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FRBSF WEEKLY LETTER Number 95-28, September 1, 1995 Using Consumption to Track Movements in Trend GDP One of the goals of economic policy is to stabilize short-term fluctuations in output and employment. Policymakers try to do this by "leaning against the wind:' That is, they try to stimulate aggregate demand when output and employment are "too low" and to reduce aggregate demand when output and employment are "too high." Whether output is "too low" or "too high" is determined by comparing actual GDP with its trend. Of course, trend GDP is not observable, so po!icymakers must rely on estimates. Measuring trend GDP turns out to be a difficult and important problem. Its difficulty stems from the fact that accurate measurement requires high quality data about the current state of the real economy and a great deal of knowledge about economic dynamics, both of which are in short supply. Its importance stems from the fact that policymakers cannot effectively lean against the wind unless they know which way it blows. Measurement errors in trend GDP are one factor that can make policy destabilizing rather than stabilizing. This Weekly Letter discusses some of the policy problems that derive from uncertainty about trend GDP. It also describes a proposal by John Cochrane (1994), who suggests that consumption can be used to track movements in trend output. His idea is quite simple: Economic theory tells us that consumption primarily reflects the expectations of private households about long-run movements in income. Therefore consumption should provide a reasonably good measure of trend GDP. Why good measures are important for stabilization policy Macroeconomic policymakers try to stabilize short-term fluctuations in output and to maintain low inflation over the long run. The rationale for trying to prevent output from falling too far below trend is a belief that this represents a waste of resources. The rationale for trying to prevent output from rising too far above trend is a fear that this may put upward pressure on inflation, which would conflict with long-run objectives. Thus policymakers seek to balance the risk of inefficient resource utilization against the risk of rising inflation. Uncertainty about trend GDP puts policymakers in a difficult position. If they are unsure whether output is above or below trend, they must be more cautious about pursuing countercyclical policies. The reason is that a mistake in measuring the gap between actual and trend output might cause policy to be destabilizing rather than stabilizing. For example, suppose that GDP were at its trend level, so that no countercyclical action is needed. If policymakers were to overestimate trend GDp, they would conclude that output is below trend and might choose to stimulate aggregate demand, thus increasing the risk of a rise in inflation. Similarl~ if policymakers were to underestimate trend GDp, they would conclude that output is above trend and might choose to reduce aggregate demand, thus increasing the risk of recession. In both scenarios, policy turns out to be destabilizing, in the sense that it pushes output away from trend rather than toward it. Furthermore, Milton Friedman (1953) demonstrated many years ago that it is not enough for policymakers to guess right about as often as they guess wrong. If policymakers bat .500, attempts at countercyclical policy turn out to be destabilizing on average. Stabilization policy must offset other shocks in order to be effective. If policy actions are timed randoml~ they become an additional source of variability rather than an offsetting factor." Therefore, in order for policymakers to pursue countercyclical polic~ they must bat better than .500, and the more aggressive are their countercyclical actions, the higher their batting average must be. Bold countercyclical actions require that policymakers guess right far more often than they guess wrong. FRBSF Estimating trend GDP Since trend GOP is not observable, economists must try to estimate it. One traditional approach assumes that the economy evolves along a longrun growth path that grows at a constant rate, with transitory shocks generating short-term fluctuations in output and employment. This approach implicitly assumes that all shocks are neutral in the long run. If this were the case, it would be a simple matter to estimate trend GOP: Trend growth is the same as the average rate of real GOP growth. However, over the last 15 years, many economists have begun to doubt the assumption that all shocks are neutral in the long run. Indeed, some shocks, such as technological innovations, probably have permanent effects