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The Regional Economist April 2004 ■ www.stlouisfed.org President’s Message “ The plans that it [the Pension Benefit Guaranty Corp.] insures are underfunded in total by more than $350 billion. Rumblings of a taxpayer bailout are being heard—shades of the 1980s’ S&L crisis.” William Poole PRESIDENT AND CEO, FEDERAL RESERVE BANK OF ST. LOUIS Pension Reform Is Needed Now veryone knows that Social Security is under stress. Less well-known is that some private defined-benefit pension plans are facing even greater problems. Under a defined-benefit plan, a company promises to pay a set monthly benefit to a retiree. If a company ceases operations and has a fully funded pension plan, retirees will continue to receive their checks and current employees will get their pensions when they retire. But for an increasing number of workers, the reality is not matching employers’promises. More and more plans are underfunded. The blame lies in two broad areas: The average life span of retirees is being underestimated, and earnings on assets of the plan are falling short. More specifically, some companies are investing too much of their pension funds in risky stocks. Others aren’t setting aside enough in the first place for pensions—or, worse, are diverting the money for other uses. And some well-established companies just can’t keep up with the burgeoning number of retirees, especially if their newer competitors have almost none. The end result is that some companies’ pension programs are in jeopardy. But isn’t there insurance to back up these plans? Yes, 30 years ago, Congress created the Pension Benefit Guaranty E Corp. to at least partly cover the owed payments. The corporation is financed by employer-paid insurance premiums and by returns on its assets. But the PBGC is being overwhelmed with requests to take over pension plans these days. As a result, the PBGC had a record deficit last year—more than $11 billion. The plans that it insures are underfunded in total by more than $350 billion. Rumblings of a taxpayer bailout are being heard—shades of the 1980s’ S&L crisis. But there’s still time to fix the PBGC. A simple first step is for the government to forbid underfunded plans from sweetening their promises to employees. Next, premiums should be more closely linked to risk. Those companies with shaky pension programs and speculative investments should pay much more for their insurance than the companies with fully funded plans and conservative investment policies. Of course, some underfunded companies will threaten to dump their pension plans or file bankruptcy if forced to pay more. They’ll want more and more extensions to get their house in order. But as we learned from the S&L crisis, such delays usually end up costing the taxpayer more in the end. Meanwhile, employers must be more careful where they invest their pension funds. Instead of buying [3] stock, they should act more like life insurance companies—investing in fixed dollar assets that mature when cash outlays are expected. The returns won’t be as high when the stock market is booming, but they won’t be as low, either, when the market tanks. The government could take many other steps to shore up the PBGC. To be in a position to encourage such reform, the more than 40 million employees who are still covered by defined-benefit plans should educate themselves about the problems. Unfortunately, many workers have never heard of the PBGC. To get them to start thinking about this issue, the government could require all companies to notify their employees annually how much they’d get if their pension plan were terminated right then. Currently, only underfunded plans must provide this information. No matter which step we take first, we must move now. If we wait a few more years, a taxpayer bailout could be unavoidable. And this drain on the Treasury could come at a time when Social Security is looking to be rescued, too. The Regional Economist April 2004 ■ www.stlouisfed.org W H AT T H E F E D S A I D / W H AT T H E M A R K E T S H E A R D Miscommunication Shook Up Mortgage, Bond Markets By Christopher J. Neely Mortgage interest rates dipped to record lows early last summer, providing homeowners with a refinancing bonanza. This decline in mortgage interest rates mirrored a fall in the 10-year Treasury bond yield (the interest rate on the bond), as shown in the left panel of Figure 1. In fact—as shown in the right panel of Figure 1—mortgage interest rates almost always mirror the yields on long-term Treasury bonds because they respond to the same forces. What factors drove the sharp declines in yields on 10-year Treasury bonds in the spring of 2003? Was the Federal Reserve responsible for the volatility, as some in the financial press have alleged? And why are mortgage interest rates closely linked to these Treasury yields in the first place? F I G U R E 1 10-Year Treasury Yields and Mortgage Interest Rates 10 - Y E A R T R E AS U RY N OT E Y I E L D AT C O N STA N T M AT U R I TY ( AVG . % ) 3 0 - Y E A R F I X E D - R AT E M O RT G AG E S : U S ( % ) 4.8 6.50 17.5 20.0 6.25 15.0 17.5 6.00 12.5 15.0 5.75 10.0 12.5 5.50 7.5 10.0 5.25 5.0 7.5 5.00 2.5 4.4 4.0 3.6 3.2 JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC 5.0 1975 2003 1980 SOURCES: U.S. Treasury, Freddie Mac/Haver Analytics [5] 1985 1990 1995 2000 F I G U R E 2 10-Year U.S. TIIS Yields, Treasury Bond Yields and Inflation Expectations 5.0 0.8 4.5 0.6 4.0 0.4 0.2 Percentage Points Percentage Points 3.5 3.0 2.5 2.0 1.5 0.0 –0.2 –0.4 1.0 –0.6 0.5 –0.8 0.0 4/1/03 4/29/03 5/27/03 6/24/03 7/22/03 8/19/03 –1.0 4/1/03 9/16/03 4/29/03 5/27/03 6/24/03 7/22/03 8/19/03 9/16/03 SOURCE: Haver Analytics L E F T Yield on 10-Year TIIS Note, Due 7/15/2012 Yield on 10-Year Treasury Note, Due 8/15/2012 10-Year Expected Inflation R I G H T Change in 10-Year TIIS Yield from 4/29/2003 Change in 10-Year Treasury Yield from 4/29/2003 Change in 10-Year Expected Inflation from 4/29/2003 Last Summer’s Bond Market The left panel of Figure 2 shows that in May and June 2003, yields of U.S. 10-year Treasury notes plummeted before rising sharply in July and August.1 The same panel shows that the yield on this 10-year Treasury note fell from 3.97 percent on April 14, 2003, to about 3.01 percent on June 13, 2003, then rebounded sharply to a high of 4.53 percent on Sept. 2, 2003.2 The roots of the sharp swings in the bond market turmoil lay in concerns about deflation—a sustained fall in the general price level—generated by steady declines in core U.S. inflation rates that began in 2001. Such a decline in the inflation rate is disinflation. By the fall of 2002, the declines had reduced U.S. inflation to levels consistent with price stability.3 That is, inflation was no longer a consideration in people’s economic decisions. In fact, inflation had declined so much that the Federal Reserve began to consider further declines to be unwelcome because they might lead to deflation. Overinflated Deflation Fears Deflation is unwelcome for several reasons. First, a sustained fall in the price level is incompatible with the Federal Reserve’s commitment to price stability. Second, some feared that the Fed’s usual monetary policy instrument—changes in the federal funds target—would be useless in a deflationary environment because of the zero nominal interest rate bound. The zero nominal interest rate bound simply means that interest rates cannot be negative because lenders would not pay to lend money when they can simply hold cash. If prices are falling, then the real interest rate (the nominal interest rate less the rate of inflation) [6] must be at least as great as the rate of deflation. And the real interest rate is a much better barometer of the stimulative impact of monetary policy than the nominal interest rate. For example, if prices are expected to fall at a rate of 2 percent per year and the Federal Reserve sets nominal interest rates at their lowest possible level (0 percent), then the real interest rate is still 2 percent, a fairly high level if economic conditions are weak. The zero nominal bound creates the incorrect perception that the Federal Reserve would be impotent in the face of deflation. Japan’s economic problems over the past decade have contributed to this view. Since 1999, the Bank of Japan has seemed unable to stimulate the Japanese economy with conventional monetary policy and has seen very sluggish growth, coupled with some deflation. Some observers have worried that these problems might afflict the U.S. economy. In November 2002, Federal Reserve Gov. Ben Bernanke gave a speech addressing the potential problem of deflation in the United States: “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Bernanke considered the chance of significant deflation in the United States to be “extremely small,” but could not discount it entirely. To dispel the notion that the Fed would be helpless in the face of deflation, however, Bernanke reviewed some policy steps that the Fed could take to stimulate the economy if deflation did occur in the United States.4 The primary measure would be to buy longer-term bonds than the Fed usually buys (one year or less) in conducting open market operations, lowering longterm yields as well as short-term yields. In this manner, the Fed could pump liquidity into the economy, stimulating spending, raising prices and ending (or preventing) deflation. The Regional Economist April 2004 ■ www.stlouisfed.org The trigger for the bond market turmoil was Fed Chairman Alan Greenspan’s follow-up April 30, 2003, to the semiannual monetary policy report to Congress. In that report, Greenspan said: As you know, core prices by many measures have increased very slowly over the last six months. With price inflation already at a low level, substantial further disinflation would be an unwelcome development, especially to the extent it put pressure on profit margins and impeded the revival of business spending. And the FOMC announcement of May 6, 2003, was widely interpreted to herald a prolonged period of lower short-term rates and/or the purchase of long-term bonds by the Fed to effect “easier”monetary policy: The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The mention of the minor possibility of “an unwelcome substantial fall in inflation,” though couched in the most careful language, raised expectations of Federal Reserve purchases of long-term bonds to battle the specter of deflation. Buy Low, Sell High Financial markets are intrinsically forward looking. If the Federal Reserve is expected to buy long-term bonds in the future, raising the prices of those bonds, then bond traders will want to purchase those bonds today to take advantage of the future price rise. Consequently, bond prices rose (yields plunged) as demand increased in the wake of the May 6 press release and continued to rise (with yields falling) until the middle of June. The right panel of Figure 2 displays this pattern of yield changes. On June 25, the FOMC held another policy meeting and cut the federal funds target by only 25 basis points—less than financial markets expected. The FOMC issued a press release that was almost identical to that published after the May 6 meeting: The probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. Despite the fact that the June 25 statement was almost identical to the statement that followed the May 6 meeting, bond markets were disappointed in the cut of 25 basis points in the funds rate target and were disappointed in the lack of plans for untraditional monetary policy measures, such as buying long-term bonds. Consequently, demand for longterm bonds began to fall, driving down prices and driving up yields. Long-term interest rates began to rise more strongly after the June 25 meeting. Indeed, many in the financial press concluded that Greenspan had deliberately duped financial markets with the previous talk of an “unwelcome fall in inflation.” His motivation was allegedly to jawbone down long-term interest rates, thereby stimulating the economy without actually having the Fed buy long-term bonds. The Federal Reserve Open Market Committee meets today, and must begin clearing up the predictable mess after The Basics of Bonds A bond is an IOU, a promise to pay an amount of money at some point in the future. Suppose that a pizza restaurant wants to borrow money to buy a new oven to bake pizza. For $950, it might sell a bond that promises to pay $1,000 in a year’s time. The yield (y) on this one-year bond would be the interest rate that makes the bond’s discounted payoff equal to its price: payoff/(1 + y) = price or y = payoff/price – 1. In the case of a bond that costs $950 and pays off $1,000 a year later, the yield is 5.3 percent. The buyer of the bond lends the restaurant $950 until the bond is paid off. Bond prices and bond yields are inversely related. When the price of a bond rises, a greater investment is needed to get the same payoff; so, the yield on the bond falls. In our hypothetical example, if demand is high, the restaurant might be able to sell these same bonds for $970 and still return just $1,000 at the end of the year. The yield then would be about 3.1 percent. Conversely, when prices on bonds fall, yields rise. [7] Alan Greenspan failed to keep up his impressive juggling trick. His plan was understandable and ambitious. Out of one side of his mouth, he talked up the economy to boost shares and consumer confidence. Out of the other, he muttered darkly about the small but significant risk of deflation and the willingness of the Fed to buy bonds to keep long-term interest rates low and encourage debtfueled spending. —“Time for clarity, Mr. Greenspan: The U.S. recovery is too precarious for the Fed to be vague.” The Financial Times, Aug. 12, 2003 Expected Inflation or Expected Growth: What Changed? To understand how the Fed’s announcements might influence bond yields, it’s helpful to look at the four components of interest rates of a particular maturity: default premium, expected inflation, inflation risk and the real component. The default premium compensates the lender for the possibility that the borrower will be unable or unwilling to pay the debt. The default premium is zero for dollar-denominated Treasury bonds because the U.S. government can always create money to repay such debt. Higher expected inflation raises interest rates because lenders demand compensation for the expected loss of purchasing power. Inflation is uncertain, however; so, lenders might also have to be compensated for the risk that it will exceed expectations—that compensation is the inflation risk premium. But current U.S. inflation is stable enough that the inflation risk premium is probably very small and unlikely to change rapidly; it can safely be ignored here. Finally, the real interest rates depend on the expected productivity of physical capital. A robust economy and high productivity encourage businesses to borrow to finance future production, bidding up interest rates. Because the default premium is zero and the inflation risk premium is negligible for U.S. Treasury bonds, the yields on those bonds are effectively composed of the real interest rate and the expected inflation rate. Did the Fed’s statements influence bond yields by changing expectations of inflation, real activity or both? One can estimate real interest rates from the yields on Treasury inflationindexed securities (TIIS).5 The principal and coupon payments on TIIS are indexed to increase with the consumer price index to protect investors from inflation, making the TIIS yields real yields. The difference between yields on conventional bonds and TIIS yields (called the TIIS yield spread) measures the market’s expectation of future inflation. For example, on Jan. 27, 2004, the 10-year TIIS maturing in January 2014 had a yield of 1.83 percent, while a conventional Treasury bond maturing in November 2013 had a yield of 4.08 percent. That means the bond market expects inflation to average about 2.25 percent (4.08 -1.83) over the next 10 years. Complicating the usual interpretation, however, is the fact that principal payments on TIIS bonds are not reduced if there is cumulative deflation. (See sidebar below for explanation.) Because of this, the TIIS spread will tend to overstate expected inflation. And greater probabilities of deflation will increase this bias. The right panel of Figure 2 shows that from May through July, U.S. real Special Treasury Bonds Can Help Gauge Expected Inflation Treasury inflation-indexed securities (TIIS) are good measures for expected inflation, but they aren’t perfect because they don’t take cumulative deflation into account. To better understand this, let’s consider how we’d calculate expected inflation from a hypothetical 10-year zero-coupon TIIS and a similar 10-year conventional bond. (A zero-coupon bond pays a single principal payment, rather than a series of smaller payments [coupons] plus a principal payment.) Suppose that the bond market considers that there are two possible outcomes for inflation over the next 10 years: 1) there’s a 90 percent chance that cumulative inflation will equal 2 percent; 2) there’s a 10 percent chance that cumulative inflation will equal –1 percent (deflation). In such a situation, the market’s true expectation of inflation will be 1.7 percent (0.9 x 0.02 + 0.1 x (–.01)). But because the principal payments