New Zealand. Sad economic forecasts

Here we introduce a new model of unemployment in New Zealand.  It extends the set of models linking the rate of unemployment and the change in labour force.  The agreement between the measured and predicted unemployment estimates in New Zealand validates our concept which states that there exists a long-term equilibrium (causal) linear and lagged link between unemployment, u_t, and the rate of change of labour force, l_t=dLF/LFdt. For this purpose, we use data borrowed from the OECD.

The estimation method is standard – we seek for the best overall fit between observed and predicted curves by trial-and-error method. All in all, the best-fit equation is as follows:

u_t = -2.0l_t-3  + 0.09         (1)

Therefore, the lead of l_t is three years. The intercept of 0.09 implies the rate of unemployment at the level of 9% when the labour force does not change. Hence, New Zealand needs increasing labour force in order to reduce unemployment.   

Figure 1 presents the observed unemployment curve and that predicted using the rate of labour force change 3 years before and equation (1). Since the estimates of labour force in New Zealand are very noisy we have smoothed both annual curves with MA(3). All in all, the predictive power of the model is excellent and timely fits major peaks and troughs after 1984.

Relationship (1) allows a relatively accurate prediction of the rate of unemployment at a three-year horizon. Figure 1 demonstrates that unemployment will likely grow to the level of 7% in 2012 from the current level of 6.5%.  Hence, the drop in the rate of real economic growth will be accompanied by an elevated unemployment.

Figure 1. Observed and predicted rate of unemployment in New Zealand. The lower panel shows the cumulative curves for the annual curves in the upper panel.

The Phillips curve in Germany

In the posts on the USA and the UK, we mentioned the anti-Phillips curve in which unemployment lags behind inflation by several years. This contradicts the paradigm of the modern economic theory. There are cases, however, which comply with the theory. The Phillips curve in Germany is a good example where unemployment leads inflation by one year.

Figure 1 displays the observed rate of unemployment, u, and that predicted from inflation, which is represented by the GDP deflator, DGDP, according to the following relationship:

u(t-1) = -1.30[0.1]DGDP(t) + 0.105[0.005]              (1)

where u leads by one year. Standard deviation of the residual error is (s=) 0.013 for the period between 1971 (start of DGDP time series) and 2010. Both coefficients in (1) are reliable, and thus, there exists a linear and lagged relation between unemployment and inflation in Germany.

Figure 1. Unemployment and DGDP (both reported by the OECD) in Germany between 1971 and 2010. The lower panel shows the cumulative curves for the annual readings in the upper panel.

Both coefficients in (1) are determined from the cumulative curves with a higher accuracy when provided by linear regression. Figure 2 depicts the Phillips curve in a standard way. The slope of -0.645 instead of the linear coefficient -1.30 in (1) is highly underestimated due to the uncertainty in both time series. At the same time, the determination coefficient R²=0.83 is a strong evidence in favour of the Phillips curve in Germany.

 The existence of a conventional Phillips curve in Germany raises a question about the consistency of monetary policy of the Bundesbank. Does the bank conduct a monetary policy, which balances inflation and unemployment? Affirmative answer is counter-intuitive as in the past twenty five years show the unwillingness of the bank to reduce unemployment in exchange for higher inflation.

Figure 2. The Phillips curve for Germany. The unemployment readings are shifted by one year ahead to synchronize with the GDP deflator estimates.

The Phillips curve and anti-Phillips curve in the U.K.

Looking at two pictures below, please decide which is closer to reality. I have found  a version of the Phillips curve for the U.K. in this paper - "What Drives Inflation in the Major OECD Economies?" by

Diego Moccero, Shingo Watanabe, Boris Cournède. To my mind, their presentation is misleading if compared to the anti-Phillips curve where unemployment lags behind inflation.

Their figure:

My figure: 

I do not understand what makes economists to have so strong prejudice against inflation leading unemployment when it is really  observed. Smells as a sect.

