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Evidence says the ECB is overreacting

Earlier this week I argued that the ECB’s inflation target of just below 2% is too simplistic, especially during periods of supply-side price shocks: energy, food, VAT hikes. Here’s a menu of reactions to the ECB’s announced rate hike (Trichet used the phrase ‘strong vigilance’, which historically is a leading indicator of a rate hike in the following month): Paul Krugman calls it ‘madness’; David Beckworth sports the ‘black eye’ metaphor; Kantoos is somewhat more explicit in his language; and Warren Mosler goes for the Disney theme.

And then I see that one of my favorite blogs, the Eurointelligence blog, interprets the policy response as warranted in the face of an ‘overheating’ export sector. From Eurointelligence:

(It is our interpretation that the ECB is very keen to drive up the euro’s exchange rate against the dollar to reduce the commodity price shocks, and to reduce the overheating in the export sector. This is why the ECB was keen to signal this interest rate as early as possible, to underline the transatlantic policy gap. We don’t think the ECB intends to hike interest rates to very high absolute levels, though we consider a 2% year-end rate realistic.)

RW: My initial reaction was: what? Am I missing something here? Is the ECB right to be strongly vigilant? Is the export sector (1) overheating? and (2) therefore unmooring Eurozone inflation expectations?


Exhibit 1: Real exports are 1.5% below the pre-crisis level (1H 2008). No overheating there. Based on the chart below, whose data are from Eurostat, I’d even argue that there is a possible stagflationary scenario on the horizon if investment doesn’t pick up.

If it’s not the export sector, perhaps it’s a broader impetus to prices driven by services and consumption goods. No.

Exhibit 2: The chart below illustrates the diffusion of HICP inflation (the ECB’s target inflation index, which is a consistent measure of inflation across the 17-member currency union). I calculate the diffusion index to measure the breadth of prices that are rising at a rate of 2%: > 50 and there’s a larger share of sub-components prices increasing at a greater than 2% annual rate, or
The breadth of Eurozone 2% price gains is very low, 31, or 31% below its historical average (45).

We know that headline inflation is estimated at 2.4% in February, or about 0.4% above the ECB’s comfort zone – perhaps that’s passing through to inflation expectations.

Exhibit 3: The chart below illustrates near-term Eurozone inflation expectations, as measured by the 5-yr inflation swap. (Note: and inflation swap is a market security that allows an investor to hedge against inflation by paying a fixed rate and receiving inflation-linked interest payments in exchange). According to the swap market, inflation expectations are priced at 2.151%; this appears well-anchored especially compared to the 2007 period when it drifted upward.

Another measure of inflation expectations, the ECB’s Survey of Professional Forecasters, sees inflation peaking in 2011 at 1.9%. No unmooring of inflation expectations there.

Related to the chart above, perhaps the ECB is looking at the sharp upward trajectory of inflation expectations in the swap market since October 2010 as unhealthy. No. That trajectory in inflation expectations is just a re-emergence of normalized inflation expectations, as the Fed worked to re-establish the US price trajectory. Global inflation expectations turned from drifting downward to a trend rate. Then perhaps it’s that Eurozone inflation expectations are outpacing those in other developed economies. Again, no.

Exhibit 4: The chart below illustrates the 5y5y forward break even rates of inflation for the US, UK, and the Eurozone, which is from page 84 of the ECB’s February (yes, this month) monthly Bulletin. The Eurozone is definitely the laggard here!

My interpretation of these statistics – and yes, there are many ways to measure inflation – is that the ECB is overreacting to the inflation pressures coming from commodity prices, energy prices, and VAT hikes. The liquidity squeeze is afoot.

Rebecca Wilder

It’s pretty simple: the ECB’s now in hiking mode

I WAY underestimated the simplicity of ECB policy. I think that the terse monetary policy objective explains quite well the ECB’s announced stance on policy today:

The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.

