R* strikes back: The Fed will hike sooner rather than later

The Federal Reserve’s mandate is clear – ensuring the maximum level of employment while at the same time ensuring price stability.

Over time the Fed’s interpretation of this mandate has changed, but we can maybe get a bit closer by saying that the Fed has an ordering of the dual mandate.

First the Fed wants to insure that inflation (inflation expectations) over time is close to 2%.

Second, once this is the case the Fed will try to “push” economic activity in the “right” direction – meaning that the Fed will ease (tighten) monetary conditions if US unemployment is above (below) the structural level of unemployment (NAIRU).

This of course also is what is reflected in for example the traditional Taylor rule, where the Fed ‘sets’ its policy rate – the Fed Funds rate – to reflect both inflation relative to the inflation target and the output gap.

However, what is not often discussed is that the Fed does not actually ‘set’ interest rates. Or rather the Fed cannot just set a level of interest rates, which it likes.

Rather the Fed will have to set the interest rate relative to the structural level of interest rates – or what the Swedish economist Knut Wicksell termed the natural interest rate – or which is often today referred to as r*.

Hence, the task of the Fed is to set monetary conditions so to ensure that actual short-term interest rates are close to r*.

If the Fed tries to push interest rates significantly below r* for a sustained perioded by injecting large of amounts of liquidity into the economy then sooner or later we will get a spike in inflation.

Therefore, the Fed really isn’t in control of interest rates – or at least the fed cannot independent of its inflation target set interest rates.

All the Fed can do is to shadow r* and thereby ensuring than inflation will be close to its inflation target.

The challenge for the Fed is that r* isn’t constant over time.

Hence, we know both theoretically and empirically that the real interest rate has been moving up and down and is different from country to country.

Hence, r* reflects structural factors – such as demographics and productivity.

In this blog post the purpose is to try to help understand the development in r* over time and to assess what implications this has for present day monetary policy in the US.

To shed light on this matter I have estimated a rather simple, but nonetheless robust model for the development in the actual Fed Funds rate since the early 1960s. This is part of a bigger research project I am doing at Copenhagen Business School.

Normally models for the Fed funds rate is seen as ‘policy rules’.

The purpose here is not to estimate a ‘policy rule’ but rather to think about the Fed’s challenge to shadow r* by estimating a model for what the Fed historically has done with interest rates.

Estimating Fed’s r*

Basically the starting point for the analysis is that the Fed is both ‘targeting’ real and nominal economic activity, which is that the dual mandate is about. Real economic activity in terms of the ‘output gap’ and nominal activity in terms of inflation.

However, we also know that this has been changing over time and the Fed’s 2% inflation target is a fairly “new” target.

Furthermore, we also know that r* is not constant over time so even when inflation is at the inflation target and the output is closed (zero) then the Fed might have to change its policy rate to reflect changes in r* that are a result of for example higher saving in the US economy (for example due to consolidation of public finances) or to reflect higher or lower productivity growth.

To reflects these factors I have estimated a model for the Fed funds rate since 1962.

To explain the development in the Fed funds rate I use the following variables:

First of all I look at potential nominal GDP growth (relative to population) growth.

This of course partly reflects the Fed’s inflation target and that we know from the so-called Fisher Equation that high inflation should cause higher nominal interest rates. Furthermore, this also captures the fact that higher productivity growth should be expected to lead to higher interest rates – as we for example recognize it from the so-called Solow growth model.

Second, I use population growth to capture both growth trends as well as for example the impact of changes in savings and risk appetite as a consequence of changes in demographic trends.

Third, even though the Fed’s task is to ensure ‘price stability’ it has not always succeed in that. The opposite of price stability is price volatility and we therefore use a 10-year moving average of yearly changes in inflation to capture the degree of price (in)stability.

