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Jobs growth still moderate

There is no way we are even close to a recession when the number of people working in the private sector grows at a 1.75% annual pace—or about 160K per month—and that is exactly what we have seen so far this year, according to the establishment survey. The increase in new jobs is disappointingly slow, to be sure, but it is not something that can be dismissed as meager or recessionary.


Yesterday I suggested that the July jobs increase reported today was likely to be better than expected, and that proved to be the case (+172K private sector jobs vs. 110K expected). I based that guess on the observation that this year's growth in jobs as reported in the household survey has been much stronger than reported by the establishment survey, and that perhaps it was time for the establishment survey to "catch up" to the household survey. That indeed happened, and as it turns out, the household survey reported a decline in jobs, thus narrowing the gap between the two from both sides. Splitting the difference between the two surveys is a strategy I've always favored, and doing so puts the growth rate of jobs somewhere in the range of 1.5–2.2%. That's just about what the pace of jobs growth was in the 2004-2006 period, in fact. In any event, no matter how you slice and dice these numbers, jobs are growing and there is absolutely no sign of a recession. 


Those in the public sector will disagree, however, since public sector jobs have been contracting for the past three years, with no end in sight. The folks at Brookings lament this fact, but they fail to recognize that there are still many more public sector jobs today than there were in 2000, whereas the number of private sector jobs has barely risen at all. Public sector jobs are declining because of public sector bloat that is being painfully reduced, and we will all be better off as a result, once the dust settles. It's also appropriate to note that wealth is created in the private sector, so that's where it is important to see the growth in jobs.


UPDATE: Today's jobs report also served to vindicate the ADP report from last Wednesday.

The Fed "disappoints" and that is good

Seems there were a lot of people hoping that the FOMC might decide to "do something" about the persistently weak recovery. Instead, while yesterday they acknowledged that economic growth has "decelerated somewhat over the first half of this year," they added merely that they will "closely monitor incoming information ... and provide additional accommodation as needed." That's hardly a clarion call for more aggressive monetary ease, and that's a good thing, because there's not much more they can or should do at this point.


Thanks to two Quantitative Easing programs, the Fed has already created an astounding $1.6 trillion of bank reserves—17 times the amount that existed prior—of which $1.5 trillion remain on deposit at the Fed in the form of Excess Reserves. In order to support the current level of bank deposits, banks only need about $100 billion of "required" reserves, leaving $1.5 trillion available to make new loans and otherwise expand the money supply. If banks are content to hold $1.5 trillion of excess reserves today, would they be much less willing to hold the same amount of reserves if the Fed cut the Interest on Reserves to 15 bps (from the current 25) as many have suggested they should? It's hard to believe that a 10 bps reduction in the yield on excess reserves would make a significant difference. (Going to zero might make a small difference, but it would also drive money market funds out of business or force them to pay negative interest rates.) If the banking system prefers to earn almost nothing on a mountain of excess reserves instead of making loans at a rate that is many multiples of that, then that can only mean that banks are too risk-averse to make more loans today, and/or borrowers in aggregate are too risk-averse to take on more debt.

In other words, the problem of weak growth cannot be traced to any shortage of money or lack of sufficient reserves, or to the level of short-term interest rates. Risk aversion and a lack of confidence are the most likely culprits, and it's hard to see how a Fed that repeatedly acknowledges that it is very concerned about the outlook for growth is making any positive contribution to the problem.

Should the Fed attempt to force-feed the financial markets with new lending? Argentina is trying to do this, by ordering banks to increase their lending between now and year end, and to do so by making loans with interest rates lower than the current level of inflation. Last time I checked, that move hasn't made a whit of difference to the Argentine economy, but it has helped push down the value of the peso on the black market, where pesos now trade at a 32% discount to the official exchange rate.

Should the Fed adopt negative interest rates? That's just another way of force-feeding money into the economy: encourage more borrowing by ensuring that borrowing costs will be lower than inflation and lower than nominal GDP. Borrowers are almost sure to win, but lenders are almost sure to lose. That's a zero-sum game that can't result in any positive contribution to growth. Money gets pumped into real estate and commodities (i.e., into real assets that will likely benefit from higher inflation) and into speculative (e.g., leveraged) activities, but not necessarily into productive (i.e., job-creating) activities. Indeed, the transparently inflationary nature of policies such as this can only induce greater risk-aversion. That's why Argentina's economy is sinking rather than picking up, precisely because the government is so transparently trying to goose lending.

