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  • When it Comes to Publicly Held U.S. Currency, It's All About the Benjamins

    There are a lot of U.S. bills in circulation. $1.2 trillion worth. And most of them, as James Hamilton points out at Econbrowser , are of the $100 variety. Benjamin Franklin adorns 75% of all the bills in public circulation. That may be hard to believe for those of us who don't regularly see 100-dollar bills being exchanged. But there is a reason for that. Hamilton: A recent paper by Federal Reserve economist Ruth Judson uses a variety of methods to infer that many of those $100 bills are being held outside the United States, where U.S. currency is sometimes regarded as a safer store of value than other local options. This is a long-standing trend that seems to have accelerated during the financial crisis. Judson estimates that about half of the growth since 1988 in currency held by the public has ended up outside the United States. That growth represents one important benefit that the U.S. has received from having a currency that is regarded as a safe and stable store of value. In effect, the growth in foreign-held dollars has meant that the U.S. government has been able to buy hundreds of billions of dollars worth of goods and services without ever needing to tax its own citizens or borrow in the form of interest-bearing Treasury securities. Which is a great deal, as long as those foreign holders don't change their minds and try to dump that currency back on us. Read Who is holding all those U.S. dollars? here .

  • James Hamilton on 'Long Term Fundamentals Underlying Equity Values'

    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 .

  • James Hamilton's Monetary Policy Review

    At Econbrowser , James Hamilton reviews U.S. monetary policy over the last four years. Or, to be exact, over the last 4 years and 4 months, since we have to start at September 2008. The fireworks began when the collapse of Lehman Brothers in September 2008 led to a freezing of credit for all kinds of essential economic activities. The Fed stepped in with a number of emergency lending programs such as the Commercial Paper Lending Facility to help the commercial paper market continue to function, currency swaps to assist foreign central banks cope with emergency dollar needs, and the Term Auction Facility to provide direct liquidity to U.S. banks. These programs totaled over $1.7 trillion at the end of 2008, but have since all been wound down. The Fed came out of it all making a profit that was returned to the U.S. Treasury. The need for these facilities began to ease in 2009, but the economy was far from healthy, with unemployment continuing to shoot up. This led to the Fed's decision in March 2009 to replace the emergency lending with large-scale purchases of mortgage-backed securities guaranteed by Government Sponsored Enterprises and to a lesser extent long-term U.S. Treasury securities. These purchases were popularly described in the financial press as the first round of quantitative easing, or QE1. Their effect was to keep the total value of assets held by the Federal Reserve from falling as the emergency lending programs declined. You may know the rest of the story. But probably not as well as Hamilton. In any case, his summary is quite handy. Read it here .

  • James Hamilton: Charting Potential Drop in U.S. Oil Consumption

    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 .

  • QE3, 'Fat Fingers,' and the Price of Oil

    At Econbrowser , James Hamilton has yet another instructive post on oil prices. Last week, he noticed this dip in the price of West Texas Intermediate crude oil: Hamilton wondered to what extent this drop could have to do with supply and demand. He writes: Those who doubt that oil prices are determined solely by fundamentals would naturally ask, what aspect of the supply or demand for oil could have possibly changed in the course of less than a minute last Monday? The obvious and correct answer is, there was no change in either the supply or the demand for physical oil over the course of that minute. The minute-by-minute price of a NYMEX contract is determined by how many people are wanting to buy that financial contract and at what price, not by how much gasoline motorists burned in their cars that minute. But since changes in the price of crude oil are the key determinant of the price consumers pay for gasoline, doesn't that establish pretty clearly that the whims or fat fingers of financial traders are ultimately determining the price we all pay at the pump? In one sense, the answer to that question is yes-- last week's decline in the price of crude oil will soon show up as a lower price Americans pay for gasoline. But here's the problem you run into if you try to carry that theory too far. There are at the end of this chain real people who burn real gasoline when they drive real cars. And how much gasoline they burn depends in part on the price they pay-- with a higher price, some people use a little bit less. Not a lot less-- the price of gasoline could change quite a lot and it would take some time before you could be sure you see a response in the data. That small (and often sluggish) response is why the price of oil can and does move quite a bit on a minute-by-minute basis, seemingly driven by forces having nothing to do with the final users of the product. But if the price of oil that emerges from that process turns out to be one at which the quantity of the physical product that is consumed is a different amount from the physical quantity produced, something has to give. Indeed, the bigger price drops we saw on Wednesday followed news that U.S. inventories of crude were significantly higher than expected . Read Fat fingers and the price of oil here .

  • James Hamilton on Five Years of Fed Moves

    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 .

  • Key Factors in Gas Prices from State to State

    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 .

