West Virginia Budget Back in Deficit Already [feedly]

West Virginia Budget Back in Deficit Already
http://www.wvpolicy.org/west-virginia-budget-back-in-deficit-already?utm_source=feedly&utm_medium=rss&utm_campaign=west-virginia-budget-back-in-deficit-already

WOWK – The devastating floods of 2016 have only added to the budget storm that hovers over West Virginia. After just one month in the new fiscal year, tax revenue in the Mountain State is already down by nearly 33 million dollars. But even without the floods, money troubles were already coming. Read/Watch

"Yes, absolutely. We have a structural revenue problem. They keep making one-time patches to ongoing expenses, and that means we are going to have to put those important priorities up front. And we are going to have to deal with our budget crisis that we are still in," said Ted Boettner, of the WV Center on Budget and Policy.

That means less money available for road repairs, school expansion, and economic development. If the situation gets worse, there may have to be more cuts in state programs:

"It's time for us to look at what we are spending, not just in trying to back fill with more taxes," said State Sen. Ed Gaunch, (R) Kanawha.

Lawmakers did raise the tobacco tax this year; but plans to levy a cell phone tax never got a hearing. Rather than raising taxes, one idea might be to eliminate loopholes and tax breaks.

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MiB: Danny Kahneman on Heuristics, Biases & Cognition [feedly]

MiB: Danny Kahneman on Heuristics, Biases & Cognition
http://ritholtz.com/2016/08/mib-kahneman-heuristics-biases-cognition/

In this week's "Masters in Business" podcast, we chat with Danny Kahneman, professor of behavioral & cognitive psychology, and winner of the 2002 Nobel Price for economics. He is also the author of the highly regarded Thinking Fast & Slow.

In a wide-ranging discussion, Kahneman discusses how he met Amos Tversky, who became his long time research partner. He notes "we" won the Nobel Prize, referring to his sharing of the prize with Tversky, who died prior to the Nobel Prize being awarded (Nobel prizes cannot awarded posthumously).

Kahneman explains how he and Tversky first discovered the heuristics of Representativeness, Availability, and Anchoring. He tells why going first in a negotiation is – contrary to common opinion – a huge negotiating advantage, as the human brain tries to make sense of the number it receives, regardless of how ridiculous it may be.

The Availability heuristic – "WYSIATI" aka What you see is all there is – reveals how people are unaware of what they do not know, and use whatever limited information may be available to create a coherent narrative, even when there is none. Hence, "Availability bias" allows people to use what looks to be salient info to fabricate narratives that seem to make sense.

You can hear the full interview, including the podcast extras, by downloading the podcast at iTunes, SoundCloud or Bloomberg. All of our earlier podcasts are atiTunes, Soundcloud and Bloomberg. (Masters in Business broadcasts all weekend on Bloomberg radio and SiriusXM, at Friday at 9pm, Saturdays at 10am, 6pm, and 11pm, and Sundays at 3am).

Next week, we sit down with Michael Mauboussin, head of Global Financial Strategies at Credit Suisse, adjunct professor at Columbia University's school of business, and author ofUntangling Luck and Skill in Sports, Business and Investing.

 

 

The post MiB: Danny Kahneman on Heuristics, Biases & Cognition appeared first on The Big Picture.

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My socialism [feedly]

My socialism
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2016/08/my-socialism.html

Geoffrey Hodgson poses an old question: what is socialism?

I share his dissatisfaction with Corbyn's definition as a way of living in which "everybody cares for everyone else." For me, socialism is not about being well-meaning busybodies. Rather, the care must be expressed via institutions which meet people's needs whilst treating them with dignity. On this score alone, our welfare state and immigration system fail.

So, can I come up with a better answer to Geoffrey's question? Here's my personal and idiosyncratic take.

First, a caveat. Like Marx, I'm not keen on detailed blueprints. Capitalism did not spring fully-formed from a single great mind, but rather evolved over centuries. The same will be true for socialism. Yes, there's a place for utopian thinking insofar as it reminds us that there are alternatives to the present system, and insofar as they ask us how we might betterembed values into institutions. But they can be a menace if they encourage sectarianism – "my utopia is better than yours" – and make the best the enemy of the good.

Instead, for me, socialism is a set of institutions which reconciles three principles.

First, real freedom. For me, socialism means giving people control to live their lives as they want. A basic income (pdf) and worker democracy are key features here.