Today the ECB announced that it would keep the refi rate unchanged at 1%, however, Trichet made it quite clear that rate hikes at the next meeting cannot be ruled out (rather should be ruled in). The market response was pretty strong: bond markets are now pricing in 75 basis points of rate hikes this year, which would take the refi rate to 1.75% by the end of 2011; the euro’s close to breaking the 1.40 mark; and the 2-year yield is 13 basis points higher on the day.

The trigger, in my view, was the ECB’s increased inflation projection:

The March 2011 ECB staff macroeconomic projections for the euro area foresee annual HICP inflation in a range between 2.0% and 2.6% for 2011 and between 1.0% and 2.4% for 2012.

The fact that the ECB is now projecting 2012 inflation upwards of 2.4% , which exceeds by leaps and bounds their 2% target in ‘ECB talk’, implies that the committee sees the medium-term outlook on inflation as seriously biased toward the upside. For the ECB, this means policy is way too accommodative.

Let’s step back a moment, though. Despite the ‘strong’ growth in the Eurozone, Germany, the largest Eurozone economy, has not fully recovered it’s GDP lost during the recession. As of Q4 2010, GDP remains 1.4% below its 2008 peak.

In my view, the ECB’s policy objective is too simplistic. During times of supply-side inflation shocks to food and commodities (i.e., wheat droughts or Middle East unrest), headline inflation overestimates the true impetus to prices.

Core and service prices are still very muted, while it’s goods prices that’s driving the price spikes.

It’s up to global growth now to see Eurozone growth through further. Better put: the Eurozone remains overly exposed to global growth shocks.

Rebecca Wilder

Trichet and King: it’s energy, VAT, and food!

The global inflation picture is heating up. On Google, a search of ‘inflation’ spanning the month of February 2011 gets 311,000,000. For one year ago, the same search parameters yielded 1,850,000 hits. Inflation’s on the monetary policy makers’ minds. But why? In the developed world, it’s a food and energy story!

Seriously, look at German and US inflation since the 1960’s. Furthermore, check out core price pressures:

US 0.95% in January 2011…

…Germany 0.77% in January 2011

Dear Trichet, King, and part of the US FOMC: it’s energy and food….energy and food….energy and food…and VAT! David Beckworth writes a great piece about the merits of inflatin targeting.

Wheat, corn, soybean, and sugar prices have surged, whose price gains are now sitting very much on the back burner to oil prices. But look, wheat, soybean, and sugar price pressures are coming down. Therefore, food prices are showing signs of peaking. This should be taken into account when the ECB and BoE meet this week and next, especially if gas and fuel prices start to hinder economic growth prospects.

Some evidence:

* In the UK, price pressures are ever-present – the diffusion is much higher than in other European economies – but it’s very likely that prices peak. The economy’s been hit by a VAT hike twice in the last two years, and the depreciation of the nominal exchange rate continues to pass through to prices. Fiscal austerity will drag aggregate demand and prices – just hold on.
* In Germany, the domestic measure of consumer prices is expected to mark a 2.05% annual pace in February (1.96% in January), but the core level is growing a just a 0.77% annual rate (in January, which the latest available data point). For now, and probably throughout the rest of the year until union contracts reset on an aggregate level, it’s really all food and energy there.
* And in the US, core inflation is rising, but that’s primarily based on the re-emergence of the micro-pressures that are owner’s equivalent rent AND food and energy. Core inflation is now rising again (see recent Calculated Risk article), however, in my view, there’s not enough leading evidence to suggest that inflation expectations have in any way become unmoored. Unit labor costs, for example, remain submerged below a sea of economic profits (more on that tomorrow – but you can see a previous post on the subject here).

Watch monetary policy closely. The oil inflation may simply be the straw that breaks the camel’s back for some, since food prices have been headed north for some time. Key central banks shouldn’t hike – UK and ECB are notable examples – but they may.

I, consequently, still ‘hope’ that the recent hawkish rhetoric coming out of the ECB is simply a reflection of the hole that is the appointee to run the ECB after Trichet leaves in October. More bluntly put: they’ll say anything to get the job. (See Eurointelligence’s case for Mario Draghi.)