on the TIIS are not reduced if there is deflation, the TIIS spread will equal 1.8 percent (0.9 x 0.02 + 0.1 x 0). In other words, when there is a possibility of cumulative deflation until maturity, the TIIS spread will tend to overstate expected inflation. And greater probabilities of deflation will increase this bias. The probability of a cumulative fall in the U.S. Consumer Price Index over 10 years [8] is probably very small, however; so, the bias is probably small. In fact, there has been no cumulative CPI deflation in any G-7 country during any 10-year period since 1960. The smallest such 10-year CPI increase is 1.6 percent, recorded in Japan from 1992 to 2002. Because the probability of substantial cumulative deflation over 10 years is negligible, TIIS spreads are probably good measures of expected inflation. Even if the bias itself is large, if the probability of cumulative deflation over 10 years doesn’t change much, changes in the TIIS spread will still measure changes in expected inflation. The Regional Economist April 2004 ■ www.stlouisfed.org interest rates (10-year TIIS yields) fell almost as much as 10-year nominal yields. Of course, U.S. TIIS spreads (expected inflation) fell much less than the U.S. real rate, slipping only about 20 basis points from April to mid-June before rising again. Unless the probability of significant cumulative deflation changed very dramatically without changing expectations of positive inflation—which seems unlikely—changes in real interest rates drove most of the fluctuations in Treasury yields. In other words, the Fed statements did not cause the bond market volatility by changing inflation expectations. Was this decline in real interest rates due to lower forecasts of real growth over the next 10 years, or did expectations of Fed long-bond purchases or other untraditional measures lead to the fall? It seems unlikely that forecasts of real growth over 10 years should change very quickly, as 10-year average growth is a fairly stable variable and there was no significant news about slowing labor force growth or technological change to dramatically change the long-term growth picture. Consistent with stable 10-year growth forecasts, the Blue Chip consensus forecast of U.S. real GDP growth in 2004 actually increased slightly from May 10, 2003, to June 10, 2003. Instead, it seems much more likely that the Fed’s pronouncements produced bond market expectations of significant long-bond purchases that drove bond prices up and yields lower. The Long and the Short of It The Federal Reserve, like most other central banks in developed economies, conducts monetary policy by targeting short-term interest rates. It is commonly accepted that the Fed, like other central banks, can change the real component of short-term interest rates by open market operations (OMO) with short-term (maturing in less than a year) bonds. A purchase of short-term bonds, for example, makes such bonds scarcer to the public, driving up prices and driving down yields. Actual transactions are not necessary, however. Central banks with a record for controlling interest rates can manipulate those rates by simply announcing the desired target.6 It is less common, however, that central banks conduct open market operations in the market for long-term bonds.7 The traditional view is that the Federal Reserve has conducted open market operations with short-term bonds because the market for short-term debt is much larger and more liquid than that for long-term liabilities and, thus, the Fed’s transactions would not unduly dis- tort short-term bond prices. Indeed, the Fed hasn’t conducted OMO with longterm bonds since “Operation Twist”of the 1960s, and many are skeptical of the ability of a central bank to alter conditions in the long-term bond market in the same way as in the short end.8 While the Fed does influence the yields on long-term bonds by altering inflation expectations and possibly expectations of growth, such influence is indirect. The events of last spring, however, make it seem likely that the Fed inadvertently lowered the real component of longterm interest rates by influencing bond markets to expect purchases of longterm bonds. Indeed, the episode underscores the importance of expectations in determining bond market conditions. Miscommunication As consumers enjoyed extra cash from refinancing their mortgages at extraordinarily low interest rates last summer, very few were aware of the chain of events that had made their bonanza possible. Declining rates of core inflation sparked fears of deflation among the public. The Fed’s efforts to inform the public of contingency plans to prevent such an occurrence created unintended expectations of Fed purchases of long-term Treasury bonds that drove down long-term Treasury yields and mortgage interest rates. When it became apparent that such expectations were unlikely to be borne out, bond yields and mortgage interest rates quickly readjusted to their previous levels. The episode reinforces the importance—and the hazards—of keeping the public fully informed as to economic conditions and how the Federal Reserve might respond to them. Federal Reserve policy-makers believed that they were only stating the obvious—that inflation could be too low as well as too high—and that they had contingency plans to deal with such an eventuality, unlikely as it seemed. Financial markets, however, concluded that deflation was an imminent threat and that purchases of long-term bonds were forthcoming. When it became obvious in June that deflation was not imminent and that untraditional monetary policy measures were not forthcoming, the financial markets felt deceived. The Fed, on the other hand, felt perplexed at the bizarre interpretation of its statements. As the Federal Reserve better informs the public about its view of the economy and its role in it, one hopes such miscommunication will become less common. Christopher J. Neely is a research officer at the Federal Reserve Bank of St. Louis. Joshua M. Ulrich provided research assistance. [9] ENDNOTES 1 The U.S. Treasury calls its debt instruments that have two- to 10-year maturity at issuance “Treasury notes,” while it terms debt instruments with maturities from 10 to 30 years “Treasury bonds.” “Treasury bills” have a maturity of one year or less at issuance. The term “bond,” however, can be used to refer to any security (i.e., bills, notes or bonds) with a fixed payoff. 2 The Treasury note in Figure 2 matures on 8/15/2012. The Treasury inflationindexed security (TIIS) in the figure matures on 7/15/2012. 3 See Greenspan (2000). 4 Clouse, Henderson, Orphanides, Small and Tinsley (2003) describe ways in which monetary policy could stimulate the economy, even under the zero nominal bound. 5 The U.S. Treasury first issued TIIS in 1997 to provide investors with an opportunity for an inflation-protected investment. 6 Guthrie and Wright (2000) and Kohn and Sack (2002) examine how markets react to statements by the Reserve Bank of New Zealand and the Federal Reserve, respectively. 7 The Fed pegged interest rates on long-term Treasury bonds for many years prior to the Treasury-Fed accord of 1951. 8 See Beckhart (1972) and Zaretsky (1993). REFERENCES Beckhart, Benjamin H. “Federal Reserve System.” New York: American Banking Institute and Columbia University Press, 1972. Bernanke, Ben S. “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks given before the National Economists Club, Washington, D.C., Nov. 21, 2002. Clouse, James; Henderson, Dale; Orphanides, Athanasios; Small, David H. and Tinsley, P.A. “Monetary Policy When the Nominal Short-Term Interest Rate is Zero.” Topics in Macroeconomics,Vol. 3, No. 1, Article 12, 2003. See www.bepress.com/ bejm/topics/vol3/iss1/art12/. Greenspan, Alan. Opening remarks to “Global Economic Integration: Opportunities and Challenges,” a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyo., Aug. 24-26, 2000. Greenspan, Alan. Follow-up to the Semiannual Monetary Policy Report to the Congress, testimony given before the Committee on Financial Services, U.S. House of Representatives, April 30, 2003. Guthrie, Graeme and Wright, Julian. “Open Mouth Operations.” Journal of Monetary Economics,Vol. 46, No. 2, October 2000, pp. 489-516. Kohn, Donald L. and Sack, Brian P. “Central Bank Talk: Does It Matter and Why?” Unpublished manuscript, Board of Governors of the Federal Reserve System, May 23, 2003. Zaretsky, Adam. “To Boldly Go Where We Have Gone Before—Repeating the Interest Rate Mistakes of the Past.” Federal Reserve Bank of St. Louis The Regional Economist, July 1993, pp. 10-11. A Jobless Recovery with More People Working? By Kevin L. Kliesen and Howard J. Wall A S DETERMINED BY