Secondly, substantive equality. Rightist cliché-mongers will sneer here that full equality is impossible. But few leftists mean that everyone must have identical incomes, any more than that they must all wear Mao suits. Instead, two possible guidelines are envy-freenessand Rawls' difference principle – that inequalities be acceptable only if they are to the greatest benefit of the least advantaged members of society.

For me, what matters here isn't just inequalities of income, but of power and respect too. For this reason, whilst redistributive taxes are necessary they are far from sufficient. What's also needed (among other things) is an end to the "messiah complex" - our moronicfaith in bosses and leaders. One reason why I doubt that Labour party is an adequate means of achieving socialism is its obsession with leaders' personalities to the detriment of sensible institutional reform.

Thirdly, we must recognise that knowledge and rationality are tightly bounded. For this reason, Geoffrey's right to say that "relatively little can be planned from the top." Markets, therefore, have a big place in socialism – not least because, as Adam Smith said, they are a means whereby people provide for others without caring. (The best counter-argument to this I've seen comes from Matthijs Krul).

This principle has another implication. Socialism should be achieved by evolution, bycreating stepping stones – small institutional tweaks that create the potential for bigger ones. For example, small acts of empowering people – such as worker directors or patients' groups – might create a demand for greater power.

In this context, expansionary macro policy and job guarantees are important in two different ways.

First, economic growth makes people more liberal and tolerant and hence supportive of beneficial change; the notion of some ultra-leftists that recessions create demand for socialism has surely been refuted by history.

Secondly, full employment would greatly undermine capitalist power. In my socialism, awful working conditions such as those at Sports Direct wouldn't exist not because they have been outlawed but because workers have the real freedom – via a basic income and good jobs elsewhere – to reject such conditions. One step to socialism consists in enabling people to follow Johnny Paycheck's example.

Yes, full employment would squeeze profits. But this would, I'd hope, create conditions for more worker ownership. Capitalism might thus wither away.

Now, you might object that all this isn't too far away from Sam Bowman's "neoliberal"manifesto. I couldn't give a toss*. If we are to move towards socialism, we must take as many people with us as a far a possible – although of course there'll come a time when Sam and I prefer different paths.

For me, socialism requires building support for institutional change. It's not about narcissistic sectarianism. As I said, this is an idiosyncratic view.

* It's a lovely paradox that it is now the right rather than the left that wants to abolish (one form of) money.

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Must-Read: This, from Paul Krugman, is 100% correct. The last eight years have taught us that as long as the distributi... [feedly]

Must-Read: This, from Paul Krugman, is 100% correct. The last eight years have taught us that as long as the distributi...
http://www.bradford-delong.com/2016/08/must-read-this-from-paul-krugman-is-100-correct-the-last-eight-years-have-taught-us-that-as-long-as-the-distribution.html

Must-Read: This, from Paul Krugman, is 100% correct. The last eight years have taught us that as long as the distribution of near-term possible outcomes includes at least a 10% or so chance of landing back at the zero nominal safe interest rate lower bound, the policies we should follow now are pretty much the policies we ought to follow at the bound.

Of course, this is the situation we will be in until the trend and expected inflation rate hits 4%/year: we are going to be in this situation for a looooooonnnngggg time:

Paul Krugman: Murky Macroeconomics:

we're not in the simple, depressed-economy world of 2011 anymore...

But here's the thing: we're not in what we used to call a normal macroeconomic situation either. Maybe we're close to full employment, but maybe not, and that's with near-zero interest rates; also, it's all too easy to imagine adverse shocks in the near future, and not at all clear how the Fed could or would respond. We are, if you like, half-out of the liquidity trap, with one foot on dry land — but the other foot is still hanging over the edge, and it wouldn't take much to topple us right back in.

What I would argue is that in this murky, fragile situation we should be conducting policy largely as if we were still in the trap--because we badly need to get both feet firmly on dry land with some distance between us and the quicksand. (And if I'm mixing metaphors--am I?--never mind. Throw the jackboot into the melting pot!) But it's not the crystalline case we used to be able to make.

Still, we need to deal with this murky situation right, which means embracing the uncertainty as part of the argument. Make murkiness great again!

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Examining Donald Trump’s Statements Today on Taxes [feedly]

Examining Donald Trump's Statements Today on Taxes
http://www.cbpp.org/research/federal-tax/examining-donald-trumps-statements-today-on-taxes

Today's speech by Republican presidential nominee Donald Trump included several statements on tax issues that could create mistaken impressions regarding current tax policies and the impact of several of Mr. Trump's proposals.  This brief report, based on prior CBPP analysis, provides some context on four of those issues.