  • Impact of Oil Prices on Gas Prices: or What drivers can expect to pay at the pump

    With Iran cutting off its oil from Britain and France, oil prices have climbed to a nine-month high this week . So what will the impact be on gas prices here in the US? The answer may not be quite as simple as "gas prices rise when oil prices rise," says Econbrowser 's James Hamilton . There's speculation involved, and the price fluctuations do not always follow as we expect: Here's a closer look at the data over the last year. Average U.S. gasoline prices fell more than you would have predicted based on the Brent price. They have since come back up. But Brent has surged another $10/barrel over the last two weeks, and gasoline prices have yet to catch up to that latest move. Based on the historical relation, we might expect to see the average U.S. gasoline price rise from its current $3.59/gallon up to $3.84. One factor that's been driving Brent and WTI up over the last few weeks has been rising tensions with Iran. But why should threats or fears alone affect the price we pay here and now? Phil Flynn, a senior market analyst at PFGBest Research in Chicago, offered this interpretation: We're seeing panic buying in Europe and Asia because they're absolutely convinced that they're not going to be able to buy Iranian oil or there's going to be some kind of conflict that disrupts the transport of oil through the Strait of Hormuz.... there is a lot of hoarding in case the worst-case scenario happens. Asian buyers have been buying up West African crude like it's going out of style. Does it make sense for consumers to suffer now just because of something that may or may not happen in the future? If there are significant disruptions, the answer will turn out to be yes. We'll be glad that we used a little less today, and left a little more in storage, to help us better cope with the huge challenges we'll be facing in a few months. If the answer turns out to be no, then this is all just a lot of pain for nothing. Read Crude oil and gasoline prices here . Also see Oil Prices and Consumer Spending from the Richmond Fed .

  • EconBrowser: Climbing the Mountain that is the Mortgage-Debt-to-Income Ratio

    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 .

  • James Hamilton: Signs the US Economy Will 'Hang in There' In 3rd Quarter

    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 .

  • James Hamilton on 'A Weakening Economy'

    At Econbrowser , James Hamilton has a rather distressing roundup of recent economic data. The already sluggish recovery has slowed down, he says. Manufacturing numbers are getting weaker, housing prices keep going down in most markets, employment may not have hit bottom...all leading to meager GDP growth: The national income and product accounts updated last week by the BEA suggested that first quarter GDP growth was even weaker than previously indicated. GDP can be calculated in two ways, by summing up data on either what gets produced or the income generated by that production. Conceptually (and by definition) the two numbers should be exactly the same, but in practice you don't come up with quite the same number using different methods. Jeremy Nalewaik has argued that the income-based measure of GDP (referred to as gross domestic income, or GDI) may be a slightly better indicator of business cycle turning points. For example, GDI gave a clearer signal than GDP of a weakening economy in 2007. GDI had been showing a little stronger growth than the GDP indicator in early phase of the current recovery (2009:Q4-2010:Q2), but has been signaling weaker growth than GDP for the most recent quarters (2010:Q3-2011:Q1). The latest BEA numbers report that total U.S. real output was growing at a 1.8% annual rate in 2011:Q1 according to the GDP measure but at only a 1.2% rate according to GDI. Read A weakening economy here .

  • Gas Prices Up, Consumer Sentiment Down

    Consumer sentiment is dropping, according to the University of Michigan's Consumer Sentiment Index . Here are the key survey findings from Reuters : The preliminary March reading of the University of Michigan's consumer sentiment index for March came in at 68.2, down from 77.5 in February. That was the lowest level since October 2010 and was well off the median forecast of 76.5 among economists polled by Reuters. The survey's barometer of current economic conditions was at 83.6, down from 86.9 the month before and below a forecast of 86.0. The survey's gauge of consumer expectations tumbled to 58.3 from 71.6, the lowest level since March 2009. Here's a look at the Consumer Sentiment Index since 1978 (chart from James Hamilton ): At Econbrowser , Hamilton shares some helpful research on the relationship between rising gas prices and consumer attitudes: We had been getting some good economic news on other fronts lately, which I had been hoping would be enough to offset the hit to consumers' budgets from energy prices. The March numbers so far are just preliminary, and consumer sentiment is a somewhat noisy indicator. But whatever you make of the latest report, it is not good news. Another question asked in the survey pertains to expectations of inflation. Consumer expectations of inflation for the next year jumped from 3.4% to 4.6%. Again gasoline prices seem to figure more prominently in consumers' expectations than we might have expected, and again we can do a simple mechanical calculation of the direct effect. Gasoline prices have a weight of about 5% in the CPI, so if all other prices were held fixed, the 20% increase in gasoline prices we've seen over the last 3 months would add about one percentage point to the CPI. Read Consumers see bad news here .

