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Over a million new jobs this year


With the October jobs data, we see that the two survey methods are now yielding about the same result: year to date, the U.S. economy has created between 1.1 and 1.4 million jobs (according to the establishment and household surveys, respectively). Prior to this the household survey had been registering about 1.8 million new jobs, significantly more than the establishment survey. I think it is safe to say that private sector jobs now are rising at the rate of about 1% per year. That's not enough to bring down the unemployment rate, of course, because the labor force tends to grow by about that much each year. But it is growth, and it is progress, however slow. It's even somewhat better than the recovery following the 2001 recession, when according to the establishment survey it took the economy two and a half years to create a million new jobs.


This next chart shows that the public sector workforce continues to shrink, having now shed about 350K jobs since the end of 2008. That's essentially unprecedented, but probably necessary given how much public sector bloat there had been in prior years.

If I were advising Fed Chairman Bernanke, I would be telling him that the QE2 program he recently announced—an unprecedented and potentially highly risky experiment in monetary stimulus—should be put on hold until evidence of a faltering economy and deflation actually become threatening. You don't drop money out of helicopters just because the economy isn't growing as fast as you'd like it to.

George Will on the elections

George Will, with some help from Don Beaudreaux, summarizes the message of this week's elections perfectly:

Liberalism's ideas are "about replacing an unimaginably large multitude of diverse and competing ideas . . . with a relatively paltry set of 'Big Ideas' that are politically selected, centrally imposed, and enforced by government, not by the natural give, take and compromise of the everyday interactions of millions of people."
This was the serious concern that percolated beneath the normal froth and nonsense of the elections: Is political power - are government commands and controls - superseding and suffocating the creativity of a market society's spontaneous order? On Tuesday, a rational and alarmed American majority said "yes."

As fear declines, prices rise


I've been trotting out this chart off and on for the past two years, and today is an excellent  time to do it again, since the S&P 500 has now made a new post-recession high. The message of this chart is that fear, doubt, and uncertainty have been unusually high since the financial crisis struck in Sep. '08, and that has helped weaken the economy and depress the value of equities. (The Vix index—a measure of the implied volatility of equity options, and shown here inverted—is a good proxy for the amount of fear and uncertainty that is priced into the market. The higher the Vix, the more people are willing to pay for the risk-reducing characteristics of options. You can find a nice discussion of how to understand the Vix here.)

This week has a been a big risk-reducing week, and that's why stocks are hitting new highs.

First we had the elections, in which the electorate sent a very clear message to Washington: stop the spending, and get out of the way of the economy. The Obama agenda is now effectively dead, and the only uncertainty remaining is how much the Republicans can reverse its heavy toll on the economy. How much will Congress be able to roll back projected federal spending? (Yes, you read that right: I believe that cutting federal spending will actually be a boon to the economy, since that is the only way to ensure that future tax burdens do not increase.) Will some or all of ObamaCare be unravelled or even repealed? Will some or all of the additional regulatory burdens inflicted on the economy in the past 18 months be lifted? Will some or all of the Bush tax cuts be extended? Might corporate income taxes be reduced?

Then came the Fed's announcement of QE2. I've been arguing for awhile that QE2 wasn't necessary at all, because there are no signs of deflation (on the contrary, there are plenty of signs of rising inflationary pressures) and there are no signs that the economy is suffering from a lack of liquidity. All the Fed really needed to do was to convince the market that it would do anything and everything to avoid the risk of deflation. Deflation fears have been with us ever since the end of 2008, and the perceived risk of deflation has played a role in keeping markets on edge and new investment and spending on hold. If the Fed could somehow convince the market that deflation risk was off the table, that would unleash a dose of optimism that could in turn result in increased investment and a healthier economy, and that in turn would support higher asset prices.

With all the talk leading up to it, and now with the announcement of QE2, the Fed has successfully reduced the market's fear of deflation. So much so, in fact, that there is now clear evidence in the bond market that inflation fears are rising. The 5-yr, 5-yr forward inflation expectation embedded in TIPS and Treasury prices now stands at just over 3%, the highest level since TIPS were first launched in 1997.

The stock market is rising because the risk of higher future tax burdens has declined, and because the risk of deflation has declined. This translates directly into a higher discounted value of future, after-tax cash flows. It's as simple as that.

Unemployment claims are going nowhere


The only information available today in the unemployment claims department is that nothing much is going on. First time claims for unemployment are right about where the 4-week moving average is, and right where the average for the year is. The employment situation is not deteriorating, but neither is it improving.