Finally, we also want to capture changes in investors’ and consumers’ optimism and pessimism and the general ‘business cycle’ and the general level of economic activity. I could have used unemployment or the output gap, but I also wanted to capture structural demographic trends so I have used the so-called employment-population ratio as an explanatory variable.

Estimation results

I don’t want to bother the readers too much with the specific statistical tests, but what I have done is simply to run a simple linear regression explaining the (nominal) fed funds rate with the four variables discussed above. The estimation period is from 1962 and until today. I use quarterly data.   

The graph below shows the actual Fed Funds rate and the predicted Fed Funds rate and we see the fit over nearly six decades is quite good (R2=0.8).

Furthermore, all four explanatory variables are strongly statistically significant and the sign on all four variables are as expected positive – meaning growth nominal GDP and population growth push up the Fed Funds rate as do higher inflation volatility and a high employment-population ratio.

Furthermore, it is notable that the model well captures the major trends in interest rates over the past six decades – higher interest rates in the 1970s and the decline in rates from the mid-80s and the ‘flat lining’ of rates over the 12-15 years.

I will not go in to too much detail in terms of the decomposition of what drives interest rates during the different periods and I will return to that in later work, but it is sufficient to say that the very low level of interest rates we have seen in the US since 2008 is more or less fully explained by the four explanatory factors – lower potential NGDP/capita growth, low population growth, low inflation volatility and a moderately low level of employment-population ratio.

Hence, the Fed funds rate is not low because the Fed’s has “manipulated” interest rates and is not low because monetary policy is has been overly easy (if anything it has been too tight – at least until recently).

Rather, low interest rates in the past decade reflect economic conditions and mostly structural economic conditions – for example weak population growth and a declining labour force due to the aging of the US population (the baby boomers have been leaving the labour market).

Looking ahead – Fed will need to hike sooner rather than later

In response to the ‘lockdown’ crisis of 2020 the Fed has cut the Fed funds rate (and implemented quantitative easing). This is completely in line with what the prediction of the model have been.

In fact the model predicted that the Fed funds rate should have been cut to -3% (!) in the second quarter of 2020.

This of course didn’t happen due to Zero Lower Bound on interest rates, but the Fed instead has opted to undertake significant quantitative easing of monetary policy. Hence, the money base has been expanded significantly. This in mind my undoubtably has been the right policy – at least in terms of the magnitude of monetary easing.

The predicted decline in the Fed funds rate primarily reflected a sharp drop in the employment-population ratio.

However, both of these variables are now clearly improving, but despite of that the Fed has so far insisted that we are far away from any rate hikes.

However, this week we have nonetheless seen quite a bit of a repricing of the markets’ expectations for rate hikes.

To answer the question about the outlook for rates we can try to make a simulation based on the model we have estimated above.

What we will try to estimate is where the Fed Funds rate should be in ‘steady state’ – hence, once the US economy has moved out of the crisis and returned to the underlining trends that we saw prior to the ‘lockdown shock’ hit in 2020.

Lets have a look at the four explanatory variables.

First we see that potential nominal GDP growth (per capita) as calculated by the Congressional Budget Office (CBO) over the past decade has been stable around 3.0%  – considerably lower than earlier decades. Hence, we use 3.0% as our measure of the long-term growth rate of potential NGDP growth (per capita).

Second, in terms of population growth we use a forecast of 0.7% annual population growth in the US – reflecting more or less most forecasts for US population growth over the coming decade.

Third, we assume that inflation volatility will remain low around the same level as we have seen over the past decade (0.25).

Finally, we assume the decline in the employment-population ratio will continue to reverse – reflecting the closing of the output gap.

Judging from recent economic data this recovery will be quite fast. For simplicity we assume that the employment-population ratio will return 60% by mid-2022. This is not necessarily a forecast of what will happen, but rather an assumption we use when making a simulation for the Fed Funds rate for the medium-term.

Fed Funds rate is heading back to 1.5% sooner than you think

If we assume that these for variables over the coming 4-6 quarters return to their steady-state levels then we can simulate what we should expect to see in terms of the Fed Funds rate.

