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NSA Claims and the unemployment rate

A reader (brodero) that pays more attention than I do to the twists and turns of data has mentioned several times that there is a nice fit between the 52-week moving average of nonseasonally-adjusted weekly claims (which obviates the need for seasonal adjustment factors), which I show in the top chart (the magenta line being the moving average), and the unemployment rate, which I show in the bottom chart. Indeed there does seem to be a nice correlation between the two. The behavior of claims to date suggests that we could see a continued, if very gradual, decline in the unemployment rate, even if nonseasonally-adjusted claims do not fall below the 400K mark for the next year. It also suggests that, as I argued in my previous post, it is premature to conclude from this week's claims data that the economy is suddenly deteriorating.

The bounce in weekly claims could be just bad seasonal adjustment

The top chart shows the seasonally adjusted version of first-time claims for unemployment, while the bottom chart shows the actual number of first-time claims. The one that's reported and commented on is the top one, while most people ignore the bottom one.

The story behind today's unexpected rise in claims to 500K is that actual claims didn't fall by as much as the seasonal factors expected. Yes, in the most recent reporting period, claims actually FELL by 22,600, whereas the reported number (seasonally adjusted) showed a rise of 16,000.

I have never believed that week-to-week changes in unemployment claims hold any significant information content, because for one, claims are subject to the vagaries of seasonality and faulty seasonal adjustment factors, and two, the economy rarely changes on a dime, from one week to the next.

Looking at the bottom chart, I can't find any evidence suggesting that the labor market has suddenly deteriorated. Note that the rise in actual claims in early July translated into a big seasonally adjusted decline. In other words, actual claims in July failed to rise by as much as the seasonal factors expected. Well, today's number could be simply the flip side of that number: claims failed to fall by as much as expected. In seasonally adjusted terms, the recent rise in claims could just be "payback" for the July decline. We'll have see what develops over the next few weeks, of course. But I think it's premature to jump to the conclusion that the labor market has suddenly taken a turn for the worse, just as it was premature to think that the big decline in claims in early July was a sign of dramatic improvement in the labor market.

Reading the economic tea leaves is never as simple as watching one series for ups and downs. You have to take into consideration a number of factors, and look for consistent patterns that tie them together. For my money, I think that recent strong growth in commodity prices, coupled with the strong growth in industrial production, strong growth in corporate profits, strong growth in shipping and rail activity, and the ongoing decline in corporate bond yields and spreads, suggests very strongly that the economy on balance is on the mend, albeit relatively slowly. To be sure, construction has yet to really improve, and the labor market is still distressed, but you can never expect everything to move in a straight line and at the same time. For that matter, the labor market is typically the among the last sectors of the economy to participate in a recovery.

A brief history of the dollar

Here, in a nutshell, is my version of the history of the dollar's history, with a focus on its major turning points. As a point of reference, I'm using the Fed's Real Broad Dollar Index (chart above), which measures the dollar's value against a large basket of trade-weighted currencies, all adjusted for changes in relative inflation. It's arguably the best measure of the dollar's true value against other currencies. I've marked 6 key turning points in the dollar, and I explain here the key events occurring around the time of each turning point. I also opine on the future of the dollar.

A: Most measures of the dollar's value only go back to 1973. That's unfortunate, since the modern history of the dollar begins in August 1971, when Nixon ended the dollar's convertibility into gold. Prior to that point, the dollar had been fixed to gold at $35/oz. since 1934, and most of the world's currencies were pegged in some fashion to the dollar. Nixon's decision to abandon the gold standard was the catalyst for what would eventually prove to be a major devaluation of the dollar. The underlying cause of the dollar's collapse, however, was the Fed's decision to ease monetary policy in support of Great Society spending programs. The Fed's easy money policy started in the mid-1960s, and it was reflected in a steadily increasing outflow of gold. The Fed was holding interest rates at artificially low levels, and this was undermining the world's confidence in the dollar. Central banks began demanding gold in exchange for their dollar holdings, until Nixon's decision put an end to that. That decision effectively relieved the Fed of the need to raise interest rates significantly, which in turn exposed the fact that there was a huge excess supply of dollars in the world.