Top Income Tax Rate

Mr. Trump said today that he would set the top individual income-tax rate at 33 percent; his prior plan had a top rate of 25 percent.  However, his plan would create a much lower rate than 33 percent for a substantial number of very-high-income households by allowing people to pay a new low rate of 15 percent on "pass-through" income (business income claimed on individual tax returns).  More than two-thirds of all pass-through business income flows to the top 1 percent of tax filers.  

This new tax break would encourage many wealthy filers to reclassify a greater share of their income as pass-through income in order to take advantage of this much lower rate.  As our recent analysis of this issue explains:[1]

History suggests that slashing the top rate on pass-through income to far below the top income and payroll tax rate, which applies to salary and wages, also would spur large-scale tax avoidance by expanding the incentive for high-income professionals to classify their income as business income instead of salary and wages.  When, for instance, Kansas exempted all pass-through income from taxes, the state watched the number of pass-through entities grow by many thousands.

This large tax cut for pass-through income would also undercut another tax change Mr. Trump mentioned today:  eliminating the tax break for "carried interest."  Under current law, investment fund managers can pay taxes on a large part of their income — their "carried interest," or the right to a share of their fund's profits — at the 23.8 percent top capital gains tax rate[2] rather than at normal income tax rates of up to 39.6 percent.  The Trump plan ostensibly would tax carried interest at ordinary income tax rates.  In fact, however, these investment fund managers generally would be able to arrange to receive their income as pass-through income.  As a result, rather than these fund managers paying a higher rate of tax on these often lucrative earnings, their carried interest would, as the Urban-Brookings Tax Policy Center (TPC) has noted, "be taxed at a top rate of 15 percent,a reduction of more than one-third."[3]   In short, the Trump plan would replace one tax break for hedge fund managers (on carried interest) with an even larger one (on pass-through income).

Average Tax Rate

Mr. Trump stated that "[t]he average worker today pays 31.5 percent of their wages to income and payroll taxes."  This figure, however, creates a distorted impression about the federal taxes that most Americans pay.  Indeed, TPC estimates that this figure is closer to the average rate paid by the top 1 percent — not the typical filer (see Figure 1). 

 

TPC not only estimates a lower average tax rate than Mr. Trump cites, but its figures also show that about 80 percent of households will pay a smaller share of their income in federal taxes this year than the average tax rate.  That's because the United States has a progressive income tax under which higher-income people pay at higher rates, and that — coupled with a high concentration of income at the top of the income scale — raises the "average" percentage of income that is paid in federal taxes to a level substantially above the percentage of income that most people actually pay. 

The following example shows how the "average" tax rate can substantially overstate the tax burdens of the typical family.  Suppose four families with incomes of $50,000 each pay $2,500 in taxes (5 percent of their income) while one wealthier family with income of $300,000 pays $90,000 in taxes (30 percent of its income).  Total income among these five families is $500,000, and the total amount paid in taxes is $100,000.  Thus, 20 percent of the total income of the five families goes to pay taxes.  But it would be highly misleading to conclude that 20 percent is the typical tax burden for families in this group.

The specific figure that Mr. Trump cited comes from an Organisation for Economic Cooperation and Development (OECD) study that created hypothetical family types to produce comparative statistics across the 34 OECD member countries.[4]  The study did not attempt to estimate actual tax rates for typical families.

Corporate Tax Rate

 Mr. Trump stated that the United States "has the highest business tax rate among the major industrialized nations of the world, at 35 percent."  As CBPP analyses have explained, however, while the U.S. statutory corporate tax rate is high, the amount that U.S. corporations actually pay in taxes — the effective tax rate — is much lower.[5]  This is largely because the U.S. corporate code is riddled with tax preferences that significantly reduce many corporations' taxes (and also create wide disparities in effective tax rates across the economy).

For example, finance firms paid about 23 percent of their profits in corporate taxes over 2007 to 2010, a Treasury analysis found, far below the statutory rate of 35 percent.[6]

Estate Tax

Finally, calling for repeal of the estate tax, Mr. Trump stated today, "American workers have paid taxes their whole lives, and they should not be taxed again at death."  In reality, as CBPP analyses[7] have explained, only the estates of the wealthiest 0.2 percent of Americans — roughly 2 out of every 1,000 people who die — owe any estate tax at all, because the first $5.45 million of a person's estate (and the first $10.9 million for a married couple) is entirely exempt from the tax.  Much of the wealth that heirs inherit from massive estates would never face taxation if not for the estate tax.  Some 55 percent of the value of the very largest estates consist of "unrealized" capital gains that have never been taxed, the Federal Reserve estimates.