The graph below illustrates that.

According to the simulation the Fed Funds rate should return to positive territory in the middle of this year. This can be interpreted as the Fed will end QE and change its forward guidance in a more hawkish direction and in the second half of the year we should actually see the Fed start hiking the Fed Funds rate.

During 2022 the Fed Funds rate should approach 1.5%.

This is of course a much more aggressive rate hike path than presently signalled by the Fed and expected by the market (around 100bp above market pricing in by the end of 2022).

However, it does not reflect an extreme assumption regarding the economy.

Rather the only thing we here assume is a return to ‘normal’ over the next 6-8 quarters and given what we are seeing in terms of the macro data at the moment and the planned major fiscal easing this certainly does not seem to be an overly optimistic take on the economic outlook. In fact it might be too pessimistic.

Furthermore, this does not reflect the change in the Fed’s inflation target from a pure 2% inflation target to an average inflation target and it does not reflect any change in the risk premium on US debt despite a very significant expansion of US public debt.

So if anything there might be reason to speculate that the Fed could be forced to hike even faster than this simulation indicates.

What if the Fed fails to hike?

Fed officials continue to argue that there is no reason to hike rates any time soon. In fact Fed chairman Jerome Powell has argued that the Fed is not even thinking about thinking about hiking rates.

But what happens if the simulated path for the Fed Funds rate is right and the Fed despite of that sticks to the promise of not hiking rates?

Then the Fed effectively will be in a situation where it will try to keep r (significantly) below r*.

The Fed has tried such policies before in the later part of 1960s and going into the 1970s and the result was rather catastrophic – inflation rose sharply. As did economic volatility.  

I certainly don’t think that the Fed will repeat the mistakes of the 1970s – at least not to the same extent – but while the Fed mostly have erred on the downside (too tight monetary policy) over the past 12 years the opposite now seems to be the case.

Hence, during the next 2-3 quarters we will likely have a test of the Fed’s commitment to it’s 2% (average) inflation target. Will the Fed for example allow inflation expectation to increase above 3%?

Or – more likely – will the Fed reverse course once it realizes that the output gap will be closed already during 2021 and inflation risks will increase further if it refuse to hike rates.

Unfortunately, the Fed has continued the mistakes of the past and communicated its monetary policy stance in terms of its policy instruments rather than in terms of communicating in terms of its policy goals.

This means that we in 2021 are likely to see the Fed being forced to change its message quite a bit. I am tempted to say that this smells of the stop-go policies of the 1970s and even though the outcome is likely to be less catastrophic than during the 1970s we could very likely see an increase in financial market volatility as a result of this.

PS there are also some elements of what we saw during 2006-7 in what is happening in financial markets, but I do not expect the same outcome as in 2008-9, but I might return to that in a later post.

PPS I have done similar modelling on the US 10 year Treasury bond yield. See here.

A model for US bond yields – the Twitter version

I have been tweeting…once again.

Tweeting on Central Bank Digital Cash

As part of my on-going research at Copenhagen Business School on the future of the Nordic banking sector and monetary policy have been researching the idea of Central Bank Digital Currency or rather as I prefer to Central Bank Digital CASH (CBDC).

Tonight I have been tweeting on some ideas and views regarding CBDCs and as with private cryptocurrencies it is not really the technology, which interests me, but rather the monetary aspects of CBDCs and what the importance for the conduct of monetary policy and the monetary transmission mechanism would be. And of course the impact on the wider economy and on the banking sector in particular.

You see my Twitter thread on the topic here (including a lot of typos…).

The clash of two Chicago school ideas

The Economist magazine quotes me on the important topic of whether we are going to see a spike in inflation or not, but at the same time also illustrates what market montarism really is about:

In the aggregate, though, investors seem unconvinced. The inflation expectations which can be derived from prices in financial markets have recently picked up a little thanks to the good news on vaccines and the prospects for a rebound in the world economy. But they still suggest that investors think next year’s inflation is more likely to be below the 2% central banks target than above it (see chart 3).