Can the Fed do anything to reduce risk aversion and boost confidence, and thus address the real underlying problems? Well, yes: they could refrain from pumping yet more reserves into an already-over-stuffed banking system, and they could refrain from reducing already-very-low short-term interest rates to zero. And that's exactly what they did with their statement yesterday. They have reduced risk aversion because they have reduced the chances of a catastrophic error of monetary policy, in which they are slow to reverse their accommodation, thus creating a huge excess supply of money which could be very inflationary. That helps explain why the dollar today is trading at close to a two-year high against other major currencies, and why gold is down 16% from last year's high.

What the Fed has yet to do is explain in greater detail why monetary policy cannot provide a magical solution to the world's problems at this point—that fiscal policy holds the key to future progress. On that score we are still waiting to see credible attempts to rein in the size and scope of government and to minimize tax and regulatory burdens in most of the world's major economies. Draghi can't come up with a ECB program that will fix that overnight; the ECB, like the Fed, can only do so much.

Slow growth, but no signs of recession

Today's economic releases shed no new light on the state of the economy, which remains one of disappointingly slow growth. Although it's very clear the economy has slowed down, there are as yet no indications that it is going to slow further or enter a recession. 


After a month of very volatile numbers, the picture of the weekly unemployment claims has clarified: the volatility was almost entirely due to seasonal adjustment factors—which attempt to predict the timing and magnitude of scheduled layoffs in the auto industry—that did not match up with the reality. By now, however, these problems are water under the bridge, and today's release is probably an accurate reflection of the underlying realities: new claims for unemployment continue to decline. On an unadjusted basis, claims are down 9% from a year ago. This is important, since if the economic fundamentals were deteriorating, we should be seeing an increase in claims, not ongoing declines. The economy is growing slowly, but it is not deteriorating.
 

Thanks to the scheduled expiration of emergency claims beneifts, and to the ongoing decline in new layoff activity, the number of people receiving unemployment insurance continues to decline on a seasonally-adjusted basis: down over 1 million in the past year, or -15.4%. This creates important new incentives in the workforce, since more people have an incentive to find and accept job offers, even though they may not be ideal jobs. This—relocating workers to the areas of the economy where they are needed and adjusting the cost of labor to new realities—is part of the natural healing process of any recession, and it has been retarded for way too long by Congress' decision to keep extending eligibility for unemployment insurance.


Announced corporate layoffs continue to run at very low levels. Once again, here is a key indicator of underlying economic fundamentals that shows no sign of deterioration.


Nondefense factory orders declined in June, and they have fallen at a 9% annualized rate so far this year. The deterioration in factory orders and related subcomponents (e.g., capital goods orders) is mirrored in the recent decline of the ISM manufacturing index, and it reflects conditions that existed 1-2 months ago, so it is arguably not new news.



Key indicators of financial health and systemic risk, captured in Bloomberg's Financial Conditions Index (first chart above), are behaving in relatively normal fashion. The Vix index of implied equity volatility remains somewhat elevated, at 18.7, but swap spreads (second chart above) are trading at relatively low levels in the U.S. and are even down significantly from recent highs in the Eurozone. The market is still in the grips of fear, and risk aversion is still high (viz. 10-yr Treasury yields at 1.46%), but markets are liquid and functioning normally. Arguably, the illiquidity that struck markets in the wake of the Lehman collapse in late 2008 was a very important factor aggravating the recessionary conditions that had been building up to that time. With banks almost frozen, for example, letters of credit were almost impossible to get, and global trade virtually collapsed. Today's liquid and relatively tranquil market conditions show no signs of deteriorating fundamentals that might threaten the U.S. economy going forward.

Mixed economic releases


The ISM manufacturing index for July came in about as expected, and it doesn't change what we already knew: the economy is in a "slow patch" with growth likely to be between 1 and 2%, as the above chart suggests. However, there is still no sign in this indicator of a recession, and that ends up being a mild positive in my view, given how bearish the market is (e.g., 1.5% 10-yr yields). 


The ADP estimate of the change in private sector employment in July was somewhat stronger than expected (163K vs. 120K), but of course this is still a fairly weak number. However, based on the above chart, the ADP number is pointing to a stronger-than-expected payroll report this Friday. The market is expecting only 110K private sector jobs to be found in Friday's release—if it came in at or above 160K that would probably be a welcome and positive surprise for the market.


This chart from last month gives yet another reason to expect a stronger-than-expected payroll report. What stands out is the very strong gains in private sector employment that have been found in the household survey so far this year, especially when compared to the fairly weak numbers we have seen in the establishment survey. It may be time for the establishment survey to "catch up" to the household survey. 


Construction spending in June came in about as expected, and it extends the upturn in the sector which began early last year. Total construction spending is up about 13% from last year's low. That's encouraging on the margin, but nothing to write home about.