THE NATIONAL BUREAU OF ECONOMIC RESEARCH,THE MOST RECENT RECESSION ENDED IN NOVEMBER 2001. By November 2003, however, the number of nonagricultural jobs— payroll employment—had fallen by about 809,000, according to the Bureau of Labor Statistics (BLS). On the other hand, also according to the BLS, the total number of people working—household employment— had risen by more than 2.3 million over the same period. How can the two measures of employment indicate such wildly different pictures of the labor market? If the number of people working has been rising, can we really say that it has been a “jobless recovery”? To address these questions, one needs to understand how the different types of labor-market data are collected and what each of the two employment measures is designed to convey. Another difference is in the ways that the surveys handle multiplejob holders. Because the household survey simply notes whether someone is employed or not, a person with two jobs will be counted just once. On the other hand, because the payroll survey counts jobs, both of this person’s jobs will be counted. A third difference between the surveys is in how they handle unpaid absences from jobs. In the household survey, a person with a job but who is temporarily absent without pay—because of illness, vacation, strike, etc.—is counted as employed. In the payroll survey, though, this person is not counted as an employee. Some Reconciliation Under the Hood Every month, in its Employment Situation report, the BLS announces the results of two surveys designed to measure the state of the U.S. labor market. The first of these, the Current Population Survey (CPS), is based on a sample of about 60,000 households and is used to construct data on the labor-market status of individuals, i.e., whether they are employed, unemployed or out of the labor force. The second survey, the Current Employment Statistics (CES) survey, is based on the payroll reports of a sample of more than 390,000 establishments employing nearly 50 million nonfarm wage and salary workers. The most important data based on the CES survey are the number of wage and salary employees, average hours and average earnings. The major difference between the two surveys is that the household survey covers more employment categories than the payroll survey does. These categories include the self-employed, farm workers, privatehousehold workers and unpaid workers in family-operated businesses. The table presents some numbers that try to reconcile some of the differences between the two employment series. The first step is to broaden the payroll employment series to include job categories that are covered by the household survey but not by the payroll survey. Specifically, add the 874,000 increase in the total number of workers in four household survey categories: agricultural employment, nonagricultural self-employment, nonagricultural unpaid family work and private-household work. The next step is to account for the 129,000 decrease in the number of workers who were on unpaid absences from their jobs and were, therefore, not counted as being on an establishment’s payroll despite having a job. Finally, to remove the double counting of people from the payroll employment number, subtract the 137,000 increase in the number of multiple-job holders. Although these adjustments add just over 600,000 to the change in payroll employment, the result is still a net job loss of 201,000 between the end of the recession and November [10] 2003. More glaring, though, is that these adjustments make only a dent in the discrepancy between the payroll and household employment numbers. What had been a discrepancy of more than 3.1 million employees before the adjustments is still a discrepancy of more than 2.5 million after the adjustments. In other words, after adjusting the payroll employment number to make it more compatible with the household measure, only about 19 percent of the discrepancy between the changes in the two employment measures is closed. Scaling by Population One explanation for the remaining discrepancy arises from the ways in which the survey results are scaled up to represent the experience of the entire population. For example, the household survey reveals the employment situation of the 60,000 or so households that were surveyed. The BLS then extrapolates from these households the employment situation across the more than 100 million households in the country. To do this, the BLS needs to have estimates of the size of the relevant subset of the population, namely, the civilian noninstitutional population that is 16 or older. If this population control overstates actual population, then employment will be overstated, and vice versa. In the late 1990s, the discrepancy between the payroll and household employment series was the opposite of what has occurred more recently. Then, people were concerned with the rapid growth of payroll employment relative to household employment. In a paper published by the New York The Regional Economist April 2004 ■ www.stlouisfed.org Fed, economists Chinhui Juhn and Simon Potter argued that the widening gap between the payroll and household surveys in the 1990s was probably due to an underestimate of the working-age population. This assessment appears to have been correct: Since then, two sizable upward revisions to the population controls narrowed the gap significantly. A second paper, presented to the Federal Economic Statistics Advisory Committee in October, provides evidence that the recent widening of the gap between the two series is probably due to overestimates of population growth.1 The authors argued that the divergence between the two series in the 1990s arose, in part, because the strong economy had attracted an influx of illegal immigration. But economic growth during the recovery and expansion has been weaker than normal. Accordingly, the recent discrepancy in the employment series might reflect the opposite bias in the population controls. In essence, current population controls assume a rate of growth in illegal immigration that was consistent with the growth of the economy in the period 1994 to 2000, but that is inconsistent with the more recent slow-growth period. In fact, the household employment numbers for January 2004, which are part of the Employment Situation that was released Feb. 6, use revised estimates of the civilian noninstitutional population. Although the BLS did not revise official estimates for previous periods, it did provide unofficial revisions for the December 2003 data, which suggest that the population control had been overstated. If this were adjusted for, household employment for December would be reduced by 409,000. For the sake of simplicity, assume that this is also the overestimate of November’s household employment. The change in household employment reported in the table would then be reduced by 409,000, as would the discrepancy after the adjustments made in the table. jobs. Following frequent revisions, however, payroll data now show that about 1.4 million jobs were added during 1992.2 Unfortunately, it may take some time before we can assess the steps that the BLS has taken since then to correct the undercounting of firms during recovery. Are We Any Closer? By reconciling the coverage of the payroll and household employment series, we were able to explain about 19 percent of the discrepancy in the change in employment in the two years following the end of the recession. We explained an additional 13 percent or so of the discrepancy by approximating the revision to the population controls for the household series. Two possible explanations for the remaining discrepancy are: (1) continuing overestimates of the population controls, which might be revised again in the future; and (2) an undercounting of the growth in the number of new establishments, although the BLS has taken steps to avoid the problems of the past. 1 Nardone et al. (2003). 