on output. Measuring trend GOP is much harder when some shocks are permanent and others are transitory. The traditional approach works very badly in this case. Although some movements in output reflect a short-term deviation from trend, as in the traditional model, others reflect a shift in trend GOP itself. Since there is no tendency for permanent shocks to revert to the simple trend line, measurement errors accumulate over time and ultimately grow without bound. Some progress can be made by allowing for occasional shifts in the trend growth rate, but this represents an ex post adjustment and therefore has limited value for policy analysis. Since trend GOP is subject to random permanent shifts, it is essential to distinguish between permanent and transitory shocks in order to track its movements. john Cochrane (1994) proposes a way to use information about consumption to help sort between permanent and transitory shocks. His idea is based on the permanent income hypothesis, which in its simplest form states that people save when income is unusually high so that they will be able to sustain customary consumption levels in thefuture when income turns out to be unusually low. For example, an ancient version of the permanent income hypothesis appears in the Biblical tale of joseph and the Pharaoh. The Pharaoh dreamt of seven fat cows followed by seven lean cows who devoured the fat ones. joseph interpreted the Pharaoh's dream in terms of the agricultural cycles to which ancient Egypt was subject. The seven fat cows represented seven abundant harvests, and the seven lean ones represented seven bad ones. In order to prevent starvation in the lean years, Joseph persuaded the Pharaoh to store grain from the good harvests and distribute it during lean years. Modern versions of the permanent income hypothesis replace dreams with rational expectations and incorporate risk aversion and variation in interest rates, but they retain the same basic insight. Consumption is determined primarily by the expected present value of future income rather than by current income alone. Cochrane applies the logic of the permanent income hypothesis to the problem of sorting between permanent and transitory movements in income. If a shock to income is transitory, it is likely to have little effect on the expected present value of lifetime income. Therefore we would not expect consumption to change much in response to transitory shocks. However, if a shock to income is permanent, it is likely to have a greater effect on the expected present value of lifetime income, and thus we would expect a greater response in consumption. If we observe a movement in income that is not accompanied by a movement in consumption, we can infer that consumers believe that the change in income is likely to be transitory. On the other hand, if consumption and income move together, then we can infer that consumers believe that the change in income is likely to be long lasting. Since consumption measures consumers' expectations <;>f long-run GOp, it should provide a good measure of the trend in GOP. The figures illustrate the results of applying Cochrane's idea to U.S. data. Figure 1 shows per capita real GOP along with the consumptionbased measure of trend, which was estimated by regressing per capita real GOP onto per capita real consumption. The fitted values from this regression illustrate movements in income that are accompanied by movements in consumption. These movements are likely to be long lasting, and they approximate movements in the trend in output. Figure 2 shows the residuals from this regression. They represent the movements in GOP that do not correspond to movements in consumption/ and they should be transitory. The shaded afeas mark the dates of recessions as determined by the National Bureau of Economic Research (NBER). Troughs in the consumptionbased measure conform quite closely to the dates of NBER recessions: They often occur in the same quarter as the NBER trough, and they always occur within plus or minus two quarters of the NBER trough. Furthermore, the consumptionbased measure does not give any false signals of recession. Another way to understand Cochrane's idea is to think about what it implies for forecasting output growth. When output is below trend, it ought to Figure 1 Per Capita Real GDP thousands of 1987 dollars 27. 5 ;:;:; ~i~~~ 25. 0 !:!~! ;:;:; 22.5 :;:;: :::~ :::;: I~i! :;:;: :.::: ,:1 20.0 \ ;j~ :!~!~ 17.5 t ~~\; f:j W~ 15.0 +n-rh-mTlTTlTrfi-rrf'i'-rrl-rfr+h-rTT".