Rebecca Wilder

Based on the German inflation print, the ECB may be less ‘hawkish’ next week than people think

Today the German Federal Statistics Office reported that the February Consumer Price Index is expected to mark a 2.0% (2.047% by my calculations, which is very close to a rounded 2.1%) annual pace in February 2011.

This is simply a ‘flash’ print, and the Statistics Office was very careful to discount the fact that inflation continues to be driven by energy. But the harmonised index of German consumer prices (HICP) increased a greater than expected 2.2% over the year, suggesting upward pressure to the headline Eurozone rate remains in play. Market participants are expecting ECB rate hikes this year – there are currently at least 2 hikes priced in through this year – based on an elevated Eurozone inflation rate, currently estimated at 2.4% in January.

The ECB is a devout inflation targeter (see first chart of this post); it’s a central bank that raised rates late in 2008 only to see Eurozone inflation plummet as the economy dropped into recession (see chart below). But I think that the ECB will be less hawkish than expected next week, because I’m noticing an interesting correlation between German-based inflation (supposedly not relevant, per se, to ECB policy), Eurozone HICP inflation (the ECB’s target rate of inflation), and the refi rate.

(Note that the ECB targets a weighted composite of harmonised index of consumer price inflation (HICP), rather than a composite of the domestic price indices. You can read about the measurement differences between domestic CPI and Eurostat’s Harmonised CPI here.)

The chart illustrates the German CPI, the German harmonised measure of the CPI (HICP), Eurozone HICP inflation, and the ECB’s policy rate. There are three things that jump out at me as relevant for ECB policy expectations: (read more after the jump!)

(1) The correlation between Eurozone HICP inflation is stronger with domestic German inflation (CPI) than with the German harmonised measure of inflation: 59% vs 88%, respectively.
(2) Related to number (1), the ECB policy rate appears to be driven more by the domestic measure of German inflation (CPI) rather than its harmonised measure. At least in the 2008 energy bubble, the German harmonised rate of inflation was falling well before the ECB hiked the refi rate.
(3) Therefore, it is possible, that with German CPI printing at a lower rate than the harmonized measure, currently 2.05% vs. 2.23%, market participants who expect a very hawkish ECB statement next week may be disappointed (the ECB announces its policy rate next week).

The exact reason for (1) is worth exploring.

Rebecca Wilder

The UK faces a serious inflation issue if oil pops!

Bond markets are pricing in rate hikes this year by the ECB and the BoE. Both are inflation targeters, so which one should react first to a possible spike in oil prices? What’s your answer?

(1) Neither. As FX appreciation and fiscal austerity pass through to domestic prices, the core will drag down the headline. If they hike, stagflation will result.

(2) The ECB, because it is the most hawkish of all central banks, in my view. The ECB mandates a rigid targeting scheme compared to that of the BoE. Since the January 2005, the BoE has successfully targeted inflation slightly under 2% just 27% of the time, while ECB has done so 61% of the time.

(3) The UK. The January 2011 UK inflation rate was 4% Y/Y (3.2% in November on a harmonized basis) and near-double that in the Eurozone, 2.4% according to the flash estimate.

Furthermore, the UK story is not one of just energy and food. The chart below illustrates the diffusion of price inflation across the components of the harmonized HICP (data at Eurostat), and the legend lists the period average for each economy. Diffusion levels above 50 indicate that a larger share of component prices are growing at an annual rate above 2% that below 2%. The diffusion a measure of the breadth of price pressures…

…and is UK inflation broad-based! In contrast, inflation in the Eurozone is focused in the commodity and energy space. Now, I’m not suggesting that the BoE hike – in fact I would recommend the opposite, or at least stay on hold – but I’m sure that the BoE has its vision acutely focused on developments in the Middle East.

If I had to choose an economy that would be derailed by the price spikes in the commodity space, it would be the UK. But I choose (1).