Auto sales continue to boom


By now, even the most pessimistic of economy watchers have to admit that there has been a significant recovery in auto sales. Since hitting bottom in Feb. '09, sales of cars and light trucks have increased at an 18% annualized rate (31% in nominal terms). To be sure, the level of sales is still historically low. But what counts—always—is the change on the margin, and that change is very positive. Rising auto sales are having an impact all the way down the production chain: higher than expected sales result in lower than expected inventories, which in turn spark higher than expected orders for new cars, which then result in unexpected increases in orders for parts and materials. That has ripple effects all throughout the economy.

And it's not just rising demand that is energizing the auto industry. Rising demand is the by-product of increased confidence in the future, the return of liquidity to the financial markets, new growth in private sector jobs (which, according to the household survey, have increased by over 1.5 million so far this year), strong demand for U.S. exports, a 9% increase in industrial production, and record levels of corporate profits. It's the increase in the economy's output (supply) that has enabled the increase in auto sales (demand).

It's not surprising therefore that Ford's stock has risen almost 900% since Feb. '09, and today reached a new post-recession high. This recovery is for real.

Deconstructing QE2: it's less than meets the eye

Today the FOMC told us they are prepared to buy an extra $600 billion of Treasuries over the next 8 months—about $75 billion per month. They did not commit, however, to buying this much: "The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."

In other words, the Fed is not going to make a big monster purchase of Treasuries that would flood the system with new money. They are going to dribble it out a little at a time, and might even decide to end the program after a month or two, should the economy and/or inflation show signs of picking up. This is almost exactly what I was hoping would happen.

With $75 billion in new purchases per month coming on top of the purchases needed to offset maturing MBS, the Fed will be buying roughly $110 billion of Treasuries a month, which, curiously, happens to be almost exactly the amount needed to fund the Federal government's budget deficit—the federal deficit over the past 12 months was $1.295 trillion, or $108 billion per month. Hmm.

If this were Argentina in the 1970s and 80s, such a program would undoubtedly lead to a huge increase in inflation—it's debt monetization, pure and simple. Back then, Argentina's government essentially ordered its central bank to print up enough money to cover the government's budget deficit. The government paid its bills with newly-printed cash money, and that money became like a hot potato that people tried to spend as fast as possible. (Holding on to currency that loses a significant portion of its value every day is equivalent to paying a tax to the government, so people naturally try to spend the money as quickly as possible, in the process acquiring things that won't lose their value—such as dollars or gold or euros or commodities or real estate.) I should know, because I lived there in the 70s and vacationed there often in the 80s. In the four years I lived there in the late 70s, inflation averaged about 7% per month, or about 125% per year. During one 3-week stay in the mid-80s, I got the distinct privilege (for an economist) of witnessing a staggering 200% rise in the price level. That works out to about 9,000% per year, enough to qualify as true hyperinflation.

But this isn't Argentina. The Fed is not going to print up a billion $100 bills every month and ship them over to Treasury. Instead, the Fed is going to buy $75 billion of Treasury securities each month on the open market, and it is going to pay for those purchases by crediting banks with newly created reserves. This is the way the Fed financed its first quantitative easing, with the purchase of $1.3 trillion of Treasuries and MBS—bank reserves increased by $1.3 trillion. Note, however, that even if the Fed buys $75 billion of Treasuries for the next 8 months, that will barely add up to 4% of GDP. Printing an amount of money equal to 4% of GDP is not going to greatly upset the inflation applecart.

Moreover, the reserves the Fed creates to buy the Treasuries can't be spent the way $100 bills can; they only exist at the Fed. They can only turn into "spendable" money if the banking system uses the extra reserves to create new loans (thus increasing bank deposits) or turns some of those extra reserves into currency. And either way, that process depends on the system wanting to borrow more money and/or hold more currency.

With QE1, we know that the banking system was content to let almost all of the $1.3 trillion in new reserves sit at the Fed, where they conveniently earn a bit of interest. Banks were extremely risk averse, and their demand for rock-solid cash-like assets was huge, so they were happy to hold on to all the new reserves. The rest of the world was also very risk averse, and there was a lot of deleveraging going on. In other words, the demand for new loans was very low at a time when banks were very reluctant to lend and the demand for money was very high. Result? The Fed ended up satisfying almost everyone, and the financial crisis passed without any meaningful inflationary consequences.

With QE2, we may find that the newly created reserves end up being more than the banking system is content to hold. If so, banks may use some or all of the new reserves to increase deposits and further expand the money supply (note: M2 already has grown by almost $1 trillion since mid-September '08, and one dollar of reserves can support up to $10 in new deposits). Or it may be that the world decides to exchange some portion of the new reserves for currency (note: currency in circulation already has increased by $130 billion since mid-Sep. '08, and one dollar of reserves can support one dollar of new currency). So we'll need to watch M2 and currency in circulation even more studiously going forward, in order to gauge how QE2 is impacting things.