Repeal would bestow tax windfalls averaging over $3 million apiece — more than a typical college graduate earns in a lifetime — on the roughly 5,400 wealthy estates that will owe any estate tax in 2016.  Such large tax breaks aimed solely at the top would exacerbate wealth inequality, which has grown significantly in recent decades.  (In 2012, the wealthiest 1 percent of American families held about 42 percent of total wealth.)[8]  Large inheritances play a significant role in the concentration of wealth; inheritances account for about 40 percent of all household wealth and are heavily concentrated at the top. 

Repeal would also add $320 billion to deficits over 2016 to 2025, including the additional interest that would have to be paid on the national debt.

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CBPP Policy Basics: Understanding the Social Security Trust Funds [feedly]

Policy Basics: Understanding the Social Security Trust Funds

http://www.cbpp.org/research/social-security/policy-basics-understanding-the-social-security-trust-funds

Few budgetary concepts generate as much unintended confusion and deliberate misinformation as the Social Security trust funds. Political candidates of both parties accuse their opponents of "raiding" the trust funds. Some writers disparage the trust funds as "funny money," "IOUs," or a "fiction." All these claims are nonsense. In fact, the Social Security trust funds are invested in Treasury securities that are every bit as sound as the U.S. government securities held by investors around the globe; investors regard those securities as being among the world's safest investments.

How Do the Trust Funds Work?

Social Security's financial operations are handled through two federal trust funds — the Old-Age and Survivors Insurance (OASI) trust fund and the Disability Insurance (DI) trust fund.  Although legally distinct, they are often referred to collectively as "the Social Security trust fund."  All of Social Security's payroll taxes and other earmarked income are deposited in the trust funds, and all of Social Security's benefits and administrative expenses are paid from the trust funds.

In years when Social Security collects more in payroll taxes and other income than it pays in benefits and other expenses — as it has each year since 1984 — the Treasury invests the surplus in interest-bearing Treasury bonds and other Treasury securities.  Social Security can redeem these bonds whenever needed to pay benefits.  The balances in the trust funds thus provide legal authority to pay Social Security benefits when the Social Security program's current income is insufficient by itself.

What Is the Trust Funds' Financial Status?

Social Security is adequately financed in the short term but faces a modest long-term financial shortfall amounting to 1.0 percent of gross domestic product (GDP) over the next 75 years, the period that the program's actuaries use in evaluating the program's long-term finances.  Social Security has run a surplus in every year since 1984, as was anticipated when Congress enacted and President Reagan signed the legislation based on the recommendations of the Greenspan Commission in 1983.

Under current projections, the combined Social Security trust funds will continue to run annual surpluses until 2020.  The interest income that the trust funds earn on their bonds, as well as the proceeds the trust funds will receive when their bonds are redeemed, will enable Social Security to keep paying full benefits until 2034.

In 2034, the combined trust funds are projected to run out of Treasury bonds to cash in.  At that point, if nothing else is done, Social Security could still pay three-quarters of its scheduled benefits using its annual tax income.  Contrary to a common misunderstanding, benefits would not stop.  Of course, paying three quarters of promised benefits is not an acceptable way to run the program, and Congress should take action well before 2034 to restore long-term solvency to this vital program.

Most analyses of Social Security focus on the combined OASI and DI trust funds, since both are integral parts of Social Security, but the two trust funds are, in fact, separate.  The DI trust fund faces exhaustion in 2023, and the much larger OASI fund is projected to last until 2035.  Congress must therefore take action by 2023 to replenish the DI trust fund.  Increasing the share of the payroll tax that is allocated to DI (and reducing the OASI share) would assure that both the OASI and DI programs remained solvent through 2034.

How Are the Trust Funds Invested?

The Social Security trust funds are invested entirely in U.S. Treasury securities.  Like the Treasury bills, notes, and bonds purchased by private investors around the world, the Treasury securities that the trust funds hold are backed by the full faith and credit of the U.S. government.  The U.S. government has never defaulted on its obligations, and investors consider U.S. government securities to be one of the world's safest investments.