Deflation in Japan. The other view

Our previous post showed that inflation in Japan can be completely explained by the change in labor force. Obviously, there are different (and wrong) explanations based on monetary policy of the Bank of Japan. Below is an abstract of  a working paper on this issue. In my view, it is absolutely worthless as not describing any period or major change in the inflation evolution. How can they seriously publish this kind nonsense?

Japan's Deflation and the Bank of Japan's Experience with Non-traditional Monetary Policy

This paper offers a brief summary of non-traditional monetary policy measures adopted by the Bank of Japan (BOJ) during the last two decades, especially the period between 1998-2006, when the so-called Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) were put in place. The paper begins with a typology of policies usable at low interest and inflation rates. They are: strategy (i), management of expectations about future policy rates; strategy (ii), targeted asset purchases; and strategy (iii), QE. Alternatively, QE may be decomposed into a pure attempt to inflate the central bank balance sheet, QE0, purchases of assets in dysfunctional markets, QE1 and purchases of assets to generate portfolio rebalancing, QE2. Strategy (ii), when non-sterilized, is either QE1 or QE2. Using this typology, I review the measures adopted by the BOJ and discuss evidence on the effectiveness of the measures. The broad conclusion is that strategies (i) and (ii) have affected interest rates, while no clear evidence exists so far of the effectiveness of strategy (iii), or QE0. Strategy (ii) has been effective especially in containing risk/liquidity premiums in dysfunctional money markets; that is, QE1 has been effective. The effectiveness of QE2, however, is unclear. The strategies, however, have failed to bring the economy out of the deflation trap so far. I discuss some possible reasons for this and also implications for the current U.S. situation.

The GDP deflator in Japan

We have already mentioned that Japan is the best illustration of our concept linking inflation/unemployment to the change in labour force. In the previouspost on inflation in Japan, we modelled the overall CPI. Here we illustrate the long term equilibrium relation between the GDP deflator, DGDP, and labour force. All data were obtained from the OECD.

By trial-and-error, we seek for the best-fit coefficients in the linear and lagged link between inflation and labour force. Because of the structural (measurement related?) break in the 1980s, we have chosen the period after 1981 for linear regression, which is common for almost all economic studies related to Japan. By varying the lag and coefficients we have found the following relationship:

DGDP(t)= 1.9dLF(t-t₀)/LF(t-t₀) – 0.0084        (1)

where the time lag t₀=0 years; Figure 1 depicts this best-fit case. There is no time lag between the inflation series and the labour force change series in Japan. Free term in (1), defining the level of price inflation in the absence of labour force change, is close to zero but negative.

A more precise and reliable representation of the observed and predicted inflation consists in the comparison of cumulative curves shown in the lower panel of Figure 1. We always stress that the cumulative values of price inflation and the change in labour force are the levels of price and labour force, respectively. Therefore, the summation of the annual reading gives the original estimates of price and workforce, which when are converted into rates.

Another advantage of the cumulative curves is that all short-term oscillations and uncorrelated noise in data as induced by inaccurate measurements and the inevitable bias in all definitions are effectively smoothed out. Any actual deviation between these two cumulative curves persists in time if measured values are not matched by the defining relationship. The predicted cumulative values are very sensitive to free term in (1).

For Japan, the DGDP cumulative curves are characterized by very complex and unusual for economics shapes. There was a period of intensive inflation growth and a long deflationary period. The labour force change, defining the predicted inflation curve, follows all the turns in the measured cumulative inflation with the coefficient of determination R²=0.96. (Again, these are actually measured curves.) With shrinking population, and thus, labour force, the GDP deflator will be falling through 2050 and likely beyond.

Figure 1. Measured GDP deflator and that predicted from the change rate of labour force. Upper panel:  Annual curves smoothed with MA(3). Lower panel: Cumulative curves between 1981 and 2010. A good agreement between the cumulative curves illustrates the predictive power of our model.

The anti-Phillips curve indicates that the rate of unemployment in the UK must drop below 7% by the end of 2013.