Lars Christensen, a Danish economist, points out that this means there is a “clash” between the two best-known economic theories associated with the Chicago school. Milton Friedman said sustained growth in the money supply leads to inflation; Eugene Fama argued that market prices fully reflect all available information. “If you believe that we are going to have inflation now…the efficient-markets hypothesis would have to be wrong,” Mr Christensen argues.

Source: The Economist

I discussed the same topic at a recent presentation at Buckingham University. You can watch that presentation here.

Covid-policies should focus on ‘health fundamentals’

The number of Covid-deaths per capita is converging towards a level which essentially is determined by what I have called ‘health fundamentals’ – or simply X*.

Europe and the US have different health fundamentals – Europe is ‘older’ and the US is more obese. Over all I would actually expect more deaths in the US mostly because of obesity, but it is clear that Europe is caching up fast now – X (actually mortality) is moving fast towards X*. Despite new restrictions being put in place everywhere.

Source: https://91-divoc.com/pages/covid-visualization/

The effect of these restrictions (as well as voluntary behviourial changes) might be to ‘postpone’ the ‘convergence’ towards what health fundamentals ‘dictate’, but not for long.

It is comparable to what economists call the vertical Phillips curve. We can use monetary and fiscal policy and other policy measures to push unemployment below the ‘natural’ rate of unemployment which is given by the structures in the labour market – for example – unemployment benefits, unionisation rates, taxes, minimum wages etc. but we can not maintain unemployment below this level for long and sooner or later unemployment will return to its natural level. Furthermore, we know there are strong negative side effects (accelerating inflation) from doing that.

It is the same with covid-deaths. We can artificially maintain mortality rates lower than what is given by health fundamentals for a short period, but at a high cost socially and economically and sooner or later mortality will return to what is given by health fundamentals.

The policy recommendation therefore should be to forget about these restrictions all together and instead focus on health fundamentals. Improving health fundamentals of course includes treatment including vaccines and for example vitamin D supplement, but also protecting the groups most at risk – e.g. the elderly and the obese. Furthermore, we also have to remember that X* is strongly seasonal in nature.

Finally, in the same way we in economic policy should focus on improving labour market structures and to the extent we want to ‘lean-against-the-wind’ with certain restrictions it should be rule-based and transparent restrictions with a proven evidence based track record (there are very few examples of that). Ideally the easing and tightening of restrictions should be decided in a transparent way by an independent ‘health council’ of experts rather than by politicians, but again most importantly we should focus on X* rather than on X.

Recovery and inflation scenarios in the USA for 2021

Swedish mortality in 2020 – It’s a lot better than you might think

Sweden has been the ‘outlier’ in terms of handling the global Covid-19 pandemic as the country’s health authorities have relied on a more laissez faire approach which have relied on the common sense of the Swedish population rather than on draconian government measures such as lockdowns and mask mandates.

In that sense Sweden has been different than basically every other country in Europe and Northern America.

Consequently, Sweden has also become the benchmark case to compare other countries to.

Unfortunately from day one of this pandemic it has all been about counting the number of people who have died from or with Covid-19. The countries with the least Covid-deaths are the “winners” – at least according to the media, commentators and politicians.

I must say I have long ago come to the conclusion that it makes very little sense making such comparisons without taking what I have termed ‘health fundamentals’ into account.

We for example now well know that the elderly and the obese are much more at risk from dying of Covid-19 than the young and healthy. Therefore, it makes little sense for example to compare a country with a lot of old people like Italy or the UK with a country with a young population like Pakistan. Or an obese nation like the US with a much more fit nation like Japan.