The Treasury securities held by the trust funds have some special features that make them even more attractive investments than other Treasury securities.  First, the trust funds' investments do not fluctuate in value and can always be redeemed at par.  Even if the securities must be redeemed early, Social Security is guaranteed not to lose money on its investment.  Second, all of the securities purchased by the trust funds — even short-term securities that will mature in one or two years — earn interest at the same rate as medium- and long-term Treasury securities (those not due or callable for at least four years).

By the end of 2015, the trust funds had accumulated nearly $2.8 trillion worth of Treasury securities, earning an average interest rate of 3.4 percent during that year.  The Social Security Administration provides monthly reports on the investment holdings of the trust funds, their maturities, and interest rates.  The trustees project that the trust funds will earn $89 billion in interest income in 2016.

Is the Federal Government "Raiding" the Trust Funds?

No.  Some critics have suggested that the lending of Social Security trust fund reserves to the Treasury represents a misuse of those funds.  This view reflects a misunderstanding of how the Treasury manages the federal government's finances.

When the rest of the budget is in deficit, a Social Security cash surplus allows the government to borrow less from the public to finance the deficit.  (The "public" encompasses all lenders other than federal trust funds, including U.S. individuals and institutions, the Federal Reserve System, and foreign investors.)  The Treasury always uses whatever cash is on hand — whether from Social Security contributions or other earmarked or non-earmarked sources — to meet its current obligations before engaging in additional borrowing from the public.  There is no sensible alternative to this practice.  After all, why should the Treasury borrow funds when it has cash in the till?

Back in 1938, the first Advisory Council on Social Security — a group of independent experts appointed to review the program's long-term finances — firmly endorsed the investment of Social Security surpluses in Treasury securities:

The United States Treasury uses the moneys realized from the issuance of these special securities by the old-age reserve account in the same manner as it does moneys realized from the sale of other Government securities.  As long as the budget is not balanced, the net result is to reduce the amounts which the Government has to borrow from banks, insurance companies and other private parties.  When the budget is balanced, these moneys will be available for the reduction of the national debt held by the public.  The members of the Advisory Council are in agreement that the fulfillment of the promises made to the wage earners included in the old age insurance system depends upon, more than anything else, the financial integrity of the Government.  The members of the Council, regardless of differing views on other aspects of the financing of old-age insurance, are of the opinion that the present provisions regarding the investment of the moneys in the old-age reserve account do not involve any misuse of these moneys or endanger the safety of these funds.

Other Advisory Councils have reached the same conclusion.

 Money that the federal government borrows from the public or from Social Security is used to finance the ongoing operations of the government in the same way that money deposited in a bank is used to finance spending by consumers and businesses.  In neither case does this represent a "raid" or misuse of the funds.  The bank depositor will get his or her money back when needed, and so will the Social Security trust funds.

When Social Security needs to start cashing in its holdings of Treasury securities to meet its benefit obligations, the federal government will have to increase its borrowing from the public, or raise taxes or spend less.  That will be a concern for the Treasury — but not for Social Security, as long as the solvency of the federal government itself is not called into question.  Social Security will be able to sell its bonds just as any private investor might do.

Would Investing the Trust Funds in Other Financial Assets Change the Situation?

No.  Although some people have argued that the Social Security trust funds would be more "real" if they were invested in private stocks or bonds, there is nothing to this contention.  If there were no change in the total federal budget deficit, such a policy would merely rearrange the holding of assets in the economy and would not change the net financial situation of Social Security, the federal government as a whole, or the private sector.  As the Congressional Budget Office has explained:

Clearly, investing trust funds in private investments could have no significant impact on the government's overall balance sheet.  If the Treasury were cut off from access to trust fund moneys, it would have to sell more securities (bills, notes, and bonds) in the credit markets.  At the same time, federal trust funds would accumulate more financial assets.  Net federal indebtedness — liabilities minus assets — would be little different than under the current arrangement.  Conversely, private investors would have to buy more Treasury debt than under current arrangements but would face a shrunken supply of the assets purchased by the trust funds.  The upshot would be a rearrangement of public and private portfolios, perhaps accompanied by a small change in the relative returns on various financial instruments.

For example, if the Social Security trust funds were to invest $100 billion in corporate stock, the Treasury would need to finance the non-Social Security deficit by borrowing $100 billion more in private credit markets.  As a result, the private sector would hold $100 billion less in equities and $100 billion more in government debt.  Neither the government nor the private sector would be better or worse off.  Last but not least, investing the trust funds in private stocks and bonds would subject the trust funds to a greater degree of risk.