We introduced a model of unemployment in the USA and other developed countries six years ago. The rate of unemployment, u_t, and price inflation, CPI_t, are driven by the same force - the rate of change of labour force. Briefly, there exists a long-term equilibrium (linear and lagged) link between unemployment, inflation and labour force. As a consequence, the rate of inflation and unemployment are also linked by a linear and lagged relationship.  In the USA, unemployment lags behind both CPI and labour force by 3 and 5.5 years, respectively. This creates a situation contradicting any mainstream macroeconomic theory. Under the conventional framework, which is usually described by the Phillips curve, the change in unemployment must be contemporary or leading price inflation. As a joke, we proposed to call the actual link between inflation and unemployment in the USA the anti-Phillips curve. As always, the economics profession ignores observations and looks for the answer in the reservation limited by theoretical barbed wire.  Here we present the case of the United Kingdom. Monthly estimates of the rate of unemployment and CPI, both obtained from the OSCD, completely confirm the concept of the anti-Phillips curve. Unemployment in the UK lags behind inflation by 24 months.

In practice, we are looking for the best-fit linear and lagged equation in the following form:

u_t = aCPI_t-j  + b      (1) 

where a and b are empirical coefficients, and j is the time lag between these variables, which can be positive, zero, or negative. Figure 1 displays the best fit model with a=0.9, b=0.041 and j=24 months. Since the monthly estimates of CPI_t are very noisy we have smoothed the predicted curve with MA(24). Overall, the rate of unemployment repeats the shape of the scaled inflation curve two years later.  The coefficient of determination R²=0.89 for the period between 1981 and 2011, i.e. for 360 readings.

From Figure 1 one can conclude that there exists an anti-Phillips curve in the UK as it was revealed for the USA. Inflation does lead unemployment and the economic theory can not ignore this observation. A good validation of the model would be the fall in the rate of unemployment in the UK below 7% by the end of 2013. The observed curve should intercept the predicted one in the near future.

Figure 1. Observed and predicted rate of unemployment in the UK. Lower panel presents the cumulative values of the curves in the upper panel. This is the best control of the link.

Labour force participation in Sweden and the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel

We have published a number of models for the rate of participation in labour force, LFP. The intuition behind the model is very simple. The growth in real GDP influences the labour force supply through redistribution of personal incomes. Fluctuations in real GDP per capita relative to that defined by inertial economic growth, A₁/G, provide variations in the distribution of personal income relative to some inertial (or neutral) growth rate. The influence of the growth in real GDP on the LFP has to be complicated by the presence of exponential distribution of personal inputs to real GDP. If the effect of real growth is based on the excess of the total personal income above its potential (inertia) level, then higher levels of LFP are more sensitive to real growth. Really, more people can be included in or excluded from the redistribution because of their smaller personal incomes for paid jobs, which are replaced by some other (not measured) mechanisms of personal income earning. It is reasonable to assume that the sensitivity of LFP to the difference between actual and potential (inertial) growth rates, e(t)=dG/G–A/G, grows exponentially with increasing LFP. In addition, there might be a time delay between action and reaction and the LFP may lag behind the e(t). Now we are ready for a quantitative analysis with a tentative relationship: 

{B₁dLFP(t)/LFP(t) + C₁}exp{ a₁[LFP(t) - LFP(t₀)]/LFP(t₀) =

          = ∫{dG(t-T))/G(t-T) – A/G(t-T)}dt

Here we present the model of labour force participation in Sweden. Figure 1 shows that the LFP is very well predicted since 1975. This model is valid for all developed countries. No macroeconomic model can predict the observed changes in LFP using only one macroeconomic parameter. Since the presented model describes the case of Sweden I also mean the latter laureates of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel awarded “for their analysis of markets with search frictions” have failed to model the labour market and predict its evolution at the same level of accuracy and forecast horizon.

Why we need the sophisticated model not describing reality if there exists a simple model predicting as accurately as one can only dream?

                  

Figure 1. Observed and predicted LFP in Sweden: T=0.