Rebecca Wilder

Interesting interpretation of Trichet’s comments regarding ECB policy

Eurointelligence cites a Die Zeit interview (the original interview here) with ECB central bank President Jean-Claude Trichet. Their take on it is quite interesting, which suggests that most are ‘wrong’ about the path of ECB policy. According to Eurointelligence:

Central bankers are trained not to say anything of any relevance in long speeches or interviews, and Jean-Claude Trichet is a master at this. So we were a little surprised when he told Die Zeit that governments should fine tune their fiscal policy in the fight against inflation. Here is the quote: “Individual countries must accept the monetary policy as a given and adjust their national policies accordingly…When a country experiences a boom, it needs to make its own national policies …more restrictive in order to avoid the economy overheating or speculation getting out of control.” The policy consensus has been for the last few decades that monetary policy is the instrument of choice to control inflation and inflation expectation, while fiscal policy should be oriented towards medium-term goals. Fiscal policy has a role to play in countries that overheat relative to the rest of the eurozone – like Spain before the crisis – but this is hardly applicable now. (If you consider Germany as overheating, there is not much you can do with fiscal policy to constrain the inflationary pressures, especially considering the time lags through which fiscal policy operates. We interpret Trichet’s statement as saying: monetary policy is currently constrained, so fiscal policy is all we have got. This is quite extraordinary, and makes us wonder whether the ECB is really determined to prevent an upward drift in inflation.)

(read on after the jump!)

RW: This could be a very astute representation of Trichet’s comments: that fiscal policy should be the main tool to target inflation expectations to the upside if the ECB feels they are taking care of the downside! The implication is that the ECB is ‘on hold’ for much longer than markets expect. Today, for example, the Eonia forward swap curve (the Eonia rate is the Euopean equivalent of the federal funds interbank rate) has 25 bps in ECB rate hikes priced in through August 2011, 50 bps through the December. The Eurointelligence interpretation of Trichet’s comments would suggest that this is way off, that the ECB is on hold for some time.

There are several caveats to consider regarding the ECB’s policy stance:
(1) As I’ve argued before, German wage pressures are bound to get a bit frothy this year, which may challenge the ECB’s resolve. If those pressures are more robust than history demonstrates I argue that they will – a new ECB president would be less accommodative in its policy response than Trichet implies…
(2) …which brings me to my next caveat: Trichet’s term as ECB President ends in October 2011. His successor – the most likely candidate at this time is Mario Draghi – will then take the monetary policy scepter. Will he/she hit the ground running? Better put: will he/she hike rates right out of the gate if German inflation and/or commodity price inflation is perking up?
(3) The ECB has been known to jump the gun with regards to commodity prices. Trichet, in his February policy statement, reiterated that he expects near-term price inflation to see its fair share of time above 2%; this suggests that he may have learned his lesson in 2008 (see this post regarding the ECB’s reactionary policy).

Fun stuff!

Rebecca Wilder

Europe’s at it again…

Key European CDS are starting to turn in the more northern direction again, as the German-French ‘pact for competitiveness’ faces near-unanimous pushback across Europe.

Credit default swaps (CDS) are a market security used by investors to buy 5-yr protection (in this case) against default (or the like). As the spread rises the implied probability of default does too. Current market values imply a 39% probability of default by the Irish sovereign (listed in legend), 20% by that of Spain, and 14% by the Italian sovereign, etc. Cash bond spreads are blowing out again, too, where Spain now must pay a 216 bps premium over Germany on a 10-yr loan (the sovereign bond). I’d say that’s not totally irrational.

I completely understand why these negotiations are stalling. I’m Spain – it’s not clear that Spain commented against the pact based on this article, but I digress – why would I agree to a deal that forces more ‘competitive’ measures, which really just means quashing indexed wage growh, reducing the government deficit, adhering to a fiscal policy rule (which, by the way should be modeled after Germany’s debt brake), and adopting a standardized tax rate? Okay, I will if you (Germany) will. Meaning, I’ll increase my competitiveness by stripping away aggregate demand if you allow prices to rise. I’m Germany – no way. (Please see my previous post which argues that a successful transition to a more stable Eurozone depends on higher Germany inflation.)

