Republicans stealing ideas from Southpark?

These plans are eerily similar: ( Click to Enlarge)

Yes, the Republican chart is real.

This is bad news

Kevin Page of the PBO has joined David Wolf in forecasting a historic contraction in Q1:

"Mr. Page told the House of Commons finance committee that, based on private-sector forecasts and his own assessments, he expected GDP to contract by about 8.5% in the first quarter of 2009 and by 3.5% in the second quarter." - Globe and Mail

I've only recently begun trying to forecast GDP and in the model that I'm using, it would be very difficult to generate a contraction of that magnitude. I would love to see the details or the rational for the PBO and Merrill forecasts .

BC Output Gap and the 2010 Games

With the 2010 Winter Games just under a year away, and given that BC is currently experiencing a sharp slowdown if not an outright recession, I though it might be interesting to see how the 2010 Games might help to speed up a recovery. To illustrate, the figure below shows the BC output gap (actual GDP as a percent of potential GDP) with and without the 2010 games.
This assumes that the 2010 games add about 1% to BC real GDP in 2010 and that growth returns to a trend rate of 2.7% in 2011. Now, I know there are those that are not in favour of the Games but I don't think you could ask for a better stimulus plan - it is temporary, targeted, and the timing could not be better. Even more, the stimulus is a mix of of government and private spending and is spread across diverse sectors of the economy.

Whether the Games will have long-lasting impacts beyond 2010, or even if the money could have been spent better elsewhere are open questions, but as stimulus, it is hard to argue against.

Weekend Quantitative Easing Wonkfest

The Fed has announced a massive quantitative easing program directed at purchases of mortgage backed securities and long-term treasuries - following the liquidity trap/deflation playbook discussed in this post.

So what is quantitative easing? Here are some great links that should tell you all you ever wanted to know. Enjoy!

Links:
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Quantitative Easing - Econobrowser
Quantitative Easing Explained - Financial Times
A look at the Bank of England’s balance sheet - Macroblog
Is quantitative easing trying to raise or lower interest rates? - Worthwhile Canadian
Initiative
How should we think about the monetary transmission mechanism? - Macroblog
Quantitative Easing and the Bank of Japan - Federal Reserve Bank of San Francisco
Did Quantitative Easing by the Bank of Japan Work? -Federal Reserve Bank of San Francisco
Fiscal Aspects of Quantitative Easing (Wonkish) - Paul Krugman
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Merril Lynch forecasting -9.1% GDP contraction in Q1/2009

Wow - makes my prediction of -4.3% look like a call to rejoice . Not sure how ML arrived at that rather staggering number but lets hope David Wolf was just trying to get some publicity because if he's right, it will mean a lot more pain for Canadians.

Forecast Update

I've updated my 2009-2010 forecast to incorporate actuals from Q4/2008. Not much has changed, I've lowered the forecast for growth slightly and increased the expected unemployment rate. It remains a very difficult forecasting environment, especially in the sort of monetary policy driven model that I'm employing.

I'll benchmark my forecasts to the pros on Bay Street once Q1 GDP is released, that should be interesting.

(click to enlarge image)

Can a Taylor rule lead to a liquidity trap?

Maybe. Here is the story (it’s a long and extremely wonkish story, but hang in) – Start with the Euler condition and the Fisher equation from a standard money-in-utility (MIU) model:

P_t(1+ ί_t)/P_t+1 = u_c,t/βu_c,t+1 (1)

Which can be rewritten as:

1+ ί_t = (P_t+1/P_t) z (2)

Where z is assumed constant and summarizes the real factors that influence the real interest rate, r*. Taking logs of both sides,

ί_t = pi_t+1 + ln(z) (3)

Further assume that the central bank follows a simple Taylor rule of the form:

ί_t = r* + pi* + δ(pi_t – pi*) (4)

Where ί_t is the nominal rate of interest and r* is the natural rate of interest. Combining (3) and (4) gives an equilibrium process for inflation that looks like:

pi_t+1 = pi* + δ(pi_t – pi*)

Finally, assume the central bank follows the so called “Taylor Principle” that the central bank reaction function should respond disproportionately, or more than one for one, to changes in inflation. Therefore, in the above equilibrium process, δ>1. Graphically, the dynamics of this equilibrium process looks like this:

Notice that the policy rule is bounded at the rate of deflation consistent with the zero nominal bound for interest rates. To see how this type of rule could lead to a liquidity trap equilibrium, observe that if inflation starts out below pi*, the stationary “good equilibrium” where inflation is equal to its target level, the central bank will cut the nominal rate in order to stimulate the economy. Under the above rule, inflation will decline leading to another rate cut, generating further expectations of lower inflation, and so on until it reaches the stable but deflationary equilibrium, pi**.

At this point you should be thinking – wait a minute, shouldn’t interest rate cuts lead to higher inflation expectations? Under normal conditions yes, but think of the above model in the present context in which inflationary expectations may have become detached from the 2% anchor and in which the economy is performing well below potential – it may be the case that rate cuts, particularly near the zero lower bound, will feed deflationary expectations. Moreover, since the only stable good equilibrium is at pi*, and because the inflation process is forward looking, the only way to get out of the deflationary equilibrium is to get expectations to jump to the good equilibrium at pi*.

I discussed how policy-makers might engineer such a jump in a previous post.

Shock Minus Control Supports an Independent Parliamentary Budget Office

This shouldn't even be a question - Give the PBO the proper funding and leave it alone to do its job. The PBO provides a valuable public service and I would love to see it evolve into a CBO type institution. Lets hope politicians in Ottawa put their money where their collective mouths are.

Canadian Economy contracts 3.4% in Q4 2008

No surprise here, growth was a little worse than my initial forecast(guess) of -2.7%. The economy is now being hit from all sides - both domestic demand and trade were down and household spending was down 0.8%, the first decline since 1995.

Ugh. Next quarter will be much worse and Q2 won't be anything to cheer about either. Hope to see some sign of recovery in Q3. Wake me up when its over.

How to get out of a liquidity trap?

Given the high probability that the Bank of Canada will inch ever closer to the zero bound when it cuts its overnight rate Tuesday, it may be a good time to ask – just how the hell do we get out of this? Here is an non-exhaustive list of ideas:

• Credible adherence to an inflation or price level target – if credible, an inflation target anchors expectations so that a bad equilibrium of unacceptably low inflation or deflation is less likely (this deserves a post of its own, but not right now).

• Assuming fiscal policy is non-Ricardian, the Government could promise to run huge fiscal deficits if inflation falls below a certain threshold.

• Central Bank open market operations in the market for long-term bonds – Goodfriend (2000) argues that such purchases could substantially increase monetary liquidity and therefore inflation expectations.

Given the above list, it would seem that Canada is well placed to get itself out of the liquidity trap. The Bank of Canada has a credible inflation target and therefore much of the work in anchoring inflation expectations has already been done. Moreover, the government has committed itself to running deficits for at least two years, and the Bank has recently announced that it will begin accepting corporate bonds as collateral in its repo arrangements, although this program is largely targeted at reducing spreads rather than altering expectations. All in all, I think this should provide Canadians with some optimism about digging ourselves out of this situation.