Is Trust Fund Debt Real If It's Not Part of Debt Held by the Public?

Yes.  Budget experts generally focus on debt held by the public — which reflects what the government must borrow in private credit markets and which excludes trust fund holdings — as the most useful measure of federal debt for economic analysis.   Some have argued that it is inconsistent to adopt that focus while simultaneously viewing the debt held by Social Security as real.  This argument is incorrect:  both measures of debt are important, but they measure different things.

Debt held by the public is a measure of the federal government's overall fiscal health.  It represents money that must be borrowed and periodically refinanced in private credit markets; interest payments on that debt represent a current drain on government resources.  If the specter of excessive debt led investors to lose confidence in U.S. government securities, federal interest costs could increase substantially, with potentially troubling implications for U.S. and world economies.

 Debt held by Social Security, by contrast, provides information about the adequacy of the program'sdedicated financing.  Debt held by trust funds does not have the same broader economic significance as debt held by the public.  Since it does not need to be financed in private credit markets, it cannot lead to a refinancing crisis.  As legal authority to spend money in the future, it is essentially similar to legal authority to meet spending commitments for other entitlement programs that are not financed through trust funds and are not included in measures of federal debt.  In addition, an increase in trust fund balances that provides authority for higher Social Security expenditures in some distant year is not equivalent to issuing more publicly held debt to finance additional spending today.  If additional spending authority leads to more federal borrowing at some time in the future, that borrowing will add to debt held by the public when that spending occurs.

As the 1938 Advisory Council on Social Security wrote in the passage quoted above, "The fulfillment of the promises made to the wage earners included in the old age insurance system depends upon, more than anything else, the financial integrity of the Government."  Protecting Social Security therefore requires not only assuring that the program itself is adequately financed but also putting the overall federal budget on a sustainable long-term course.

---

 

For more information, see this CBPP report:

Kathleen Romig, "What the 2016 Trustees' Report Shows About Social Security," July 12, 2016.

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Bernanke: Shifting Fed Policies

The Fed's shifting perspective on the economy and its implications for monetary policy

Ben S. BernankeMonday, August 8, 2016

The headline on a recent piece by Ylan Mui of the Washington Post —"Why the Fed is rethinking everything"—captured the current moment well. The Federal Reserve has indeed been revising its views on some key aspects of the economy, and that's been affecting its outlook both for the economy and for monetary policy. In this post I document and explain the ongoing shift in the Fed's economic views. I then turn to some implications, suggesting among other things that, for now at least, Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance.

Talking about the "Fed's thinking" is of course very loose. There are few official communications from the Federal Open Market Committee (FOMC) as a whole, and those that exist (such as the statements issued after each FOMC meeting) have the prose style that might be expected of a document prepared by a large committee. The usual practice therefore is to try to infer the FOMC's policy inclinations from the views expressed by individual FOMC participants in various forums. To quantify changes in the thinking of FOMC participants, I use in this post the Fed's Summary of Economic Projections, a summary of participants' forecasts that the Committee releases four times a year.

Shifting views on the economy. Each quarter, individual FOMC participants—the Washington-based members of the Fed's Board of Governors and all 12 of the regional Federal Reserve Bank presidents—submit their projections of how they expect certain key economic variables to evolve over the next 2-3 years and in the longer run. "Longer-run" projections are defined by the Fed as the values to which the variables in question are expected to converge under appropriate monetary policy and in the absence of further shocks to the economy; these projections can thus be thought of as the "steady-state" or "normal" levels of the variables, to which the economy tends over time. I'll focus here on FOMC participants' longer-run projections of three variables—output growth, the unemployment rate, and the policy interest rate (the federal funds rate)—and designate these longer-run values by y*, u*, and r*, respectively. Under the interpretation that these projections equal participants' estimates of steady-state values, each of these variables is of fundamental importance for thinking about the behavior of the economy:

• Projections of y* can be thought of as estimates of potential output growth, that is, the economy's attainable rate of growth in the long run when resources are fully utilized
• Projections of u* can be viewed as estimates of the "natural" rate of unemployment, the rate of unemployment that can be sustained in the long run without generating inflationary or deflationary pressures
• Projections of r* can be interpreted as estimates of the "terminal" or "neutral" federal funds rate, the level of the funds rate consistent with stable, noninflationary growth in the longer term

Importantly, standard macroeconomic analysis implies that the three variables above are largely out of the control of the Fed: Potential output growth depends on factors like productivity and population growth, the natural rate of unemployment is determined by various features of the labor market (such as the extent of mismatch between workers and jobs), and, given the inflation rate (which is set by the Fed), the terminal policy rate depends on factors like the rate of return on capital investment and the supply of saving. Changes in policymakers' estimates of these variables thus reflect reassessments of the economic environment in which policy must operate.

