had already assumed financial responsibility for these agency obligations. Rather than trying to serve as lender of last resort, these more recent measures (sometimes referred to as "QE1" and "QE2") were instead just intended to help keep long-term borrowing costs low and to make sure that the U.S. did not experience a Japanese-style deflation. Read U.S. monetary policy since the financial crisis here .

When we look at how much the cost of a gallon of gas varies from state to state, the first cause that comes to mind is the different tax rate for gas from state to state. But while that explains part of the cost variance, it does not account for all of it. At Econbrowser , James Hamilton breaks down the key factors in state gas prices in a series of helpful maps. First, there is this map from GasBuddy.com that shows how different gas prices can be from state to state, or even county to county: So while taxes are a major factor, Hamilton cites a number of other key factors, like state requirements for the quality of fuel, and the cost of crude oil at regional refineries: For example, sweet crude in Louisiana is currently fetching $125 a barrel, or $27 more than its counterpart in Wyoming. If the refined product market in Wyoming were completely separate from that in the rest of the country, we might then expect gasoline in Wyoming to be 68 cents/gallon cheaper than on the coasts as a result of differences in the cost of crude alone. But the refined markets are not completely separated, and no producer would want to sell gasoline in Wyoming if you had an easy way to get it to somebody willing to pay 68 more cents per gallon for it. Although America's pipeline system for transporting crude oil is not up to the task of moving all the crude available in Wyoming to refineries in Louisiana, the infrastructure for transporting refined products is somewhat better. The result is that Americans in the middle of the country pay more and those on the coasts pay less than they would if the product markets were completely isolated geographically. The equilibrium price differential is the one that equalizes the return from selling in different markets after taking into account transportation costs. Read Why do gasoline prices differ across U.S. states? here .

In the latest Foreign Policy , Menzie Chinn and Jeffry Frieden argue on behalf of conditional inflation targeting. A little inflation would be welcome, they say, in that it would "reduce the debt burden to more manageable levels." They write: Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems. To back up his assertion that a little inflation is not a threat, Chinn adds this graph of implied inflation at the Econbrowser blog. Do you agree with Chinn that fear of inflation is "unwarranted"? Read A Call for Action: Conditional Inflation Targetting here .

James Hamilton thinks that in order to return to a healthy economy we need to do something about this: Household mortgage debt skyrocketed in the 2000s, and income did not keep up. The solution depends on some mix of foreclosures, increased saving, and GDP growth. But these elements don't make good teammates with the economy in its current state. So Hamilton, writing at EconBrowser , offers some support for the Federal Housing Finance Agency proposal to alter the Home Affordable Refinance Program : One obstacle to refinancing has been mortgages that are underwater, which means that, as a result of declines in house prices since the time of the purchase, the principal owed on the mortgage exceeds the current resale value of the home. Previous rules would not allow Fannie or Freddie to guarantee a loan whose value exceeds that of the home, which refinancing an underwater loan would require. The new FHFA proposal relaxes that requirement so as to allow refinancing for underwater loans that were originated more than 2-1/2 years ago and on which the borrower is current on the payments with no late payments over the last 6 months. One question of interest is, who will ultimately end up losing the income that corresponds to the household's gain from refinancing? Since the original loans are currently guaranteed by Fannie or Freddie, and since Fannie and Freddie's liabilities in turn are now de facto guaranteed by the U.S. Treasury, one's first thought might be that the household's gain is ultimately the loss of the U.S. Treasury. However, Fannie and Freddie guarantee against default but not against the loss that comes from pre-payment, so it's the holder of the loan, not the U.S. Treasury, that loses. On the other hand, Fannie and Freddie own over a trillion dollars of the loans themselves, and the Federal Reserve owns another trillion. The Federal Reserve contributed $82 billion to the U.S. Treasury this year from its earnings on the mortgage-backed securities and other assets that it holds. A lower income flow from these would reduce the size of the payments to the Treasury that the Fed is able to make and increase the net contribution the Treasury needs to make to keep Fannie and Freddie solvent. Read Hamilton's full analysis here .

At Econbrowser , James Hamilton lays out the case for the economy to stabilize somewhat in the second half of 2011. He can't quite bring himself to say that it will get better, instead saying that he doesn't "expect things to get a whole lot worse." A major culprit for the slowing recovery has been oil prices--and specifically the impact of oil prices on new car sales. But Hamilton expects car sales to pick up as retail gas prices come down. He shares this look at the trend in car sales: Hamilton argues that the recent trouble for auto sales were very different from the back in 2008. Read his analysis here .