Der Spiegel spells it out pretty succinctly in an article that is now two weeks old but still totally relevant:

Germany will only agree to additional guarantees for the euro rescue fund — as the Commission and other parties have called for — if its partners approve its competitiveness pact.

Simply put: we (Germany) will only agree to eventually bail you out if you agree to our harsh demands at that time, or you agree to our harsh demands now. You’re choice.

This political drama is far from over. (More exciting analysis below the jump)

(Dan here…Kantoos responds to Rebecca… )

Here’s another little fact to think about: The price to buy protection against a default by the Japanese sovereign is just 77 bps, that’s only 23 bps above that for the German sovereign. This is ironic because Germany is the premiere demander of fiscal austerity, while Japan is not (to say the least) with gross debt equal to 221% of GDP (according to the IMF) – or is it?

The table below lists common characteristics usually associated with rising CDS spreads (CDS spreads are current as of 4pm today and may vary according to pricing source): the stock of debt held by foreigners (any currency denomination) and the stock of gross public debt. The final column illustrates the ability of a country to print fiat currency that is not backed by anything but government decree.

I think it’s pretty clear: Japan and the US have very elevated government debt, but low external holdings AND can print their own money to finance liabilities (which by the way are in most part denominated in their respective currencies). Clearly markets’ attach weight to this simple fact via low CDS spreads.

To be continued….

Rebecca Wilder

The ECB would quash a discrete shift in German nominal GDP rather than accommodate it

David Beckworth points to Scott Sumner, who points to Kantoos on the effectiveness of nominal income targeting in Germany. Kantoos’ illustration certainly suggests that the ECB has been successful in getting the dynamics of output and prices (nominal GDP) right over the last decade.

I have no contention with the historical evidence. Whether or not the historical data supports an effective nominal GDP target is trivial compared to the suggestion that the ECB will tolerate a pickup in German nominal GDP going forward. Wage pressures and lower unemployment will lead higher nominal GDP, but will likely increase German inflation as well; this will set the stage for tighter, rather than accommodative, ECB policy.

Although Kantoos did acquiesce that the ECB doesn’t officially target nominal GDP, he didn’t, in my view, give this simple fact enough face time. The ECB is the most hawkish of the G4 central banks. As you can see from the histogram of inflation over the last decade, the central tendency is very strong at 2-2.5%.

As the histogram shows, the ECB rarely institutes a policy rule that drives inflation above its stated objective: “the ECB aims at inflation rates of below, but close to, 2% over the medium term.” The ECB’s reaction-function to German price pressures will be of utmost importance, given Germany’s 26% weight in Eurozone inflation.

Kantoos and David Beckworth posit that the 2% wage growth achieved due to highly competitive German industry (see reference at end of post) is evidence that the ECB targeted nominal GDP and nominal per-capita GDP effectively. In contrast, I would argue that the ECB’s had it pretty easy, where the recession simply delayed the inevitable tightening that would have occurred in favor of the 2% inflation target.

(Read more after the jump)
Measured on a quarterly basis, annual per-capita nominal income growth in Germany averaged just 2.1% since Jan. 1999 (when the ECB took over monetary policy across the Eurozone). Germany represents 26% of the HICP (harmonized price index used by the ECB, and the weighting data is available at Eurostat table prc_hicp_inw), so upward economic pressure on German prices and output (nominal GDP), would manifest into, all else equal (i.e., not offset by deflation in other big countries), average inflation above the ECB’s comfort zone – I use the word ‘zone’ loosely; it’s 2%. The ECB is unlikely to tolerate this.

Currently, tax hikes and a rebound of economic activity and commodity prices are pressuring prices in even the ‘fiscally austere’ European economies (Spain at 2.9% annual inflation in December). So the offset to German inflation pressures on the average inflation rate are not existent at this time.