By early 1973, when this chart begins, the dollar had lost about 10% of its value. Despite the Fed's repeated attempts to tighten monetary policy by raising interest rates throughout most of the 1970s, the Fed's efforts were on balance "too little too late." The dollar collapsed, and investors scrambled to sell the dollar and buy gold, commodities, and real estate. Inflation soared to double digits.

B: By early 1979, the collapsing dollar, double-digit inflation and the feckless Carter administration had combined to create a deeply pessimistic outlook for the U.S. It's no wonder that the dollar fell to an all-time low against other major currencies around this time. Then in August 1979, Carter had the foresight to appoint Paul Volcker to head up the Fed with a mandate to stop inflation. Over the next few years, Volcker slammed on the monetary brakes, causing interest rates to soar. When tight money combined with the confidence-boosting Reagan tax cuts in the early 1980s, the dollar began to take off.

C: The dollar reached an all-time high against other currencies in early 1985. It was benefiting from a powerful combination of tight money, high real interest rates, falling inflation, low taxes and strong economic growth. It's hard to imagine a better combination of forces. Sadly, however, it soon became fashionable among politicians and pundits to complain that the strong dollar was too strong—too much of a good thing was not welcome, especially among industrialists that were having trouble exporting because of the dollar's strength. So it was that the Plaza Accord was signed in September 1985, in which the world's major governments agreed to lower the dollar's value. Volcker did his part to weaken the dollar by expanding bank reserves by more than 30% in the space of just 18 months.

Alan Greenspan took over the Fed in August 1987 at an inauspicious time. The dollar had lost almost one-fourth of its value in just over two years, and the Reagan administration was faltering, having agreed to a 40% hike in the capital gains tax. Confusion abounded, confidence faltered, and the stock market cratered in October. Greenspan successfully navigated the storm, eventually tightening policy enough to halt the rise in inflation that followed in the wake of the dollar's collapse—the CPI rose from a low of 1.1% in late 1986 to a high of 6.3% in late 1990.

D: By early 1995 the dollar hit an all-time low, burdened by the high inflation of the late 1980s, the weak presidency of Bush I, the disappointing recovery following the 1990-91 recession, the tax hikes in the early years of the Clinton administration, the threat of HillaryCare, and the Fed's surprise tightening of monetary policy in 1994 (the CPI was a relatively low 2.5% when the Fed stunned the bond market in early 1994 with a tightening).

Despite the dismal state of affairs that prevailed as 1994 drew to a close—recall the Orange County bankruptcy and the Mexican peso devaluation of December '94—things began to improve shortly thereafter. The Republicans, led and inspired by Newt Gingrich's Contract with America, took charge of Congress in early 1995, and Clinton saw the wisdom of triangulation. The economy began to boom, and federal spending was held in check. Confidence rose as the capital gains tax was reduced in 1997 and the housing market began to elevate, boosted by Clinton's decision to exempt most homeowners from paying capital gains on the sale of their house. Meanwhile, the Fed kept real interest rates high from 1995 through 2000, worried that the economy was "overheating." The dollar received a major boost in 1997, as a wave of S.E. Asian currency devaluations sharply boosted the demand for dollars.

E: The dollar hit a high note in early 2002, supported largely by the view that the U.S. economy was likely to outperform other major economies, even though the recovery from the 2001 recession was modest. Plus, fears of a global deflation/depression were running high at the time, as commodity prices and gold hit lows in late 2001 and early 2002, and corporate defaults soared.

Things turned around as the Fed embarked in earnest on an easing campaign which eventually took the Fed funds rate down to 1% in mid-2003, where it stayed for one year even though the Bush tax cuts helped the economy boom in the latter half of 2003. That was followed by a very cautious and gradual rise in the funds rate, in a manner reminiscent of the 1970s. The Fed seemed always to be raising rates by too little, too late. The CPI rose from a low of 1.1% in mid-2002 to a high of 5.6% in mid-2008. The final phase of the dollar's weakness came in 2006-8, as the U.S. housing market began to implode, eventually culminating in the subprime mortgage crisis, the failure of Lehman Bros., and the deepest recession since the early 1980s.