So how has the Fed's thinking changed?  The table below shows long-run projections of output (y*), the unemployment rate (u*), and the federal funds rate (r*) made by FOMC participants in June 2016 (the most recent available) and in each June of the prior four years.

Why are views shifting?  The changing views of FOMC participants (and of most outside economists) follow pretty directly from persistent errors in forecasting economic developments in recent years:As the table shows, FOMC participants have been shifting down their estimates of all three variables—y*, u*, and r*—for some years now. The declines in the past year have been particularly striking: Based on the midpoints of the central tendency ranges in the table, between June 2015 and June 2016 the typical participant marked down her estimates of both y* and u* by 0.25 percentage points, while the median estimate of r* dropped by 0.75 percentage points.  Cumulatively, over the past four years, estimated y* has fallen 0.5 percentage points, estimated u* has declined 0.75 percentage points, and estimated r* has fallen by a substantial 1.25 percentage points.  Relative to the underlying variables, these are large changes: For example, over a ten-year period, a potential growth rate of 2.4 percent (the middle of the 2012 range) cumulates to about a 27 percent total gain in output, whereas at 1.9 percent (the 2016 estimate) cumulative growth in ten years is instead about 21 percent, equivalent to a difference of about $1.1 trillion in GDP (in 2016 dollars).

1. Estimates of potential output growth (y*) have declined primarily for two reasons. [1] First, potential growth depends importantly on the pace of growth of productivity (output per hour). [2] Unfortunately, productivity growth has repeatedly disappointed expectations during this recovery. For example, in 2009, leading scholars were predictingproductivity growth in the coming years of about 2 percent per annum; in fact, growth in output per hour worked has recently been closer to half a percent per year. It's possible that productivity may recover, of course, but if it doesn't, then potential growth rates in the future will be lower than had been expected earlier.Second, although Fed forecasters have been too optimistic about output growth in recent years, they have also been, interestingly, too pessimistic about unemployment, which has fallen faster than expected despite the slow rise in GDP. Generally, the unemployment rate tends to fall when output is growing faster than its potential—a basic macroeconomic relationship known as Okun's Law. [3]The observed combination of slow output growth and rapid unemployment declines can be consistent with Okun's Law only if growth in potential output has been lower than thought.
2. The downward revisions to estimates of the natural unemployment rate (u*) largely reflect the fact that inflation has come in lower than forecast in recent years. According to the so-called Phillips curve, another basic macroeconomic relationship, inflation should rise when unemployment is persistently below u*. In 2012, as the table above shows, estimates of u* by FOMC participants centered around 5.6 percent. However, despite the facts that the unemployment rate fell below 5.6 percent in February 2015 and has been at or below 5 percent since last October, inflation has not increased, at least not to the extent expected. Although multiple factors influence inflation, one way to reconcile the recent behavior of inflation and unemployment is to revise down one's estimate of the natural unemployment rate.
3. Downward revisions in the estimates of the terminal or neutral fed funds rate (r*) also have multiple sources. Slower potential output growth implies lower returns to capital investment, and thus a lower r*; and indeed the pace of business investment has been disappointing, especially recently. A lower value of r* could also help explain the relatively sluggish pace of actual output growth, since it would imply that current policy is not as stimulative as previously thought (i.e., the current policy rate is not as far below r* as was believed). FOMC participants also pay attention to market signals: Low longer-term market interest rates imply that investors see a continuation of low real returns, low inflation, and low risk premiums on safe forms of debt, all of which point to a lower federal funds rate in the long run.

In short, over the past few years, and especially during the past 12 months, FOMC participants have significantly revised down their estimates of potential long-run U.S. economic growth, the long-run or "natural" rate of unemployment, and the long-run ("terminal") value of the federal funds rate—all of which are key determinants of economic performance.

What are the implications of these revisions for monetary policy and Fed communications?  Over the past couple of years, FOMC participants have often signaled that they expected repeated increases in the federal funds rate as the economic recovery continued. In fact, the policy rate has been increased only once, in December 2015, and market participants now appear to expect few if any additional rate rises in coming quarters.