My sense is that the ECB is biding its time until German price pressures emerge before they have to tighten monetary policy across the Eurozone. For example, the ECB must have been happy that some German unions are negotiating wage hikes that are lower than the current rate of annual per capita nominal GDP growth, 4% Y/Y in Q2 and Q3 2010. (see chart above).

So how much time does the ECB have? At this time, excessive inflation is not ubiquitous in the German HICP, the ECB’s preferred measure of inflation. Currently it really is mostly a food and energy story.

I computed a diffusion index across all of the subcomponents of the HICP index for some Eurozone economies. The index is pretty simple: above 50, there are more components of the HICP that are growing at a greater than 2% annual pace, while below 50, there are more components growth below the 2% pace.

The December diffusion in Germany, 28, is lower than its average since 2004, 33. Not only has Germany historically seen prices growing broadly lower than 2%, but they still are. However, despite the low the level of diffusion, the trend is upward.

As wage contracts reset, I expect that the breadth of price increases will increase and drive overall inflation above the historical German comfort zone, 1.5% average 1995-2007 (before the recession). In the weaker economies, Portugal (not shown), Italy, and Spain, there has been a pickup in subcomponent-level 2% inflation as well – eventually pressures in these economies should fade with fiscal austerity.

However, pressures are in the pipeline. Tight capacity utilization and labor markets will inevitably drive inflation on the cost side.

According to the European Commission, the survey of German Q1 2011 capacity utilization, 84.9%, is above its decade average, 83.1%. Eventually, German firms will have to pay higher wages on the margin in order to satisfy strong(er) demand.

And German labor markets are tight. Schroeder’s labor reform has dropped the unemployment rate, 6.6% in December 2010 on a seasonally-adjusted and harmonised basis, to well below its 15-year average, 8.5%. Inflation from the cost side is certainly in the works, barring a surge in productivity, that is.

In my view, German prices should be allowed to trend upward – the German real exchange rate is too low. If Spain, Italy, Portugal, or Ireland are to have any chance at all for fiscal austerity to actually drop the fiscal deficit, German prices must rise (I’ve written about this before). In my view, though, it’s more likely that the ECB attempts to quash a discrete shift in German nominal income growth via tighter policy than accommodate it.

Rebecca Wilder

Reference: The European Commission publishes a quarterly report on Price and Cost Competitiveness, a fantastic resource. Regarding German trends in competitiveness and the real exchange rate, please see the charts for Tables 3, 4, and 5 on page 2-12 (.pdf page 16) in the latest quarterly report on price and cost competitiveness.

Thoma: The Slow Recovery of Unemployment

Mark Thoma is a truly stand-up guy. We need more like him screaming for the unemployed and underemployed. I’ll comment just a bit more after Mark’s commentary.

Mark Thoma on The Slow Recovery of Unemployment:

I don’t like to make economic forecasts. Though I do it on occasion, I generally leave that to Tim Duy — he’s much more of a data grubber than I am so he’s better at it anyway. I do try to comment on what data says when it’s released, mostly at MoneyWatch, but I don’t generally consider those to be formal forecasts of where the economy is headed.

There’s a good reason why I try to avoid forecasts. In the past, whenever I’ve tried to predict the path the economy would take, I’ve found myself reading subsequent data releases in a way that supports the forecast. I think that once you make a forecast, it affects your objectivity, and I think that applies generally, not just to me.

Perhaps that’s why I’m feeling more and more alone in talking about the current state of the economy. Though the worries began long before this, in June of 2008 I did a MarketPlace segment where I predicted that the recovery of unemployment would lag output, and I said that policy should begin addressing the problem immediately due to the long lags between the time when policy begins is first considered and the time it actually has an impact on the economy. Ever since, I’ve found myself watching to see if that forecast was correct (which is another reason why I don’t like to make forecasts — you hope you are correct, but being correct in this case means people will struggle to find jobs, so it brings on an internal contradiction — how can you hope people will struggle?).