-,-'h-rn 54 58 62 66 70 74 78 82 86 90 94 Figure 2 Cyclical Component of GDP percent deviation from trend 0.04 ::;:. ::::: ::::. ::;:: 0.02 :~i~! :~::::: :::: ;\t :.;.:;: ::~. ~::: ::: :::::.; ~\~ f~:~ ~;~ ":; r ~\1 ~:;: :r~ 0.00 f -0.02 Finally, although consumption is not an exact measure of the trend in output, it compares favorably with a number of other commonly used measures. For example, Cogley (1995) simulates a variety of models of trend and cycie and finds that the consumption-based measure is a useful, robust indicator of the unobserved true cycle. Conclusion Measuring trend GDP is important because central banks cannot lean against the wind if they do not know which way it blows. This is difficult because it requires sorting between shocks that have permanent and transitory effects on output. Economic theory tells us that consumption may be useful for this purpose, and there is some empirical evidence to support this idea. :~:: ;:!: :!:j: :r -0.04 ::!:! ~r t~: -0.06 relative to the path of expected future income, because consumers will want to save in order to prepare for less favorable times ahead. Similarly, the income-consumption ratio should be low when consumers bel ieve that current income is low relative to the path of expected future income, because in this case consumers will reduce current savings in order to maintain current consumption. It is clear from the figures that the income-consumption ratio is an excellent predictor of future growth. For example, the income-consumption ratio is low at the troughs of recessions, when output growth is about to pick up, and it is high near the end of expansions, when output growth is about to slow down. Cochrane uses formal statistical techniques to confirm that the income-consumption ratio has significant predictive power for future output growth; :;::: II 54 58 62 ~~ :~.' ;:;:::. r :;:;~;! t! .;.;.:: :::;::: ;.:.; :::;::. ::::::~ Desiree Schaan Research Associate ;~;~ ;::;; Timothy Cogley Senior Economist ::.' .:;: 66 70 74 78 82 86 90 94 References Cochrane, John H. 1994. "Permanent and Transitory Components of GNP and Stock Prices." Quarterly Journal of Economics 109(1), pp. 241-265. grow faster than average in order to catch up. Similarly, when output is above trend, it should grow more slowly than average in order to let the trend catch up. The permanent income hypothesis implies that the income-consumption ratio should be a good predictor of future output growth. This ratio should be high when consumers believe that current income is high Cogley, Timothy. 1995. "Evaluating Non-Structural Measures of the Business Cycle." Unpublished manuscript. Friedman, Milton. 1953. "The Effects of a FullEmployment Policy on Economic Stability: A Formal Analysis./I In Essays in Positive Economics. Chicago: University of Chicago Press. Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor or to the author. Free copies of federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Weekly Letter texts and other FRBSF publications ilnd data are available on FedWest Online, a public bulletin board service reached by setting your modem to dial (415) 896-0272. Research Department Federal Reserve Bank of San Francisco P.O. Box 7702 San Francisco, CA 94120 Printed on recycled paper Q with soybean inks. W ~ ~ Index to Recent Issues of FRBSF Weekly Letter DATE NUMBER TITLE AUTHOR 2/3 2/10 2/17 2/24 3/3 3/10 3/17 3/24 3/31 4/7 4/14 4/21 4/28 5/5 5/12 5/19 95-05 95-06 95-07 95-08 95-09 95-10 95-11 95-12 95-13 95-14 95-15 95-16 95-17 95-18 95-19 95-20 5/26 95-21 6/9 6/23 7/7 7/28 8/4 8/18 95-22 95-23 95-24 95-25 95-26 95-27 Rudebusch Hutchison Mattey/Dean Levonian/Furlong Spiegel Moreno Mattey Dean Judd/Trehan G Iick/Moreno Huh Parry Laderman Glick/Trehan Judd Kwan Schaan/Cogley Kasa Rudebusch Motley Zimmerman Mattey/Spiegel Golub What Are the Lags in Monetary Pol icy? Central Bank Credibility and Disinflation in New Zealand Western Update Reduced Deposit Insurance Risk Rules V5. Discretion in New Zealand Monetary Policy Mexico and the Peso Regional Effects of the Peso Devaluation 1995 District Agricultural Outlook Has the Fed Gotten Tougher on· Inflation? Responses to Capital Inflows in Malaysia and Thailand Financial Liberalization and Economic Development Central Bank Independence and Inflation Western Banks and Derivatives Monetary Policy in a Changing Financial Environment Inflation Goals and Credibility The Economics of Merging Commercial and Investment Banking Financial Fiagil ity and the Lender of Last Resort Understanding Trends in Foreign Exchange Rates Federal Reserve Policy and the Predictability of Interest Rates New Measures of Output and Inflation Rebound in U.s. Banks' Foreign Lending Is State and Local Competition for Firms Harmful? Productivity and Labor Costs in Newly Industrializing Countries The F,RBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.