2 This is the change in payroll employment between January 1992 and January 1993. REFERENCES Juhn, Chinhui and Potter, Simon. “Explaining the Recent Divergence in Payroll and Household Employment Growth.” Federal Reserve Bank of New York Current Issues in Economics and Finance, Vol. 5, December 1999, pp. 1-6. Nardone, Thomas; Bowler, Mary; Kropf, Jurgen; Kirkland, Katie; and Wetrogan, Signe. “Examining the Discrepancy in Employment Growth between the CPS and the CES.” Paper presented to the Federal Economic Statistics Advisory Committee, Oct. 17, 2003. Kevin L. Kliesen is an economist and Howard J. Wall is a research officer, both at the Federal Reserve Bank of St. Louis. Can the Employment Numbers Be Reconciled? The two official employment series—payroll and household—tell very different stories about the so-called jobless recovery. Some of the discrepancy is due to the differences in the types of jobs covered by the surveys used to create the series. For instance, one series does not consider agricultural workers or the self-employed. Even after adjusting for these and other differences, the discrepancy remains large. Change in employment November 2001 to November 2003 (in thousands) A Payroll employment (CES survey) – 809 B Household employment (CPS) 2,330 CPS job categories not covered by CES survey Agricultural employment Nonagricultural self-employed Nonagricultural unpaid family workers Private-household workers Counting Firms Because payroll employment is derived from a sample of nonfarm establishments in the economy, it is also subject to substantial revisions over time. In the present context, the concern is that current methods do not keep up with the relatively rapid growth of establishments during recovery periods. If so, then the scaling up from the sample will underestimate the actual number of employees. This was a problem during the recovery following the 1990-91 recession, during which payroll employment data throughout 1992 were indicating a net loss of ENDNOTES C Total D Unpaid absences E Multiple-job holders F Adjusted payroll employment (A+C+D-E) Discrepancy before adjustments (B-A) Discrepancy after adjustments (B-F) SOURCE: Bureau of Labor Statistics, as of December 2003 [11] 184 732 0 – 42 874 – 129 137 – 201 3,139 2,531 Tough Lesson: More Money Doesn’t Help Schools; Accountability Does By Rubén Hernández-Murillo and Deborah Roisman M ost discussions about government policies on education presume by and large that increasing public funding of schools will improve education quality. But research in economics provides strong evidence that policies focused on increasing schools’ resources have little or no effect on academic achievement. Under the current system, the interests of teachers and school district administrators are often inconsistent with an efficient use of school funds to improve performance. Individual teachers’salaries and the security of administrators’jobs are not usually linked to students’academic performance. This lack of accountability stems from a lack of competition among public schools. This article reviews some of the main ideas of the economics of public schools, including the apparent lack of a relationship between spending policies and education quality as measured by standardized test scores. To illustrate these points, a snapshot of the characteristics of a few school districts in the St. Louis area is presented. School Districts in St. Louis Tables 1 and 2 present several input and outcome variables for school districts in the St. Louis area. Education quality is measured with the mathematics index test score for elementary schools (fourth grade) from the Missouri Assessment Program (MAP). All variables are for the academic year 1999-2000. Table 1 presents the characteristics of school districts with test scores that are well below the state average, and Table 2 presents the characteristics of school districts with scores that are well above the state average. Even though the two sets of school districts represent opposite extremes of academic performance, they have comparable measures of expenditures per pupil and student-teacher ratios. (Note that although Clayton and Ladue have much larger expenditures than other high-score districts, they have only slightly better test scores than Webster Groves, another district in the same group that has much lower expendi- tures and a much higher studentteacher ratio.) Where they really differ is that the high-score districts have much larger shares of households with a bachelor’s or higher degree (a proxy for the parents’ education attainment) and much larger median incomes for households with children. This suggests that student achievement depends more on family characteristics than on spending policies. Public Spending on Education If there were no public schools— if education were provided by a completely free market with no subsidies to households or schools—investment in schooling would fail to attain socially optimal levels. This is because of what economists refer to as market failures. Government intervention in the provision of education services is largely motivated by an attempt to alleviate the effects of these market failures. Economist Caroline Hoxby highlights two important kinds of [12] market failures. The first kind arises because individuals consider only their own benefits and costs when deciding how much to invest in their children’s education. From a social standpoint, however, an individual’s education may generate positive benefits to other persons; for example, less-educated people learn from interacting with more-educated people. Individuals do not account for these benefits to others and, therefore, invest less in education than what would be socially optimal. The second kind of market failure is liquidity constraints. These constraints occur because people are unable to borrow against their children’s future income to pay for their education today. As a result of this, constrained parents also invest less in their children’s education than they would want to spend. In general, underinvestment in education because of market failures can be addressed in one of two ways (or a combination of the two). The government can provide subsidies— either to parents or to schools—while The Regional Economist April 2004 ■ www.stlouisfed.org For these reasons, many economists believe that policies tied to students’outcomes (test scores) might be more useful than policies based on input variables (such as studentteacher ratios and spending per pupil) at improving competition among schools, in spite of the claims that standardized test scores do not accurately reflect academic achievement. The No Child Left Behind Act, signed by President George Bush in 2002, is an example of a policy that explicitly recognizes the failure of past spending efforts to improve students’ academic performance. The act amends the Elementary and Secondary Education Act of 1965 and is now the most important federal law regarding public education. The new law is designed to improve the incentives for school officials, teachers and parents by holding schools accountable for the performance of students. The No Child Left Behind Act calls for federal funds, particularly those targeted at improving the test scores of the disadvantaged (Title I), to be subjected to an accountability mechanism by which schools’progress will be measured every year. The goal is for all children in the public school system to be proficient in reading and math by 2014. Students’performance will be measured primarily with test scores: Schools will be rewarded or sanctioned, depending on the tests’ results. Schools that continually fail to achieve progress could be forced to provide students with supplemental programs, such as tutoring, or, if needed, options to transfer out of failing schools. On the positive side, MAP index District Table 1 Education Reforms teachers who receive academic awards will be eligible to obtain financial rewards, too. In Missouri, the accountability system will continue to be based on the existing assessment program, but it will be complemented in the next few years to conform to the federal requirements. The state already makes available to the public report cards detailing the continuous progress of schools, but the No Child Left Behind Act contemplates supporting additional involvement of parents in the school districts’efforts to meet the accountability requirements. Table 2 the actual provision of education is left to the private sector. Alternatively, the government can provide education itself and charge little or no tuition. With rare exceptions, the latter solution has prevailed. The government provision of education, however, introduces additional distortions. Economist Eric Hanushek argues that under the current organizational structure of many public school districts, teachers and administrators often do not have the same incentives as private schools have to use resources effectively. Primarily, he says, this is because the decisions of how to allocate funds in public schools are not tied to the performance of students and because school districts fail to respond to competitive pressures from other public school districts or from the private school system. Wellston Normandy St. Louis City Hancock Place Maplewood-Richmond Heights Jennings Riverview Gardens Averages Rockwood R-VI Lindbergh R-VIII Brentwood Webster Groves Clayton Ladue Averages 152.4 