  • Econbrowser: Progress Report on QE2

    At Econbrowser , James Hamilton takes a crack at evaluating the effectiveness of the Fed's latest quantitative easing tactics (and includes some helpful graphs for anyone trying to teach the subject): The graph below provides our calculations of the average maturity of publicly-held debt both before and after the Fed's operations, updated to include the first 3 months of QE2. The blue line is the average maturity (in weeks) of debt issued by the U.S. Treasury. The green line is the average maturity of publicly held debt, that is, the green line represents the results of subtracting off the Fed's holdings of Treasury debt. Historically the green line was above the blue. This is because the Fed preferred to buy the shorter-term debt, as a result of which the average maturity of the remaining debt held by the public (green) was bigger than that for the debt as originally issued (blue). However, since the start of 2008, that relation has been reversed-- the Fed has been buying a disproportionate share of the longer-maturity debt, and thus has been a factor in reducing the average maturity. But also since 2008, the Treasury has been issuing more long-term debt faster than the Fed has been buying it, so that the green line continues to rise over time. What we find in the latest data is that this trend has continued over the last 3 months, even with QE2. The graphs below highlight details of the last year. The top panel is the average maturity of publicly-held Treasury debt inclusive of all Fed operations, that is, it corresponds to the green line in the preceding figure. Although the average maturity in the second and third months of QE2 (December and January) fell a little below that for the first month (November), the average maturity in every one of these three months was bigger than in every month of the two years prior to QE2. The second panel shows the fraction of publicly-held Treasury debt (again, after netting out the Fed's operations) that is of 10 years or longer maturity. This has gone on to make new highs in both December and January. Our conclusion is that if QE2 made a positive contribution to the improving economic indicators since the program began, it could not have been through the mechanism of shortening the maturity of publicly-held Treasury debt. There are, to be sure, other places where the Fed's QE policies could have made some sort of impact, and Hamilton notes this in his post. Read Progress report on QE2 here .

  • James Hamilton: Inside the Numbers on Latest Unemployment Report

    According to the Bureau of Labor Statistics unemployment report for December , released on Friday, the US unemployment rate has dropped to 9.4%. Good news, right? Not so much, says James Hamilton , writing at Econbrowser : Unfortunately, the household numbers look much less rosy when you look at them a little more closely. For one thing, the impressive December gain comes right after an estimated loss according to the household survey of 175,000 jobs in November and a whopping loss of 294,000 in October. How can the household survey be signaling a falling unemployment rate over the last 3 months if its measure of the number of people working has actually gone down? Hamilton goes on to provide an answer to that question, and his approach is very instructive: Let me use an average over the last two months to smooth out some of the wild volatility in the household employment numbers and highlight what's changed in terms of people's employment status. In November and December, the civilian noninstitutional population over age 16 increased by 180,000 per month. The figure below illustrates what would have happened if these new people had entered into the respective employment categories at the same rate as the existing population. For example, if 58% of those 180,000 new potential workers found jobs, the number of employed individuals would have increased by 105,000 each month. If in December the number of employed had increased by 105,000, the number of unemployed increased by 11,000, and the number not in the labor force by 64,000, then measures such as the unemployment rate and the labor force participation rate would have been unchanged. Average additions (in thousands of people per month) that would have kept the unemployment rate, employment rate, and labor force participation rate unchanged between October and December. But we know that in reality, the unemployment rate was not unchanged, but fell from 9.7% in October to 9.4% in December. The figure below shows that this is attributable mathematically to the fact that almost 200,000 fewer workers were counted as being unemployed in December compared with October. Actual average monthly changes in November and December in the number of people in different employment categories, with the actual change minus the change predicted in the previous figure indicated in parentheses. Read Interpreting the employment numbers here .

  • James Hamilton Tries to Quiet Fears of a Double Dip Recession

    To those who are concerned the economy is headed toward a second recession, ( or the long slow depression that Paul Krugman fears ), James Hamilton lays out a series of reasons not to worry. Hamilton argues that the economy is still growing--albeit very slowly. His first piece of evidence: the PMI Composite Index for June. At first glance, this looks like an indication that things are getting worse in the manufacturing sector: Here´s why Hamilton thinks this is not a sign of a downturn: The ISM manufacturing PMI index for June was 56.2, the lowest value since December. But any value above 50 means that a plurality of managers reported that June was better than May. The uninterrupted string of above 50 readings we've seen going back to August of 2009 means that mangers have seen improvements month after month. A value of 56.2 is higher than that seen in 80% of the months over the last ten years. This is just one of many economic indicators Hamilton explains in defense of his measured optimism. Read his full post here .
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