F: The thing that turned the dollar around after it plumbed fearsome lows in early 2008 was the global panic-driven demand for dollars that developed as economies began collapsing. This didn't last long, however, since the dollar reversed course starting in March of last year as it gradually became apparent that a global deflation/depression was not in the works as so many had feared. Fed policy helped accentuate the dollar's ups and downs, because the Fed was slow to accommodate the intense dollar demand that developed in the latter half of 2008, and then reluctant to tighten policy as dollar demand fell and the economy recovered in mid-2009.

The future: The value of a currency can be strongly influenced by demand for that currency, and that demand can in turn be driven by factors affecting the prospects for economic growth. Politics can also influence the value of a currency. Ultimately, however, the central bank has the final word. Thus, the dollar's future value is critically dependent on what the Fed does over the next year or two, especially given the enormous and unprecedented expansion of the Fed's balance sheet over the past two years.

Today the dollar is only 4-5% above its all-time lows relative to other currencies, and the dollar—along with almost every other currency on the planet—is at all-time lows against gold and most commodity prices. The dollar is still benefiting from safe-haven demand to some extent, but fundamentally it is very weak. The prospects for the U.S. economy are not very bright (many in fact are calling for another painful recession), and Obama's and Congress' approval ratings are abysmally low. Taxes are going to rise after the end of this year, unless the Congress votes to extend the Bush tax cuts. States and municipalities are reeling from their fiscal burdens. The Fed is promising to be massively accommodative for as far as the eye can see. Washington is pounding the table for the Chinese to weaken their currency, which is a polite way of saying they'd like to see a weaker dollar. The news is seemingly bad on all fronts, with almost no hope for any improvement.

This is where my contrarian instincts kick in. The news is bad, the fundamentals are horrible, and fiscal policy and politics are absymal. No wonder the dollar is close to an all-time low. But for the dollar to get weaker, things have to deteriorate even more than they already have.

If instead of deteriorating, things just improve a little, the dollar could hold these levels and perhaps improve with time. If things began to change for the better in a big way, it's difficult to imagine how strong the dollar might be several years from now. What if the Fed manages to pull off a reversal of its quantitative easing in time to avoid a massive overhang of dollars and an eventual hyperinflation? What if Congress votes to extend the Bush tax cuts? What if the November elections result in a massive shift in the balance of Congressional power, and a new wave of Tea Party-inspired politicians rescind ObamaCare and the remainder of the failed stimulus package?

Call me an incurable optimist (as so many here have), but I think there's a decent chance that the fundamentals behind the dollar can improve. Things are so bad now that the future could easily be less awful—and maybe even much brighter—than the market seems to believe.

Full disclosure: I am very long the dollar at the time of this writing.

The Tea Party Manifesto

That's the title of a nice article by Dick Armey and Matt Kibbe in today's WSJ. I've long been a fan of Dick Armey's ever since I met him at one of Jude Wanniski's fabulous Polyconomics conferences some 15 years ago. Not only is he a smart economist and strong believer in free markets and limited government, he's also just a really nice guy. He proved that last point when, as he asked if he might join us at the breakfast table, he offered to bring my wife some coffee. He didn't do that to buy our vote, he did it because it was the right thing to do. And he was the House Majority Leader at the time, if memory serves.

Armey and Kibbe are leading figures behind Freedomworks, a good place to go if you want some informed and well-organized information about what the Tea Party stands for. Here are some excerpts from the article, which I'm sure isn't as good as Armey and Kibbe's new book, Give Us Liberty, which was released today.

Our community is built on the Trader Principle: We associate by mutual consent, to further shared goals of restoring fiscal responsibility and constitutionally limited government. 
Decentralization, not top-down hierarchy, is the best way to maximize the contributions of people and their personal knowledge. Let the leaders be the activists who have the best knowledge of local personalities and issues. 
[The Tea Party] ...demands fiscal policies that limit government, restrain spending, promote market reforms in health care—and oppose ObamaCare, tax hikes and cap-and-trade restrictions that will kill job creation and stunt economic growth. 
The tea party movement is not seeking a junior partnership with the Republican Party, but a hostile takeover of it.
The American values of individual freedom, fiscal responsibility and limited government bind the ranks of our movement. That makes the tea party better than a political party.
I think this is all very powerful stuff, obviously, since it has already shaken up the political status quo in both parties. It's a fresh approach to politics, because it focuses almost exclusively on fiscal issues. As far as social issues, it is limited to an emphasis on individual liberty, which if interpreted correctly can be a very big tent covering folks of many religious and moral persuasions.