UPDATE: July auto sales were ever so slightly higher than expectations (14.05M vs. 14.0M), but this is a rounding error in a series in which monthly sales are annualized and seasonally adjusted. All we know is that the uptrend in sales, which began over three years ago, appears to remain intact: since the early 2009 low, sales are up 50%, and over the past year, sales are up 15%. Both are rather impressive figures.

China's currency is not undervalued

After 18 years of an appreciating yuan/dollar exchange rate and a huge, $3.2 trillion accumulation of foreign exchange reserves, China's currency and forex reserves are roughly unchanged over the past year. This is a potentially important development, since it suggests that the yuan is no longer undervalued, and that China may be entering a new phase in its economic development, in which future growth is likely to be slower but more balanced.

In early 1994, China opted for a monetary policy that targets the value of its currency vis a vis the dollar. This is a legitimate policy option, but very different from the monetary policy that all other major central banks have adopted, which is to target short-term interest rates. In order to manage its exchange rate, China's central bank must buy and sell foreign currency depending on the balance of capital inflows and outflows to their country. If there is a net inflow of capital, the BoC must buy whatever excess of foreign currency there happens to be, thus adding to its foreign exchange reserves while at the same time expanding the supply of yuan in the economy; otherwise, the excess of foreign currency would depress the value of the yuan and violate the peg. Conversely, an outflow of capital would require the BoC to sell foreign exchange and shrink the supply of yuan, thus supporting the yuan. In this manner, capital inflows feed directly into an expanding economy and an expanding money supply.


For the past 18 years, China has experienced an almost relentless and massive inflow of capital. The inflow was so massive that the BoC was ultimately forced to revalue the yuan by 37% in several stages, following its initial 8.72 peg, as reflected in the blue line in the chart above. As China deregulated and privatized its economy, allowing the entrepreneurial energies of the world's most populated country to flourish, the world was quick to see the investment opportunities in China. Investment flows followed, and they were huge. This meant that the BoC had no alternative but to make massive forex purchases (red line in the chart above), and that was a good thing because the abundant supply of yuan this created provided the wherewithal for the Chinese economy to grow roughly 10% per year (in nominal terms, the economy increased a mind-boggling tenfold) as foreign investment inflows financed a booming Chinese economy.



By pegging the yuan to the dollar, China effectively "outsourced" its monetary policy to the U.S., and so it is not surprising that inflation in the two countries is virtually identical, especially now that the economy has had many years to adjust to its currency peg.



The chart above makes it clear that the yuan has been a relatively strong currency since the adoption of its dollar peg. Against a basket of currencies, and adjusted for inflation differentials, the BIS calculates that the yuan has appreciated by over 50% since 1994. Interesting factoid: since 1994, the yuan has depreciated by only 10% vis a vis the mighty Swiss franc, and it is unchanged against the franc for the past 8 years.

Moreover, the fact that reserves and the currency have been flat for the past year tells us that China's capital flows have reached a sort of equilibrium. No longer is there relentless upward pressure to revalue the yuan. Indeed, China could now argue that balanced capital flows are proof that the yuan is no longer undervalued against the dollar. The yuan has perhaps appreciated enough.

Presumably, the BoC could have stopped trying to peg the yuan to the dollar once China's forex reserves had reached some invincible number like $1 trillion. But it seems they wanted to go even further in order to convince the world that the yuan, like their economy, was serious, strong, and here to stay. So now, forex reserves total a little over $3 trillion, most of which is held in the form of dollar, euro, and yen-denominated bills, notes and bonds. Think of those reserves as the collateral backing up China's M2 money supply, which today is equivalent to about $12.5 trillion dollars. By comparison, U.S. M2 is only $10 trillion, and that is "collateralized" by the Fed's holdings of $1.6 trillion of notes, bonds, and MBS.


In the future, China should have no problem accommodating more economic growth with its current level of reserves—the lack of growth in reserves over the past year poses no threat at all to China's ability to continue growth. By simply by lowering banks' required deposit reserve requirement ratio, which is currently 20%, China's banking system can create all the cash and currency needed to support an expanding economy for years to come.



As the above chart suggests, China's galloping growth phase seems to have come to an end. To judge from the evidence of the past year—i.e., no increase in forex reserves and no change in the yuan/dollar exchange rate—no longer does the world in aggregate see obvious bargains in China, or excessive growth, or low-hanging investment fruit. This is likely due to a combination of factors: the yuan's strong performance relative to almost all other currencies; weaker growth in other countries, which translates into weaker demand for Chinese exports; and weaker growth in China, which dampens potential investment returns. Capital inflows have come to a halt because China is no longer the most attractive investment destination in the world.