Hence, in my view the outcome in terms of Covid-deaths is mostly explained by these health fundamentals rather than by policies, behaviour or culture. These later factors may have an impact in the very short-term (weeks or months) but over months they are much less important than health fundamentals.

But one thing is to look at Covid-deaths and compare them across countries, but what about total mortality? After all the important thing really isn’t Covid-19. The important thing is total mortality (and age-adjusted mortality).

Thinking about this got me to look at Swedish mortality over the last couple of years. In this blog post I will share my main conclusions from looking at the numbers.

I have looked at daily deaths in Sweden from 2015 and until today.

Daily deaths spiked in April-May 2020

Lets start with the clean numbers for daily deaths for each of the years since 2015.

The years from 2015-19 are different shades of grey while 2020 is is red.

The first thing we notice obviously is that starting from around mid-March 2020 daily death numbers started to rise fairly sharply. In the same periode in the previous years the ‘normal’ seasonal pattern had been a gradual decline in daily deaths.

So there is no doubt that the Covid-19 pandemic clearly is visible in the numbers. Furthermore, this period of “excess deaths” lasted until around the beginning of June.

However, what we also see if we take a closer look is that prior to the pandemic had hit in mid-March the number of deaths had actually been rather low compared the previous years and similarly from around mid-May deaths have again dropped below the average number of deaths in prior years.

This is an indication that there was a significant amount of fragile elders who had survived longer than normally would had expected.

Therefore, some of the excess deaths during the March-May period might therefore be explained by “too few” deaths during January and February compared to what we would have expected.

In fact if we look at 2019 we see that year had somewhat lower general mortality in Sweden normally – further supporting what my fellow Danish economist friends Christian Bjørnskov and Jonas Herby have called the ‘dry tinder’-effect.

In the graph below we see this fairly clearly. Looking at the last decade we see a pretty strong ‘dry tinder’-effect – if the number of deaths is high one year (eg 2012) then change in the number of deaths will likely be negative the following year (eg 2013).

Based on this simple historical relationship we should expect thee dry tinder-effect to have had around 2,300 deaths to the total number of deaths in 2020 due to the ‘low base’ in 2019.

However, even if we ignore the ‘dry tinder’-effect the mortality rate in Sweden during 2020 has been a lot less dramatic than some pundits would have you believe.

We can see that by simply looking at the total number of people who has died in Sweden so far this year.

We see that during March-May there was a considerable excess mortality so by the end of May total deaths was more than 10% above normal levels.

However, since then we have see a gradual return towards ‘normal’ and presently the total number of deaths if around 4% above normal.

In total numbers this means around 3,000 more Swedes have died in 2020 than ‘normally’, which is less than half of the number of people who has officially died with/from Covid-19.

This to me is a strong indication that the Covid-19 pandemic more than anything has moved forward deaths by weeks or months rather than by years and it is an indication that Covid-19 to a considerable extent has ‘replaced’ other ‘normal’ causes of dead among the old such the flu or

In fact if the trend from recent months continue during the next couple of months we might we the entire excess mortality for the ‘pandemic year March 2020-March 2021’ disappear.

So yes, a deadly pandemic hit Sweden in 2020, but if one steps back a bit and look at the total number of deaths for the entire year it to see the pandemic.

A way to illustrate that is to forecast how many deaths in total we will see in 2020.

I have done that by assuming that we will see the numbers of deaths in the reminder of the year as normal then we are likely to see around 94,000 deaths in total for all of 2020.

That will mostly likely make it the most deadly year over the last decade but it will none the less be fairly close to the number of deaths in 2012, 2017 and 2018. Sweden was as fairly hard hit like other European countries by influenza pandemics during these years.

Mortality is higher in Denmark than in Sweden

The number of deaths with/from Covid-19 in Sweden has been considerably higher than the other Nordic countries, but what about total mortality.

As a Dane (of Swedish descent) I of course can’t help comparing Swedish and Danish mortality.