What happened? Market commentary on FOMC decisions typically focuses on short-run factors, such as the uncertainty created by the recent vote in the United Kingdom on whether that country should leave the European Union. While such factors do affect the meeting-to-meeting timing of monetary policy decisions, they can't account for extended deviations of policy from its expected path. The more fundamental reason for the shift in policy trajectory is the ongoing change in how most FOMC participants view the key parameters of the economy.

The two changes in participants' views that have been most important in pushing the FOMC in a dovish direction are the downward revisions in the estimates of r* (the terminal funds rate) and u* (the natural unemployment rate). As mentioned, a lower value of r* implies that current policy is not as expansionary as thought. With a shorter distance to travel to get to a neutral level of the funds rate, rate hikes are seen as less urgent even by those participants inclined to be hawkish. Likewise, the decline in estimated u* implies that bringing inflation up to the Fed's target may well take a longer period of policy ease than previously believed. The downward revisions in estimated u* likely have also encouraged FOMC participants who see scope for further sustainable improvement in labor market conditions.

The downward revisions to estimates of y* have mixed implications for policy. On the one hand, lower potential output growth suggests that slow GDP growth may not be due primarily to inadequate monetary or fiscal policy support for aggregate demand, but rather reflects constraints on the supply side of the U.S. economy. If y* is truly independent of Fed policy, as the standard textbook analysis assumes, then a lower estimate of y* implies less scope for monetary policy to increase growth and greater risk of inflationary overheating if monetary ease continues for too long.

On the other hand, as mentioned earlier, the recent decline in productivity growth (and thus in potential output) has been both large and mostly unexpected. Some have hypothesized that this decline is not purely exogenous but has been influenced, to some extent, by short-term economic conditions. For example, the slow recovery from the Great Recession likely impeded capital investment, business formation, and the acquisition of skills and experience by workers, which in turn may have contributed to the disappointing pace of productivity gains. [4] The converse possibility, that stronger economic growth today might have positive and lasting effects on the economy's ability to grow, is for some an argument for erring on the side of more stimulative policies.

The bottom line is that, broadly speaking, FOMC participants' views of how the economy is likely to evolve have not changed much:  They still see monetary policy as stimulative (the current policy rate is below r*), which should lead over time to output growing faster than potential, declining unemployment, and (as reduced economic slack puts upward pressure on wages and prices) a gradual return of inflation to the Committee's 2 percent target. However, the revisions in FOMC participants' estimates of key parameters suggest that they now see this process playing out over a longer timeframe than they previously thought. In particular, relative to earlier estimates, they see current policy as less accommodative, the labor market as less tight, and inflationary pressures as more limited.  Moreover, there may be a greater possibility that running the economy a bit "hot" will lead to better productivity performance over time. The implications of these changes for policy are generally dovish, helping to explain the downward shifts in recent years in the Fed's anticipated trajectory of rates.

FOMC communications also have been affected by the recent revisions in the Fed's thinking. It has not been lost on Fed policymakers that the world looks significantly different in some ways than they thought just a few years ago, and that the degree of uncertainty about how the economy and policy will evolve may now be unusually high. Fed communications have therefore taken on a more agnostic tone recently. For example, President Bullard of the St. Louis Fed has recently proposed a framework which implies that, in most circumstances, economic forecasters can do no better than to assume that tomorrow's economy will look like today's. Other participants, noting earlier failures of forecasting, have argued that (for example) policy should not react until inflation has actually risen in a sustainable way, as opposed to being only forecast to rise. In general, with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data. Ultimately, the data will inform us not only about the economy's near-term performance, but also about the key parameters—like y*, u*, and r*—that the FOMC sees as determining that performance over the longer term.

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[1] The two reasons are not really independent:  Both turn on the fact that when productivity growth is low, then, by definition output grows slowly relative to labor input.

[2] Potential output growth also depends on the growth rate of the labor force. However, the slower pace of labor force growth was widely anticipated and thus incorporated into forecasts of potential growth for some time.

[3] Roughly, Okun's Law says that if GDP grows one percentage point faster than potential GDP, then the unemployment rate will fall about one-half percent per year.

[4] The idea that the current level of economic activity can have persistent effects on potential output has been dubbed "hysteresis." Larry Summers is both an originator and a recent proponent of the idea.  It's also received some support from researchers at the Federal Reserve.

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Comments are welcome, but because of the volume, we only post selected comments. 

John Case
Harpers Ferry, WV

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