Commodity prices hit new post-recession high

This chart of the CRB Spot Commodity Index (which consists of non-energy, basic industrial commodities, many of which have no related futures contracts) shows some pretty impressive strength, having risen 50% from its recession lows in late Dec. '08. Until the recent rise in the index which began in mid-July, the correlation between this index and the S&P 500 was about 0.85. The correlation has dropped since then because commodities have risen but equities have been flat. It may be that equities are simply slow to recognize the reality of ongoing global growth and the continued absence of fundamental deflationary forces that are reflected in strong commodity prices. I take encouragement from this, because at the very least commodity prices tell me that the market may be wrong to fear a double-dip recession and deflation.

Housing starts have been stable for over a year

Housing starts have been extraordinarily weak since early last year, but the important news is that they have been relatively stable, and that is a good sign that the housing crisis is passing. While this chart suggests they are up at an 11% annualized rate from their all-time recorded lows, it's not much to cheer about. But since residential construction amounts to only 2.5% or so of GDP, whether starts rise or fall by 10% from here is just not going to make a great deal of difference to the economy.

I think the more important story here is that 1) housing was in excess supply in 2005, 2) at a time when prices reached very high levels in real terms, 3) causing a big decline in construction and a big decline in prices. That process of adjustment to an oversupply of housing and excessively high prices has now been underway for over 4 years. Construction has dropped by some 75%, to a level significantly below what is needed to keep up with ongoing household formations, and prices have fallen in real terms by about one-third on average. Both construction and prices have now been relatively stable for the past year. The commercial real estate market was a bit slow to participate in this big adjustment, but it too has seen huge price declines followed by an extended period of price stability (see chart below).

All of this suggests that the economy has had plenty of time to adjust to the housing crisis. There have been massive shifts of resources away from construction. This may be one of the biggest curve-balls the economy has had to deal with in my lifetime, but it is no different in principle from what happens during every recession: something happens that was mostly unexpected, and that results in the failure of many business and investment plans; people have to adjust their thinking and their plans to accommodate to a new reality; resources have to be shifted from the area that is suddenly out of favor to new areas that begin to emerge as favorites; and relative prices change significantly, as this is the market's way of encouraging people and resources to shift (e.g., some prices decline while others increase). Policymakers typically react too late to all this, and in their efforts to assist the process of adjustment, they invariably end up impeding progress.

But with the passage of time, the forces of recovery take hold and the economy begins to grow again. If policymakers correct their mistakes (e.g., by extending the Bush tax cuts and cutting back on spending), then the forces of recovery are going to get a big boost. Either way, the economy is growing and should continue to grow, and all those who worry about a double-dip recession will realize that they were fighting the last war.

No sign of deflation at the producer level

There's not even a hint of deflation in the producer price indices. The core index, in fact, is up at a 2% annual rate over the past six months, and at a 2.6% rate in the past four months.

Important reminder: given the still huge amount of "idle capacity" in the economy (e.g., the economy as a whole is operating at about 10% less than it could be if we were at "full employment), the conventional theory of inflation is being sharply repudiated by these numbers. We should be seeing clear signs of deflation if the conventional view were correct, but we're not. That's because inflation is a monetary phenomenon, and it only occurs when money is in excess supply. We know that money is in excess supply these days because: the dollar is very weak relative to other currencies, gold and commodity prices are rising, the yield curve is still quite steep, inflation expectations are positive, and real interest rates are low or negative. And don't forget that the Fed has pledged with its heart and soul to avoid a deflationary outcome, and they have backed up their words with over a trillion dollars of money creation. In my experience, one should never doubt that the Fed will achieve its stated goals.