As I said above, I don’t think I’m alone in reading data in a way that supports previous forecasts, and others are much more bullish about the latest data releases than I have been. Part of my point has been that the data can be read another way. When people say, for example, that there’s nothing in the latest employment report to change the relatively optimistic forecasts they’ve made recently, I try to say that there’s nothing in the data to reject the alternative forecast either, i.e. that we are still headed for a very slow recovery of employment. Whatever your null hypothesis or prior beliefs were, the latest data did little to change that outlook.

My reason for noting that the data can be read another way goes beyond trying to show that I was right and others were wrong about how long it would take for employment to recover. I am very worried that we are, for all intents and purposes, about to abandon the millions who are still unemployed. Once we conclude that a robust recovery is underway, we will turn our attention to other things. All of the social services that we need to provide for the unemployed, simple and important things like making it possible for their kids to get dental care to name just one example, will be ignored. We devote little if any effort to job creation. We will simply turn our backs and move on.

I fully understand the desire to have a perfect landing, to get policy just right. But just right when the costs of unemployment are so much higher than the costs of inflation means that we should bias policy toward the unemployment problem. If we are going to make a mistake, it should be too much unemployment, and the inflation that comes with it, rather than too little. However, with the inflation hawks writing almost daily in the WSJ and elsewhere that we need to raise interest rates immediately to avoid inflation, and with all of the pressure to address the budget deficit, if anything the bias in policy seems to be in the other direction. Thus, while I acknowledge the fact that I am probably reading the data in a way that is favorable to previous statements, there was a good reason to worry back in 2008 that this would be a problem, and I believe there’s still good reason for worrying about it today. If I have read the data more pessimistically than others, the reason for it is simple — to push against the chance that we will forget about all the households that continue to struggle. If Ben Bernanke’s right, even with current policy we are looking at years until employment gets back to normal and we must do all that we can to help people find jobs or, failing that, provide the social services they need to get by until the employment picture improves.

Until I am sure that the economy is on firmer footing than it’s on now, and that employment prospects have improved substantially, I will continue to be the one who pushes back against optimistic reading of the data. And I will make no apologies for it beyond what I’ve said here.

(More comments after the jump)
RW: Just today I was reading an Economist article from last week’s publication, Et in Arcadia ego (even in Arcadia I exist), about the homeless population that is building in the hardest hit parts of the economy (generally related to the manufacturing and housing decline). Tent cities, surging homeless rate, and poverty are becoming more of the ‘norm’; it’s really rather heart wrenching if you think about it.

And then I see a chart like this (h/t Ken Houghton at AB) on inflation expectations and asset prices. Yes, propping up asset prices – that’s what the Fed’s done here is inflate asset prices – will have the intended effect of dropping the saving rate and increasing current consumption; but to what end? Wall Street’s doing just fine, in fact. I’m a macroeconomic analyst and portfolio manager in the global fixed income space and have seen a nice shuffling around in the labor force. I wouldn’t say that jobs are plentiful, but popping up, nevertheless.

On forecasting, I find it very interesting that when Wall Street economists model their outlook for the unemployment rate – according to Bloomberg, the consensus expects the unemployment rate to drop to 8.5% in 2012 – they assume that the 2.8 million workers that are marginally attached to the labor force (of which discouraged workers is a subset) will not re-enter. Mathematically, that drops the unemployment rate: compared to a year ago, January 2010, the number of marginally attached workers has increased from 1.07% of the working-aged noninstitutional population to 1.17%, while the U3 unemployment rate dropped 9.7% to 9.0%. (the alternative measures of unemployment are listed in Table A-15 here.)

I think that run75441 says it well (in the comment section of this post):

If NILF [not in the labor force] keeps going up, it does not matter what U3 does which is a joke. Parity for U3 is reached when Participation Rate equals the Participation Rate of 2001. The numeric is to nervous and today’s measurement of U3 has no meaning.

Mark, thank you for your voice. It takes a lot of courage to push back against those that see just the tip of the economic iceberg, i.e. the parts of the economy that are trucking along just fine right now.