176.3 182.9 187.5 187.6 188.9 189.8 183.3 227.9 228.5 232.3 235.2 237.5 238.7 230.5 REFERENCES Hanushek, Eric A. “Measuring Investment in Education.” The Journal of Economic Perspectives, Fall 1996, Vol. 10, No. 4, pp. 9-30. Hanushek, Eric A. “The Failure of InputBased Schooling Policies.” National Bureau of Economic Research, Working Paper No. 9040, July 2002. Hanushek, Eric A. and Rivkin, Steven G. “Does Public School Competition Affect Teacher Quality?” in Caroline M. Hoxby, ed., The Economics of School Choice, pp. 23-47, Chicago: The University of Chicago Press, 2003. Hoxby, Caroline M. “Are Efficiency and Equity in School Finance Substitutes or Complements?” The Journal of Economic Perspectives, Fall 1996, Vol. 10, No. 4, pp. 51-72. Spending Studentper pupil teacher ratio Percentage of households with bachelor or higher degree Median household income (1999) 13.1 16.2 14.0 16.3 13.0 16.0 17.1 14.7 17.2 15.4 12.6 15.7 11.5 12.5 15.9 0.7 14.8 16.7 4.8 27.1 7.3 10.7 15.1 41.0 30.6 51.3 45.4 67.1 62.3 43.9 14,158 31,041 21,925 33,053 35,891 29,353 34,353 24,897 56,872 50,018 41,711 50,028 71,448 84,324 58,174 7,981.2 7,563.3 9,543.9 6,546.7 8,909.2 6,723.8 8,065.9 8,967.3 7,430.5 7,171.5 9,711.2 7,160.2 14,787.4 11,536.1 8,270.4 Comparable Inputs, Different Results Conclusion The accountability mechanism implemented by the No Child Left Behind Act highlights the use of standardized test scores to measure education quality. Although such scores may be imperfect measures of education quality, their use is meant to shift attention to outcomes and to avoid reliance on input measures, such as student-teacher ratios or spending per pupil. Some economists believe this is important because an accountability system opens the door for additional reforms that would help provide parents and school officials with the right incentives to make socially optimal choices on education investment. Incentives based on students’outcomes are more likely to be effective and to have a long-term impact on academic achievement than the incentives provided by merely increasing spending in education. Rubén Hernández-Murillo is an economist, and Deborah Roisman is a research associate, both at the Federal Reserve Bank of St. Louis. [13] Most of these school districts in the St. Louis area have comparable inputs—spending per pupil and student-teacher ratios. But the academic performance of their students varies dramatically, as measured by a test from the Missouri Assessment Program (MAP). School districts with scores on the MAP test below the state average of 209.9. School districts with scores on the MAP test above the state average of 209.9. NOTES: 1. Test score data are from the Missouri Department of Elementary and Secondary Education; other variables are from the Common Core of Data available from the National Center for Education Statistics. 2. Averages were computed using the number of students in each district as weights. The state average MAP Index computed for 521 school districts was 209.9. 3. Spending per pupil represents total expenditures for instruction divided by the total number of students. 4. Median household income refers to households with children. Community Profile Madison Well-Preserved Looks to Attract More than Just Tourists Looks Tourists By Stephen Greene To ti na cin Cin To is ol ap an di In [ 421 The Hilltop 7 Michigan Rd. 62 Clifty Falls State Park 7 Madison Downtown Historic District 56 le uisvil To Lo Oh ILLINOIS i o Ri ve r KENTUCKY INDIANA MISSOURI KENTUCKY EIGHTH FEDERAL RESERVE DISTRICT TENNESSEE ARKANSAS MISSISSIPPI Madison B Y T H E N U M B E R S Population Madison 12,004 Jefferson County 31,705 Labor Force Jefferson County 14,015 Unemployment Rate Jefferson County 4.4% Per Capita Personal Income Madison $18,923 Jefferson County $17,412 Top Five Employers King’s Daughters Hospital........................993 Arvin Sango Inc. ........................................750 Grote Industries.........................................750 Madison Consolidated Schools ..............454 Rotary Lift....................................................449 NOTES: Population is from 2000. Labor force and unemployment rate are from December 2003. Per capita personal income is from 2000. Attracting high-paying technology jobs to Madison is a primary goal of David Terrell of the industrial development corporation. W hen the Ohio River overflowed its banks at Madison, Ind., in 1997 and water rose to the top of some rooftops, one century-old house was knocked off its foundation. After evaluating the damage, the federal government agreed to pay for the home to be torn down. But when Madison’s Historic Preservation Board heard about this, it swooped in to save the house. Welcome to Madison, where Mother Nature is no match for the local preservation movement. As one Madisonian says, only partly in jest, “When we see an empty building around here, we don’t knock it down; we turn it into a museum.” Madison’s eight museums are located in 19th century buildings downtown, all 133 blocks of which are listed on the National Register of Historic Places. “The preservation consciousness here is part of the secret of why Madison is such a draw,”says Gary McConnell, who operates the Lanham House Bed and Breakfast and Café Express coffee shop on Main Street. “I hear all the time from my guests, ‘We can’t believe what a Mayberryesque kind of town Madison is.’” Situated within 90 minutes of Louisville, Cincinnati and Indianapolis, Madison is a tourist destination for many. With bed and breakfasts, cafes, antique shops, churches and a fountain lining Main Street and with a scenic riverfront featuring a park, brick walkways, visiting riverboats and regularly scheduled festivals, Madison holds much appeal for the workaholic in need of a recharge. But many residents here share the sentiment of David Terrell, executive director of the Madison-Jefferson County Industrial Development Corp., who says, “Madison cannot thrive solely on tourism.” To sustain itself economically, Terrell says Madison needs to build on its industrial base while also bringing higher-paying technological jobs to town. [14] “Two Cities in One” Madison’s quaintness is partly due to geographical quirkiness. One side of downtown hugs the river, while the rest is surrounded by rolling hills. But a three-mile drive up the hills reveals a different world, an area locals call the Hilltop. “Madison, to me, is unique,”says Matt Forrester, president of River Valley Financial Bank, which sits on the Hilltop. “It’s truly two cities in one. You have the downtown area with its more old-world retail below the hill, and the more commercial and industrial parts of town up on the Hilltop.” Adds McConnell, “It allows us to keep the historic flair going down here, untainted by new things.” The Hilltop includes a series of strip malls, fast-food restaurants and a Wal-Mart Supercenter. It also is home to a diverse group of manufacturers, including Madison’s two largest industrial employers—Arvin Sango Inc. and Grote Industries. Arvin Sango produces exhaust system assemblies, vehicle body stampings and other automotive parts. The company, a joint venture created in 1988, has a majority of Toyota’s exhaust business, including supplying products to the automaker’s two nearby assembly plants, in Georgetown, Ky., and Princeton, Ind. Grote Industries is a leading producer of vehicle safety systems, mainly sophisticated lighting products for commercial vehicles, such as delivery trucks and tractor-trailers. The company The Regional Economist April 2004 income increases. www.stlouisfed.org “By what percentage, I don’t know, but it needs to be better,” winding state roads leads from Madison he says. “To me, to four interstates, the closest of which that’s a measure of (I-71) is 20 miles away. But what may the proper type be a bonus to the weekend tourist lookof success.” ing to indulge in small-town America Terrell says that can be a drawback to an industry look50 percent of the ing to invest in the global economy. workers in Madison “Road access is definitely a chalare employed in lenge,” Grote says. “The community the service sector. and county need to gain interstate That serves as a good access, whether it’s a Super 2 or an pool from which to actual interstate adjacent to the town.” draw candidates for A Super 2 is a wide, flat two-lane Hanging Rock Hill, located between downtown and the Hilltop, is part of jobs requiring higher road with wide shoulders and long Madison’s scenic landscape. skills, he says. visibility for safer passing. moved its headquarters to Madison in Jeff Garrett, who runs the Venture “I think that’s critical for the long1960. Family-owned since it started Out