At the same time as capital flows reach a kind of equilibrium and growth cools, the world senses that the yuan is increasingly unlikely to continue appreciating, and this in turn means that speculative excesses are diminishing. If the yuan is going to be more stable in the future, then it makes less sense to speculate by buying the yuan or by buying Chinese assets. Investors increasingly must focus on things that make economic sense, and less on speculation. This takes some of the froth off of growth, and means that future growth is likely to be more balanced. The prospect of a slower-growing China may dampen one's enthusiasm for global growth in general, but that concern is offset by the likelihood that future growth will be more balanced, less speculative, and thus more durable.

Memo to Mitt: stop bashing the Chinese, please!

Why capitalism succeeds and redistribution fails

George Gilder, long one of my favorite business and economic philosophers, has written yet another brilliant essay, "Unleash the Mind," in which he explains how capitalism really works, why the redistribution of wealth only destroys wealth, and why increasing wealth is not a zero-sum game. Some choice tidbits from a rather long article:

America’s wealth is not an inventory of goods; it is an organic entity, a fragile pulsing fabric of ideas, expectations, loyalties, moral commitments, visions. To vivisect it for redistribution is to kill it.

Capitalism is the supreme expression of human creativity and freedom, an economy of mind overcoming the constraints of material power.

All progress comes from the creative minority. Under capitalism, wealth is less a stock of goods than a flow of ideas, the defining characteristic of which is surprise. If it were not surprising, we could plan it, and socialism would work.

Most of America's leading entrepreneurs are bound to the masts of their fortunes. They are allowed to keep their wealth only as long as they invest it in others.

In capitalism, the winners do not eat the losers but teach them how to win through the spread of information. Far from being a zero-sum game, where the success of some comes at the expense of others, free economies climb spirals of mutual gain and learning. Far from being a system of greed, capitalism depends on a golden rule of enterprise: The good fortune of others is also your own.
The secret of supply-side economics is not merely to incentivize people to work harder or accept more risk in order to gain a greater reward. The reason lower marginal tax rates produce more revenues than higher ones is that the lower rates release the creativity of employers, allowing them to garner more information ... command more capital ... attract more highly skilled labor ... reduce time and effort devoted to avoiding taxes ... conduct more experiments ... try more business plans ... generate more productive knowledge.

Read the whole thing, it's quite illuminating. HT: Ashby Foote


Upbeat economic releases

Today's economic releases were generally upbeat. No sign of anything that looks like a recession, just more signs of improvement in a variety of areas.


June Personal Income came in a bit stronger than expected (+0.5% vs. +0.4%), and it has increased 3.5% over the past year in nominal terms, and 2% in real terms. Government transfer payments accounted for only a small fraction of the June gains, so this is "real" improvement. In the first half of 2012, real personal income is up at a 4.4% annualized rate, which is comfortably higher than its 3.2% average growth rate over the 40 years leading up to the last recession. Plus, as the chart above shows, real personal income has now hit a new all-time high. That's one more in a growing list of indicators that now show a full recovery from the devastating 2008-9 recession. Personal income has traditionally not been a leading indicator, but when it posts numbers like these, it's not to be ignored.


Both the Case Shiller and the Radar Logic housing price indices have registered stronger-than-expected gains in recent months. The Radar Logic index (not seasonally adjusted) is now up 0.3% over the past year, while the seasonally adjust Case Shiller index is down only 0.7%. More signs, in other words, that housing prices are in a bottoming process.


As this chart shows, house prices have increased only marginally relative to rents over the past 25 years. Since mortgage rates are at all-time lows, house prices are looking very attractive relative to the cost of renting. The "bubble" in housing prices has burst, and prices are now back down to reasonably attractive levels.


The Fed's preferred measure of inflation, the Core Personal Consumption Deflator, is up 1.8% in the past year, and it has risen at an annualized rate of 2.0% in the past six months. No sign here of deflationary pressures that would warrant further quantitative easing measures. Indeed, this chart suggests inflation is right in line with the Fed's target.


This chart disaggregates the personal consumption deflator into its three main components. What stands out is that durable goods prices have been falling for the past 17 years. There is a lot of deflation in the durable goods sector, but this has been more than offset by rising prices for services (which are mostly driven by wages) and non-durable goods (e.g., food, energy). If you assume that service sector prices are a proxy for income, then incomes have risen by 120% relative to durable goods prices since the end of 1994. Put another way, durable goods prices have fallen by more than half relative to incomes. We've never seen relative price shifts of this magnitude. Ever. Not even close. Consumers have never had it so good when it comes to the purchase of durable goods such as computers, electronics, cars, etc. We can probably thank the Chinese and technological progress in general for much of this boon, since cheaper durable goods free up money that can be spent on other things.