With today's clever announcement, the FOMC has not only indicated that it is willing to undertake a substantial QE2 program if the need arises, but it is also giving itself some time to make sure that nothing gets greatly out of hand. There is no need to panic—yet.

Corporate downsizing is essentially over


According to the Challenger tally, announced corporate layoffs are almost nonexistent, and have been so for the past several months. This is an indication that corporations have essentially finished their downsizing, and are now lean and mean ready to expand. With no shortage of liquidity in the economy (although smaller firms appear to have much more difficulty accessing credit than larger firms, who find it relatively easy to raise money in the bond market), what appears to be lacking to date is the confidence and the incentive to undertake new ventures and new projects. This is likely to improve now that the elections are past, especially to the extent that a new Congress is able to extend the Bush tax cuts, reduce corporate tax burdens, reduce regulatory burdens, and roll back ObamaCare.

Service sector still healthy, but trailing the manufacturing sector


After a few months of disturbing weakness, the ISM survey of the service sector shows that business activity is once again improving, though not yet strongly.

Over two thirds of those surveyed in both the service and the manufacturing sectors are reporting paying higher prices. This adds to the growing mountain of evidence that deflationary pressures are almost nowhere to be found. Instead, it is a warning that firms are likely to begin passing along to consumers the higher prices they are paying for inputs (some firms are already doing this, e.g., General Mills, Starbucks, MacDonald's, Kimberley Clark and Goodyear).


This last chart shows the employment component of the ISM service sector report. In contrast to the manufacturing sector, where a clear majority of firms say they are hiring, only a slim majority of service sector firms report increased hiring activity. We thus have a clear divide between the two sectors of the economy, with the manufacturing sector looking a lot healthier and more dynamic than the service sector (which is of course by far the largest sector). This helps explain why overall employment growth remains sluggish.

How Fed policy influences the dollar



It's no mystery that yield differentials between currencies can drive the relative behavior of currencies, but it's not always the case. For example, double-digit yields on a currency plagued by high inflation most likely can't keep that currency from falling relative to currencies with lower inflation and lower yields. But when you consider two major currencies, such as the Euro and the Dollar, with inflation rates that are substantially similar, then interest rate differentials can indeed explain much of the variation in the relative value of those currencies. That's what the two charts above illustrate.

The top chart shows 2-yr government yields in the U.S. and in Germany. These yields are best thought of as the market's estimate for what short-term rates are going to average over the next two years, and those rates in turn are largely determined by central bank policy. In the U.S., 2-yr Treasury yields are trading at 0.34%, which means the market expects the Fed to keep the overnight funds rate at 0.25% for most of the next two years. In Germany, however, 2-yr Bund yields are 1.0%, which implies that the market expects the ECB to keep its target rate at 1% for the next two years. Thus, US 2-yr notes promise a total return of 68 bps, whereas 2-yr bunds promise a 200 bps total return. The return on Euro-denominated bonds makes them more attractive than dollar-denominated bonds, thus attracting capital to the Euro and away from the dollar and causing the dollar to fall against the Euro. (The chart uses the Dollar Index, but that has a 0.98 correlation to the Euro over the past 5 years, so the story is the same.)

The bottom chart compares the yield differential between the US and Germany with the value of the dollar. Note that the two are highly correlated; today's widening yield differential in favor of Germany (lower rates in the US, higher rate in Germany) tracks the weakening of the dollar. This same dynamic is playing out between the US and Australia, where the central bank today raised its target rate to 4.75%. Since early last year, higher yields in Australia have helped propel the Aussie dollar to a 50% gain against the US dollar.

If the Fed "disappoints" the market tomorrow by announcing an unimpressive QE2 program, this would likely result in a strengthening of the dollar. That's because it would imply that the Fed wasn't quite as worried about the economy and deflation as everyone thinks, and that in turn would imply that the Fed would be less likely to keep rates at very low levels for as long as everyone currently thinks. And that, of course, would result in a rise in US 2-yr yields and a narrowing in the US-German interest rate differential, to the dollar's advantage.

I'm hopeful that tomorrow the Fed will err on the side of caution with its next round of quantitative easing. I don't see the need for QE2, and any additional easing at this point is only bad news for the dollar (much of which is already priced in). Weakening the dollar is not the way to strengthen the US economy, and printing more money is not the way to stimulate the economy. Forcing more dollars on the world only drives down the value of the dollar and reduces the demand for US investments.

More evidence of rising inflation expectations


This chart is a good way to track how the bond market's inflation expectations are being driven by the prospect of another round of quantitative easing (QE2).