Business Center, a 40,000-square- term growth that Madison could enjoy,” operations at the turn of the 20th cen- foot business incubator in the industrial Grote says. “Without it, my concern is tury, Grote’s sales totaled $150 million park on the Hilltop, agrees with Terrell. that this town will be bypassed.” last year, according to Bill Grote, com“We don’t have an unemployment Terrell admits that poor interstate pany president. He says Madison issue here; we have an underemploy- access can be problematic in terms of offers an inviting business climate. ment issue,” says Garrett. “What we’re business attraction. He expects the “Madison is a vibrant, thriving com- trying to do is get the pay per job higher problem to be alleviated within the munity with a really active chamber of and raise skill levels so our quality of next 10 years with the conversion of commerce,”Grote says. “The assets of life increases proportionally with that.” state road 256 into a Super 2. the town, with the historic area and Since opening in 1996,Venture Out Scott Hubbard, manufacturing genthe river, make for a good living envi- has graduated six businesses. Currently, eral manager at Arvin Sango, says his ronment for raising children.” the incubator houses 12 startups, company hasn’t had major problems ranging from a photography studio to transporting its products, but adds that a leather-goods company that special- “for the economic development of the Seeking “Intellectual Capital” izes in halters for horses. To support his region, a Super 2 would be a big boon.” efforts, Garrett draws upon the SouthA greater transportation concern to Terrell of the industrial development eastern Indiana Small Business Devel- Hubbard and others is the bridge over corporation is aware that luring large opment Center, located in the same the Ohio River that leads from Madison manufacturers employing to Kentucky. The bridge hundreds of people is was built in 1927 and much more difficult these is antiquated, says days. Factors such as Forrester of River Valley overseas competition conFinancial Bank. “It’s two tribute to this challenge. lanes, and it’s very narHis strategy is to instead row. Most of the resiattract “intellectual capital,” dents in the community including people who work will feel better once we in computer programming, get a new bridge.” engineering and highFrequent maintenance tech manufacturing. work on the bridge “Fifteen years ago, leaves residents on the communities were willing Kentucky side, many of to bring in any kind of whom work in Madison, company as long as it with few options. The employed people—no next bridge is 30 miles matter what the skill level away. A replacement A worker at the Grote Industries plant creates plates for semitruck headlights. or the wage,” Terrell says. bridge is years, maybe The company has called Madison home since 1960. “Over time, we’ve gotten decades, in the future. more sophisticated and come to under- building. The center, one of 12 in the In his job, Terrell is determined to stand how the economy is changing. state, offers counseling, training, and not let the transportation challenges We need to take a more strategic look marketing and financial assistance for keep Madison from reaching its goals. at what we’re about and what we want small businesses in a nine-county area. “It’s just one of those things where to be. We may be better off looking for you say, ‘Well, let’s not make it a bara company that employs 20 to 50 people rier.’ We will go out there and sell and pays a much higher wage for jobs A Bridge Too Old what we can sell.” that are more technologically complex.” Looking down the road five years, Another aspect of Madison’s charm Stephen Greene is a senior editor at Terrell says he knows Madison will be is its relative seclusion. One does not the Federal Reserve Bank of St. Louis. on the right track if the overall per capita accidentally end up here. A series of ■ [15] National and District Data Selected indicators of the national economy and banking, agricultural and business conditions in the Eighth Federal Reserve District Commercial Bank Performance Ratios fourth quarter 2003 U.S. Banks by Asset Size ALL $100 million$300 million Return on Average Assets* 1.41 1.18 1.10 1.27 1.18 1.45 1.31 1.45 Net Interest Margin* 3.96 4.47 4.50 4.35 4.43 4.13 4.28 3.81 Nonperforming Loan Ratio 1.20 0.91 0.96 0.86 0.92 0.98 0.95 1.33 Loan Loss Reserve Ratio 1.76 1.39 1.41 1.43 1.42 1.73 1.57 1.84 less than $300 million $300 million$1 billion less than $1 billion $1billion$15 billion Return on Average Assets * Net Interest Margin * 1.33 1.31 .75 3.83 3.45 Indiana 1.10 1 1.25 3.94 3.92 4.30 4.13 3.98 4.06 Missouri 1.75 Tennessee 2 percent 3 Nonperforming Loan Ratio 4.5 1.56 1.47 1.47 Kentucky 0.87 Missouri 1.5 1.75 2 percent 1 1.25 1.5 Fourth Quarter 2002 Fourth Quarter 2003 NOTE: Data include only that portion of the state within Eighth District boundaries. SOURCE: FFIEC Reports of Condition and Income for all Insured U.S. Commercial Banks *Annualized data [16] 1.66 1.55 1.28 1.25 Tennessee 1.31 1.63 1.47 1.43 1.46 1.41 Mississippi 0.74 0.80 0.81 1.25 5.5 1.30 1.31 Indiana 1.62 1.23 1.20 1 5 1.43 1.39 Illinois 1.07 1.13 4.48 Arkansas 1.56 1.46 .75 4 Eighth District 1.34 .5 3.5 4.63 Loan Loss Reserve Ratio 1.10 1.20 0.93 4.01 Mississippi 1.50 4.74 3.73 Kentucky 1.66 1.68 .50 4.52 Illinois 1.30 1.22 1.14 1.08 .25 4.28 Arkansas 0.82 0.91 0 4.08 Eighth District 1.10 1.14 1.13 1.17 0.80 More less than than $15 billion $15 billion For additional banking and regional data, visit our web site at: www.research.stlouisfed.org/fred/data/regional.html. 1.75 The Regional Economist April 2004 ■ www.stlouisfed.org Regional Economic Indicators Nonfarm Employment Growth* year-over-year percent change fourth quarter 2003 united states Total Nonagricultural eighth district –0.2% –0.8 1.1 –4.3 –0.7 –4.5 1.2 1.4 2.0 0.8 –0.2 –0.2 Natural Resources/Mining Construction Manufacturing Trade/Transportation/Utilities Information Financial Activities Professional & Business Services Educational & Health Services Leisure & Hospitality Other Services Government –0.4% –1.2 0.6 –2.5 –0.4 –2.4 –0.1 –0.2 1.2 0.1 –1.7 0.1 arkansas –0.3% –0.5 –1.9 –3.4 0.5 –3.3 0.9 –1.0 2.2 1.7 –0.4 0.4 illinois indiana –0.8% –1.7 –0.9 –2.9 –0.2 –2.7 –0.1 0.0 0.7 –0.9 –2.4 –1.2 –0.7% 0.9 7.2 –2.5 –0.9 –0.8 –0.8 –3.5 –0.6 –0.1 0.3 0.3 kentucky mississippi –0.6% –1.8 –2.1 –1.8 –0.6 0.2 –0.2 0.3 1.4 0.4 –3.0 –1.2 –0.1% 3.3 1.6 –3.6 0.9 0.8 –0.6 5.0 0.4 –1.5 –2.0 1.4 missouri tennessee 0.0% –7.3 2.9 –1.3 –1.4 –4.2 0.0 –1.0 2.0 1.1 –3.4 2.1 0.2% –4.5 –4.1 –1.8 –0.1 –2.3 0.3 1.3 3.0 1.1 0.3 0.8 *NOTE: Nonfarm payroll employment series have been converted from the 1987 Standard Classification (SIC) system basis to a 2002 North American Industry Classification (NAICS) basis. Eighth District Payroll Employment by Industry–2003 Unemployment Rates percent United States Arkansas Illinois Indiana Kentucky Mississippi Missouri Tennessee IV/2003 III/2003 IV/2002 5.9% 6.5 6.7 5.1 6.0 5.8 5.4 6.1 6.1% 6.4 6.8 5.3 6.3 6.3 5.8 6.0 5.9% 5.6 6.7 5.0 5.7 6.9 5.6 5.1 Professional & Business Services Financial Activities 5.6% Information 2.1% 10.9% 14.9% 15.8% Other Services 4.1% Government Manufacturing Natural Resources & Mining 0.3% Construction 4.7% fourth quarter third quarter Housing Permits Real Personal Income † year-over-year percent change in year-to-date levels year-over-year percent change 7.7 7.3 United States 11.2 11.3 1.1 0.1 1.7 Indiana 7.0 Kentucky 8.6 10.1 11.5 17.0 5 2003 7.9 2.4 Missouri 15 2002 1 2 2003 † [17] 2.2 1.3 20 percent 0 2.9 2.0 1.1 Tennessee 10 1.9 2.0 2.1 Mississippi –0.6 4.5 2.7 1.9 Illinois 1.9 2.9 0 1.9 1.1 Arkansas 6.3 7.2 –5 Leisure & Hospitality 9.0% 20.5% Trade/ Transportation/ Utilities Educational & Health Services 12.2% 3 4 2002 NOTE: Real personal income is personal income divided by the PCE chained price index. Major Macroeconomic Indicators Real GDP Growth Consumer Price Inflation percent percent 10 4.0 8 3.5 all items 3.0 6 2.5 4 2.0 2 1.5 0 all items, less food and energy 1.0 –2 1999 00 01 02 03 0.5 1999 04 NOTE: Each bar is a one-quarter growth rate (annualized); the green line is the 10-year growth rate. Feb. 00 01 Civilian Unemployment Rate Interest Rates percent percent 8 fed funds target 7 6 5 4 three-month t-bill 3 2 1 0 1999 00 01 6.5 6.0 5.5 5.0 4.5 4.0 3.5 1999 Feb. 00 01 02 03 02 03 04 NOTE: Percent change from a year earlier 04 NOTE: Beginning in January 2003, household data reflect revised population controls used in the Current Population Survey. 