I'm nothing short of flabbergasted at the persistence of the belief that we are at risk of falling into a deflation, when all the important monetary indicators are all pointing in the opposite direction.

Industrial production is steadily improving

Industrial production has been rising at a fairly rapid 6-8% pace since the middle of last year, and that is undeniably good news. It still has a ways to go to recover fully, but at this rate we'll get there by next summer. Although the pace of growth in industrial production is quite strong from an historical perspective, the depth of the recent recession would normally have called for much stronger growth and a faster recovery. That this hasn't happened explains why everyone is so gloomy these days, despite the glaring evidence that things are definitely improving. There is still a lot of "idle capacity" in the economy, from under-utilized plant and equipment to millions of workers without jobs. It's going to take a lot of time to get all that back to work, because in the meantime the economy needs to do a lot of adjusting to new realities—for example, among other things, we have to shift resources from homebuilding to whatever the next big boom industry is going to be (wish I knew). This is an ongoing process, but it takes time to become obvious.

Bond yields and inflation

The 10-yr Treasury yield has fallen to a new post-2008 recession low of 2.58%. Yields have been lower, but only by a bit, and only in the late 1930s and 40s, which were times of profound concern about the future of economic growth. I take this as prima facie evidence that market is priced for some very, very bad news. Pessimism can hardly get much deeper than it is today. I reproduce the history of the CPI over this same period below:

Note that the late 30s and most of the 40s were times of very high and volatile inflation, yet 10-yr Treasury yields were a mere 2-2.5%. If this is not a great example of how low bond yields are not a reliable indicator of impending deflation, I don't what is. Indeed, if history is a guide, very low bond yields such as we have today have more reliably been a sign of very high inflation (note how bond yields were relatively low in 1975, when inflation spiked to double-digits.

As with my post yesterday, I am not claiming that low yields are proof-positive that inflation is set to rise. Rather, I think it's important to note that the history of very low bond yields offers little or no comfort to those who are betting that deflation is more likely than reflation going forward.

Commercial paper comeback

Here's an obscure but important measure of credit availability and financial market health that shows dramatic improvement year to date: nonfinancial commercial paper issuance (i.e., short-term obligations of large, generally highly-rated companies, typically used to fund short-term credit needs such as accounts receivable and inventories). That this measure has jumped over 50% in less than eight months is a very positive sign in my book. For one, it means that credit markets are vibrant: not only are large corporations willing to take on extra debt, but investors are willing to buy it. And since commercial paper rates are extraordinarily low (about 0.25% for 60-day paper), the availability of very cheap financing appears to be encouraging companies to expand their operations.

A look at inflation over the past century

Mark Perry has an interesting post today on the "variability" of inflation over the past four decades, and how it was higher last year than it was in the wild and crazy inflation years of the 1970s. It reminded me of this chart which I put together many years ago, so I thought it worthwhile to update the chart and let readers compare it to Mark's charts and his commentary. What I'm measuring here are several things: each set of bars collects information on the CPI by decade; the red bars stretch between the high and low water mark for the year over year change in the CPI during each decade; the yellow line marks the average inflation for each decade; and the blue bars show the average plus or minus the standard deviation of inflation for each decade. My numbers are at odds with his, but that is probably because I'm measuring inflation over different time periods and using a different method (i.e., he uses a GARCH model, whereas I use a simply average ± one standard deviation). Note how extraordinarily volatile inflation was in the 1910s, 20s, 30s, and 40s, even though the average rate of inflation for those four decades was relatively low. Also note that deflation was not only present in the Depression, but also in the 1920s and early 1940s.

The main lesson I would draw from this chart (and from Mark's) is that U.S. inflation has been all over map: very high, very low, and at times quite volatile. There is no law written anywhere that says inflation in the U.S. must be low and relatively stable, because in fact it has rarely been low and stable. The 1960s and the 1990s stand out as the most tranquil periods for inflation in the past century, but even then inflation ranged from 1.5 to 6.2% in the 1990s, and from 0.7 to 6.1% in the 1960s.

Bottom line: the past offers little if any guidance for what inflation is likely to do in future years.