The blue line is the slope of the yield curve from 10 to 30 years. Since late August, when talk of QE2 began heating up, the long end of the yield curve has steepened dramatically and to new all-time highs. That is a direct reflection of the fact that bond investors are getting nervous about the long-term prospects for inflation. The Fed may be able to keep 10-yr yields from rising with massive bond purchases and promises to keep the funds rate near zero for a long time, but the Fed has little or no ability to distort 30-yr Treasury yields. The curve is steepening because investors are shunning long-term bonds.

At the same time, the 5-yr, 5-yr forward breakeven inflation rate shown in red (which the Fed has said is its favorite measure of inflation expectations, and which is more sensitive to changing expectations that the spread between 10-yr Treasury yields and 10-yr TIPS yields) has surged from 1.92% in late August to 3.07% today. If we throw out the blip in early August, this measure of inflation expectations is higher than it has been at any time since TIPS were first launched in 1997. This is a fairly dramatic statement on behalf of the bond market, which until recently has been very reluctant to entertain any fears that the Fed may have gone too far in its efforts to stimulate the economy.

Will no one at the FOMC meeting tomorrow and Wednesday have the courage to stand up and argue against QE2? There is no shortage of evidence to support the case that QE2 is not only unnecessary but also foolish. High on the list would be 1) today's much-stronger-than expected ISM manufacturing report, 2) rising inflation expectations, 3) $1350 gold, 4) a very weak dollar, and 5) soaring commodity prices. There is no sign of a double-dip recession, no evidence of deflation, plenty of rising prices, no signs of any liquidity shortage, and lots of evidence that the Fed's actions to date have resulted in an over-supply of dollars to the world.

Construction spending still weak



Construction spending was flat in September, and remains weak overall. Residential construction as a percent of GDP has fallen to a new all-time low of just 2.2%, so even if activity in that sector continues to slide it will have very little impact on the economy as a whole. Growth in residential construction has been a mainstay of almost all recoveries in the past, with the current recovery being the notable exception. That's one more reason why this recovery has been and is likely to continue to be disappointing.

Online Help Wanted Ads jump 34% in the past year


According to the Conference Board, online help wanted ads surged by one-third in the 12 months ended October. October advertised vacancies were up by 113,700 from the September level, which compares favorably to the market's expectation that private payrolls increased by about 80K in October. Interestingly, California was the largest contributor to new vacancies, accounting for 32,100 jobs, or almost 30% of the total. This is welcome news for a state that is really struggling. Even Nevada saw an increase, albeit quite modest. (We spent a day in Las Vegas last month and I was surprised at how many people I saw on the streets, and how difficult it was to get a restaurant reservation on a weekday night.)

The index is still shy of the high set in 2008, but on balance it's one more reason to remain optimistic about the future course of the economy.

HT: "brodero"

Manufacturing report suggests stronger Q4 GDP


The October manufacturing report from the Institute for Supply Management came in stronger than expected, across the board. As this first chart shows, the level of the manufacturing index is consistent with GDP growth that is significantly higher than what has been reported in recent quarters. I believe this is one more reason (see my recent post on why the acceleration in M2 growth is another reason) to expect some acceleration in the pace of GDP growth in the current quarter. At the very least, today's ISM report provides zero evidence of any economic slowdown.


Export orders jumped in October, suggesting that the slowdown in exports which contributed to slow the economy in the third quarter is reversing in the current quarter. Growth in exports is a very positive sign, particularly since it is now still apparent that the U.S. is not going to be the engine of global growth as it has been in the past. The most dynamic engines of growth this time around are in the Asia/Pacific region and in the emerging market economies.


Fully 70% of those surveyed reported paying higher prices. This is another strong argument against the persistence of deflationary risks in the economy. The majority has consistently reported paying higher prices ever since the recession ended almost 18 months ago.


Finally, the manufacturing employment index has been at an unusually high level for the past nine months, strongly suggesting that manufacturing employment continues to expand. Growth in manufacturing employment was reflected in the establishment survey of manufacturing jobs beginning early this year, with the exception of modest and disappointing job losses in August and September. With this ISM report it is now likely that we will see renewed job growth in the manufacturing sector (and most likely more than the 1,000 new jobs the market is expecting to see) in the employment report that will be released this Friday.

Given the broad-based strength in the October ISM report, coupled with the ongoing rise in commodity prices, the weakness of the dollar, the continued growth of the economy, and the absence of deflationary pressures in the official price indices, I would argue that there is no need at all for the Fed to resort to another round of quantitative easing. Given political realities, however, they probably feel compelled to "do something." That something is likely to be a modest QE2 announcement—a hundred billion or so of asset purchases in installments—after the FOMC meeting on Wednesday.

"Less We Can"

That's the clever slogan of Mark Grannis, a distant relative of mine, and the Libertarian candidate in Maryland's 8th Congressional District. George Will calls attention to him and to other notable battles being waged in his article "What's at stake Tuesday."