The graph below shows the number of daily deaths in Denmark and Sweden adjusted for population size.

It is clear that Sweden was much harder hit by the pandemic in March-May than Denmark.

However, it is also clear that Swedish mortality was considerably lower both period to the pandemic and from May and onwards.

In fact if we look at the total number of deaths in Denmark and Sweden more Danes have died than Swedes adjusted for population size.

The reason for this simply is that the ‘normal’ mortality rate is higher in Denmark than in Sweden. Or said, in another way – a lot more Danes die from cancer than Swedes die from Covid-19.

Mortality has been high, but certainly not catastrophic

Every death is tragic and Sweden has certainly been hard hit by Covid-19. However, when we take a closer look at Swedish overall mortality in 2020 it is also clear that 2020 hardly is the kind of disastor that some pundits would like it into being.

Covid-19 is not “just a flu”. It is certainly more deathly for particularly the elderly. However, in terms of the impact on total Swedish mortality it has more or less been on a comparable level to the ‘bad flu-years’ 2012, 2017 and 2018.

Furthermore, while Sweden has been hard hit by Covid-19 the overall mortality rate is still lower than in neighboring Denmark, where Covid-19 hardly is visible in the mortality rate.

All data in this blog post is from the Swedish statistics office (SCB) and from Statistics Denmark.


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The Czechs and the Swedes – the tale of two Covid-strategies

This is the number of new daily deaths from/with Covid-19 in Sweden and the Czech Republic.

Source: Here.

The two countries are similar in many ways – the population is just over 10 million in both countries; the average age is around 41 and the number of elderly people as share of the population is also pretty much the same (3-4% of the population is over 80 years old).

Life expectancy in Sweden, however, is 82 years while it is 79 years in the Czech Republic.

The immigrant population in Sweden is much larger as share of the population than is the case in the Czech Republic.

These two factors make it more likely that Sweden will see more Covid-19 deaths than the Czech Republic as we know that the mortality form Covid-19 increases sharply for those older than 70 years old. The average age of the dead from/Covid-19 in Europe is around 80 years.

On the other hand, the Czech Republic is in the top-10 of the most obese countries in Europe and we know that obesity strongly increases the risk of dying from Covid-19. Sweden on the other hand is one of the least obese nations in Europe.

More and more evidence show that vitamin D deficiency is highly correlated with Covid-19 deaths (see here).

Sweden does not have a major problem with vitamin D deficiency, but immigrants in Sweden do have serious problems with vitamin D deficiency as do many residents in nursing homes. The data I have seen on vitamin D deficiency in the Czech Republic indicates the problem is bigger than in Sweden.

These factors indicate that we should expect more Covid-death in the Czech Republic than in Sweden.

When the pandemic started to spread in March the Czech Republic went into a rather draconian lockdown. Sweden as we know did not.

Source: here.

Covid-death rose much more in Sweden initially and the Czech Republic was celebrated by many as an example of how to avoid death – just lockdown the country.

However, now things are changing. New daily deaths in Sweden remain very low, while they are rising fast in the Czech Republic and the country seems to be heading for another lockdown.

Judging from Apple Mobility data economic activity is now again falling fast in the Czech Republic, but not in Sweden.

Source: Here.

That being said we also need to get things into a proper perspective. In 2018 more than 3000 Czechs died from the ‘normal’ flu (around 2000 Swedes died).

Presently 5900 Swedes have died with Covid-19. In the Czech Republic 1200 has died with Covid-19.

Looking ahead it is worth noticing that Sweden in most rankings of the quality of healthcare systems is top-5 in the world – the Czech Republic is way behind. Similarly, Swedish GDP per capita is doble that of the Czech Republic.

In terms of government efficiency and governance Sweden is top in the world. On the Corruption Perception Index Sweden is number 4. The Czech Republic is 44.

These factors would also indicate more Covid-deaths in the Czech Republic than in Sweden.