10-year t-bond Feb. 02 03 04 NOTE: Except for the fed funds target, which is end-of-period, data are monthly averages of daily data. Farm Sector Indicators U.S. Agricultural Trade Farming Cash Receipts billions of dollars billions of dollars 110 40 35 30 25 exports 105 livestock imports 20 crops 100 95 15 10 5 90 trade balance 0 1999 Nov. Jan. 00 02 01 03 85 1999 04 NOTE: Data are aggregated over the past 12 months. Beginning with December 1999 data, series are based on the new NAICS product codes. 00 01 02 03 04 NOTE: Data are aggregated over the past 12 months. U.S. Crop and Livestock Prices index 1990-92=100 145 135 crops 125 115 105 95 livestock 85 75 1990 Feb. 91 92 93 94 95 96 97 [18] 98 99 00 01 02 03 04 The Party Heats Up The Regional Economist April 2004 ■ www.stlouisfed.org National and District Overview BY KEVIN L. KLIESEN H elped along by a healthy dose of stimulative monetary and fiscal policies, 2003 turned out to be a pretty exceptional year for the U.S. economy. Compared with 2002, last year saw stronger economic growth, continued low and stable inflation, modestly lower interest rates, rising corporate profits and a robust rally in the stock market. To cap it off, labor productivity (output per hour in the nonfarm business sector) increased at its quickest pace since 1965. Though subject to revision, preliminary estimates show that real GDP increased by 4.3 percent in 2003, while CPI inflation measured 1.9 percent (both measured by the percentage change from the fourth quarter of 2002 to the fourth quarter of 2003). In 2002, real GDP increased about 2.75 percent, while the CPI rose about 2.25 percent. In the face of this heartening performance of the economy, employment gains remained hard to come by. (See related article on pp. 10-11.) Despite modest increases over the last five months of 2003, U.S. nonfarm payroll employment declined by less than 0.1 percent from December 2002 to December 2003. As a result, the civilian unemployment rate was little changed in 2003. After inching up over the first half of the year from 6 percent in December 2002 to 6.3 percent in June 2003, the unemployment rate then fell modestly over the second half of the year, to 5.7 percent in December. In the Eighth District of the Federal Reserve System, four states saw declines in their unemployment rates from December 2002 to December 2003, while the other three states experienced slight increases. On average, the District’s seven-state unemployment rate fell from 5.7 percent to 5.4 percent. Only three states posted positive growth in nonfarm payroll employment from December 2002 to December 2003: Indiana, 0.4 percent; Missouri, 1.7 percent; and Tennessee, 0.1 percent. One of the most important developments in 2003 was the continued strong growth of labor productivity. Instead of averaging 2 percent over the four quarters of 2003, as Blue Chip forecasters had expected in December 2002, labor productivity growth averaged a little more than 5.25 percent. The influence of rapid productivity growth over the past couple of years has been especially strong in the domestic labor market. In essence, firms (on average) have found that they have not needed to hire more workers to boost output. Whether through improved production processes, better equipment or supply chains, or enhanced worker training programs, the private sector has experienced tremendous growth in labor productivity over the past few years. That said, historical experience suggests that labor productivity growth cannot continue to outstrip the growth of real GDP indefinitely when population growth remains about 1 percent. Ultimately, strong labor productivity growth means rising real incomes, lower costs, higher profits and, yes, rising employment. Twice a year, typically in February and July, the Federal Reserve releases its Monetary Policy Report to the Congress. Each report publishes projections by the Federal Reserve governors and Bank presidents for a few key economic variables. In the February 2004 report, Fed policymakers reported that their belief is that the “economic expansion will continue at a brisk pace in 2004.” Specifically, the most likely scenario is for real GDP to increase by between 4.5 to 5 percent between the fourth quarter of 2003 and the fourth quarter of 2004. Consumer prices, as measured by the personal consumption [19] expenditures chain-type price index, are expected to increase by between 1 and 1.25 percent, while the unemployment rate is projected to fall to about 5.5 percent. In general, Fed policy-makers are expecting modestly faster real GDP growth in 2004 than does the Blue Chip Consensus forecast, but slightly lower inflation and a lower average unemployment rate by the end of the year. Although the Fed does not forecast employment, the general consensus of private-sector forecasters is that nonfarm payroll employment gains will average about 150,000 a month. In all likelihood, continued strong productivity growth will continue to limit the pace of job creation. A former Federal Reserve chairman once said that the Fed’s job was to take away the punch bowl before the party got out of hand. As events over the past few years have demonstrated, though, one of the insurmountable difficulties of economic forecasting is the inability to predict the unpredictable. If, however, as forecasters suggest, the party’s starting to heat up, then pulling the punch bowl will be a matter of when, not whether. Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann provided research assistance. REGIONAL ECONOMIST | APRIL 2004 https://www.stlouisfed.org/publications/regional-economist/april-2004/special-treasury-bonds-can-help-gauge-expected-inflation Special Treasury Bonds Can Help Gauge Expected Inflation Treasury inflation-indexed securities (TIIS) are good measures for expected inflation, but they aren't perfect because they don't take cumulative deflation into account. To better understand this, let's consider how we'd calculate expected inflation from a hypothetical 10-year zero-coupon TIIS and a similar 10-year conventional bond. (A zero-coupon bond pays a single principal payment, rather than a series of smaller payments [coupons] plus a principal payment.) Suppose that the bond market considers that there are two possible outcomes for inflation over the next 10 years: 1. there's a 90 percent chance that cumulative inflation will equal 2 percent; 2. there's a 10 percent chance that cumulative inflation will equal -1 percent (deflation). In such a situation, the market's true expectation of inflation will be 1.7 percent (0.9 x 0.02 + 0.1 x (-.01)). But because the principal payments on the TIIS are not reduced if there is deflation, the TIIS spread will equal 1.8 percent (0.9 x 0.02 + 0.1 x 0). In other words, when there is a possibility of cumulative deflation until maturity, the TIIS spread will tend to overstate expected inflation. And greater probabilities of deflation will increase this bias. The probability of a cumulative fall in the U.S. Consumer Price Index over 10 years is probably very small, however; so, the bias is probably small. In fact, there has been no cumulative CPI deflation in any G-7 country during any 10-year period since 1960. The smallest such 10-year CPI increase is 1.6 percent, recorded in Japan from 1992 to 2002. Because the probability of substantial cumulative deflation over 10 years is negligible, TIIS spreads are probably good measures of expected inflation. Even if the bias itself is large, if the probability of cumulative deflation over 10 years doesn't change much, changes in the TIIS spread will still measure changes in expected inflation. REGIONAL ECONOMIST | APRIL 2004 https://www.stlouisfed.org/publications/regional-economist/april-2004/the-basics-of-bonds The Basics of Bonds A bond is an IOU, a promise to pay an amount of money at some point in the future. Suppose that a pizza restaurant wants to borrow money to buy a new oven to bake pizza. For $950, it might sell a bond that promises to pay $1,000 in a year's time. The yield (y) on this one-year bond would be the interest rate that makes the bond's discounted payoff equal to its price: payoff/(1 + y) = price or y = payoff/price - 1. In the case of a bond that costs $950 and pays off $1,000 a year later, the yield is 5.3 percent. The buyer of the bond lends the restaurant $950 until the bond is paid off. Bond prices and bond yields are inversely related. When the price of a bond rises, a greater investment is needed to get the same payoff; so, the yield on the bond falls. In our hypothetical example, if demand is high, the restaurant might be able to sell these same bonds for $970 and still return just $1,000 at the end of the year. The yield then would be about 3.1 percent. Conversely, when prices on bonds fall, yields rise.
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