Rebecca Wilder

The household survey paints a clearer picture of the January employment report than does the nonfarm payroll

I’ll forward you to Spencer’s post on the January Employment report. As always, he sifts through this massive report and eloquently describes the state of the labor market. But I thought that I’d add a bit on the disparity between the household survey and the establishment survey.

The annual population revisions and weather distortions have confused some. The issue at hand is, that the BLS’ two surveys, CPS (Current Population Survey, from which the unemployment rate is derived and called the household survey) and CES (Current Employment Statistics, from which the nonfarm payroll is estimated and called the establishment survey), offer conflicting views on the strength of the headline report (i.e., just the statistics about the unemployment rate and the nonfarm payroll): the unemployment rate dropped 0.4% to 9.0%, while the nonfarm payroll increased a meager 36,000 when 146,00 was expected (by Bloomberg consensus).

The report is not conflicting, in my view – it’s just weather related stuff that impacts the CES, and to a much lesser extent the CPS. The drop in the unemployment rate, although usually the statistically less popular data point, is probably the best descriptor of the monthly shift in the labor market: strong. (A 9% unemployment rate cannot be described as strong by any measure out there; I digress.)

All of this information is stated in the BLS release, which you can find here. Below I describe (1) the revisions to the CPS and (2) the weather-related distortions that discount the establishment number.

Why the drop in the unemployment rate is credible. The summary statistics show the labor force falling by 504,000. The annual revisions dropped the labor force by 504,000, so the unrevised numbers show the labor force unchanged over the month.

The summary statistics show the number of employed increasing by 117,000 The annual revisions dropped the employed by 472,000, so the unrevised number of employed increased by 589k in the release. This is a big gain.

In fact, the revisions do not materially alter the 2010 unemployment rate nor its trend in any way. By my calculations – please correct me if I’m wrong – the unemployment rate would have been 9% with or without the CPS survey revisions.

For many reasons, the change in those ’employed’ in the household survey (+589k) does not match up to the change in the nonfarm payroll in the establishment survey (+36k); but the direction of the changes across both surveys are often similar. However, +589k is sizeable by any historical standard.

So why +36k in the establishment survey versus the +589k in the household survey? Weather. Nomura economists David Resler, Zach Pandl, and Aichi Amemiya did some research on weather-related months(no link available since this is proprietary paid research and bolded by me):

In one of the largest first reported declines on record, the BLS in its February 7, 1996 report calculated that non-farm payrolls FELL by 201,000 from the previous month. The outsized decline hit both manufacturing (-72,000) and services (141,000) but the construction industry registered a net job gain of 13,000. At the time, the BLS blamed the big winter storm for skewing the job loss and a month later reported that payrolls surged by 705,000 in February after a revised drop of 188,000 in January. Since then, subsequent benchmark and seasonal factor revisions have resulted in a history showing a drop of 19,000 in January 1996 followed by a 434,000 increase in February.


These observations suggest January’s severe winter storm could skew the measurement and estimation of payrolls this year as well. From those prior episodes, we calculate that the winter storms led to a .0007 to .0015 deviation from “normal” seasonal job change in those months. A similar deviation of employment from normal seasonal patterns implies that the change in non-farm payrolls would be likely to fall in a range of -50,000 to +56,000.

Ex post, they were right – they published this research before the January employment report was released – not only about the expected weather distortions, but also regarding the level (-50k to +56k). Accordingly, it’s very likely that next month we’ll see outsized gains, given the history of this type of distortion.

Therefore, until I see a weak February number (one month from now), I’m going to assume that the headline figures were strong and consistent with the unemployment rate dropping 0.4% to 9.0%.

Of course, there’s a slew of workers that are not in the labor force that may re-enter, which would undoubtedly drive the unemployment rate up (it probably will). And let’s remember this when talking about a “strong” employment report: 9% doesn’t represent the severity of the unemployment problem – the employment to population ratio does.

Rebecca Wilder