So all in all if we look at what I would call ‘health fundamentals’, which include demographics and socio-economic factors there seem to be little reason to expect less Covid-19 deaths (on a per capita basis) in the Czech Republic than in Sweden.

What is different is the timing – Sweden allowed the virus gradually to spread through society (as we normally do with the flu) and consequently ‘front-loaded’ the deaths.

This would have been a mistake if there was a cure just around the corner, but realistically it is unlikely that we will see widespread Covid-vaccination before well into 2021.

The Czech Republic through draconian lockdown policies ‘postponed’ some Covid-deaths, but now it is coming back. Governments cannot micromanage a virus. The Swedish health authorities realized that. The Czech government did not.

I have many friends in the Czech Republic and dearly hope that death rates will soon stop rising, but we are entering winter and judging from the ‘normal’ seasonal flu pattern we should expect deaths to continue to rise until the spring – whether it is Covid-19 or the flu, but I hope I am wrong.

ONE factor explains most of the differences in Covid19 deaths across US states

Since the outbreak of the Covid-19 pandemic I have closely been monitoring the data for the number of deaths and infected across different countries and I have spend considerable time trying to estimate statistical models to explain variations in deaths and infects across different countries.

It quickly became clear to me that relative few factors could explain this variation and back in April I wrote a blog post in which I claimed that ONE factor could explain most of the variation in Covid-19 deaths across countries.

That factor was age or rather the number men older than 80 years as share of the male population.

There really wasn’t anything overly surprising about that as it fast became clear that very few young people or children died from Covid-19 and the average age of the Covid-19 victims was around 80 years old in most countries.

However, I was really never satisfied with this explanation. There had to be more to the story.

The next factor I looked at – but never published my results of – was obesity. Here the results also were pretty clear. The share of the population who are obese seems to be a fairly strong indicator of Covid-19 mortality. This is also confirmed from numerous ‘micro’ studies looking at individual hospitals or cities (see here for an discussion).

But that still isn’t enough to explain the Covid-19 ‘mystery’ as we can also note what we in economics would call ‘stylized facts’ about Covid-19:

  • There seems to be a strong – flu-like – seasonality in Covid-19 cases, which seems to be linked to latitude (see here and here).
  • There is a significant over-representation of Covid-19 cases and deaths among blacks in the US (see here) and the UK (see here) and among black immigrants (mostly Somalis) in for example Sweden and Denmark (see here), while blacks in the Southern Hemisphere does not seem to be overly hard hit by the Covid-19 pandemic.
  • A majority Covid-19 deaths in the developed countries seem to have happened in nursing homes (see here).

I have no medical training and certainly was not familiar with the academic literature on the importance of vitamin D deficiency in general health, but I have been catching up fast and it is now pretty clear to me that if we look at all of these groups – the elderly, particularly those in nursing home who spend a lot of time indoors, blacks living in Northern hemisphere and the obese they all tend to suffer from significant problems with vitamin D deficiency. The same of course is the case with the seasonality – and there is a well-established relationship between the seasonality in flu and seasonal variation in vitamin D (see for example here).

It is for example a well-established fact that particularly the elderly in Spain and Italy suffer from vitamin D deficiency (see here) and numerous studies have shown that African immigrants in Scandinavia also suffer from vitamin D deficiency (see here).

So the only logical thing would be to look at variation in Covid-19 deaths across countries and try to explain that with the share of the population who suffers from vitamin D deficiency.

However, this is where we run into problems – it is very hard to come across comparable data on this across countries. There is some, but there is still too much problems with the data to do a proper statistical study of enough countries (see here for an example nonetheless).

So instead I decided to look at something else – the variation in Covid-19 deaths across US states and the share of the population in each who are African-American.

The reason for this is that numerous studies have shown that as many as 80% of all African-Americans suffer from vitamin D deficiency (see here) so if vitamin D deficiency really is a key explanatory variable in terms of explaining Covid-19 mortality then we should expect that Covid-19 mortality rates should be higher in US states with a larger share of population who are black.

You can judge for yourself by looking at the graph below.

As we see there is a very strong correlation between the share of the African-American population and Covid-19 mortality rates across US states.

In fact it is by far the strongest statistical relationship I have been able to find among all the variables I have been looking at (including age, obesity, population density and longitude).

Obviously this relationship can be due to a number of factors – among them numerous socio-economic factors – but to me at least this is further indication that vitamin D deficiency is an extremely important variable in understanding variation in Covid-19 mortality across different groups of people and across countries.

And this leads me to the conclusion that maybe we should do less testing for Covid-19 and more testing for vitamin D deficiency and a significant part of the public health response to the Covid-19 pandemic should be to focus on protecting groups with vitamin D deficiency and treating it.

The Fed just de facto increased its inflation target to 2.5%

The long awaited update of the Federal Reserve’s Monetary Policy Strategy has just been announced.

Here are the key points:

  • On maximum employment, the FOMC emphasized that maximum employment is a broad-based and inclusive goal and reports that its policy decision will be informed by its “assessments of the shortfalls of employment from its maximum level.” The original document referred to “deviations from its maximum level.”
  • On price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2 percent by noting that it “seeks to achieve inflation that averages 2 percent over time.” To this end, the revised statement states that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
  • The updates to the strategy statement explicitly acknowledge the challenges for monetary policy posed by a persistently low interest rate environment. Here in the United States and around the world, monetary policy interest rates are more likely to be constrained by their effective lower-bound than in the past.

This is pretty much as expected, but it is nonetheless a significant change relative to the earlier strategy.

Most important clearly is the fact that the Fed has changed its inflation target from a regular inflation target to an ‘average inflation target’.

Under a regular inflation the Fed would let bygones be bygones and if the target has been undershoot or overshoot it would not have implications for the future path of monetary policy. However, under an average inflation target the Fed will try to ‘payback’ if the target has been overshoot or undershot in the previous period.

This obviously is something similar, but not entirely the same as a level target where the Fed would have targeted the price level.

Market monetarists like Scott Sumner, David Beckworth obviously for years have argued that the Fed should implement a NGDP level target. Unfortunately the Fed has not chosen to follow that path, but with an average inflation target we certainly have moved closer so I personally welcome this decision and I believe it will be helpful in securing nominal stability going forward.

The Fed is now de facto targeting 2.5% inflation for the coming years

The Fed has since 2012 had an official 2% inflation target (measured as core PCE inflation). However, the Fed has also consistently failed to hit this target and if we look at 5 and 10 year moving averages of inflation then inflation has been close to 1.5% rather than 2%.

Consequently if we look forward the Fed needs to payback by having inflation above 2% for a sustained period.

The Fed has not said what kind of time interval with will be looking at but i think it would make sense to look at a 5-year moving average.

Average inflation target

Over the past year PCE core inflation has average around 1.5% and if we also assume the ‘payback period’ is five years then this would imply a 2.5% de facto inflation for the coming five years.

If we compare this to market expectation then we see that Fed monetary policy is indeed too tight as 5-year market inflation expectations are presently around 1.6% and if we further correct for the fact that market inflation expectations refers to headline CPI inflation rather than core inflation then the difference is likely a further 0.5%.

breakeven 5-year

Said in another way – if the Fed policy change would be 100% credible we should expect market inflation expectations to jump to close 3%. This hasn’t happened…yet, but let see if Fed chief Jerome Powell dare follow through on his announcement today.

No matter what it is hard not to see today’s announcement has a de facto announcement of further monetary easing from the Fed. Not surprisingly global stock markets have risen on the news and the dollar has weakened. If Powell follow-through we should expect a lot more of that going forward.

And yes, in terms of my forecast that US unemployment will drop below 6% by November this certainly helps.

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