When Experts Misunderstand Unemployment Statistics

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I know everyone likes a conspiracy.  Obviously, hedge funds manager Kyle Bass appears to infer the government is  the Bureau of Labor Statistics (BLS) ‘semi-rigged’ the unemployment statistics.  In an interview on CNBC Squawk Box interview, Bass says that an improved unemployment rate is deceptive.  He expects that the unemployment rate might even drop further, but it will be misleading because it will be a result of people dropping out of the labor force rather than jobs being created. While he might have a valid point, it is incorrect to suggest that the government does not track ‘true’ unemployment.

Economists recognize that the ‘true’ unemployment rate not only tracks those currently looking for a job, but those that want a job and quit looking due to being discouraged.  This is measured and is located in Table A-15 of the monthly job report, thus not hidden from the public.  Unlike his claim that the true unemployment rate is 11 percent, this alternative measure of unemployment is actually at 12 percent.  Now before giving Bass praise for pointing out a supposed weakness in the unemployment rate, it should be noted that this figure has been steadily dropping over the last year.  In fact, it has dropped substantially from the last year when it was 13.6 percent.  Since the end of the recession in June 2009, we have recently seen a steep decline that suggests the job market is improving.

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This alternative measure of unemployment looks at the following:

  • Unemployed and currently looking for work
  • Marginally attached to the labor force, meaning that they are no longer looking for work, but want a job and have searched for a job within the last 12 months.  (Note:  We consider this to be the discouraged worker)
  • Working part-time for economic reasons.  (Note:  Would like to work full-time, but cannot find full-time work.  Therefore, it does not include part-time workers by choice, such as college students who only want to work part-time so that they can go to school full-time.)

Having said that, it is obvious that the jobs picture is not perfect.  Even though part-time employment has declined over the last year, it still remains highly elevated from the pre-recession period.  Also, wages also remain stagnant.  In my opinion, the main problem is a changing landscape of the economy where we are seeing a shift from value in using our hands (manufacturing) to using our minds (services).  Right now, we are in a transitional phase with plenty of low-paying, low skill jobs and many high-paying, high skill jobs.  The problem is there are not enough decent paying, middle skill jobs.  Until these workforce skills are updated, wages will remain stagnant.

While it makes for good TV, do not be fooled with this faux conspiracy.

Maintaining Fed Credibility Is Key To Controlling Inflation

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Diana A. Cooke and Wiliam T. Gavin of the St. Louis Fed’s Regional Economist do an excellent job in explaining the role of Fed credibility on inflation.  Inflation is the rise in overall prices and its measure is critical in determining the overall health of an economy.  Even though some inflation is actually healthy, high rates of inflation erodes wealth and causes investor and consumer uncertainty.  Also, deflation can be even more damaging as businesses struggle to make ends meet due to an inability to raise prices.  That is why investors and the business community values any insight on predicting future inflationary trends.

There is historical relevance of Fed credibility and the trend of inflation.  The Fed is represented by the Federal Open Market Committee that sets interest rates through conventional means, such as open market operations, discount rate, and reserve requirement, and non-traditional methods, such as quantitative easing, referred to as large scale asset purchases by Bernanke.  If you want to learn more both methods, view this lecture from former Fed Chairman Ben Bernanke.

Specifically, look at the video between 8:40 to 12:40 where Bernanke discusses the Fed’s conventional methods in controlling monetary policy.  From 12:41 to 19:09, he talks about non-conventional methods.

Now referring back to Fed credibility and its impact of inflation, we noticed the following trends:

In the 1970s, the Fed had little credibility and that is one of the reasons why inflation was high at that time.  This goes back to the last of the ten principles from Mankiw, which states that there is a short-run tradeoff between inflation and unemployment.  Mainly due to Middle East unrest that drove oil prices very high, the U.S. economy suffered from high rates of inflation.  This stunted economic growth and in an attempt to boost job growth, the Fed pursued easy money strategy to keep interest rates low.  However, the market frowned upon this action and that drove inflation even higher.  This is shown with the graph from Cooke and Gavin below:

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Notice how the Fed Funds Rate which is shown in red was driven down around the mid-1970s.  During that period, inflation was very high.

It was not until late 70s and early 80s where we see the Fed Funds Rate raised in order to fight inflation.  This move eventually killed high inflation, but it came at a cost of higher unemployment and two recessions.  It was during this period, described as 1980-1986, where the Fed regained its credibility and that was a main contributor to falling prices.

This credibility held true for the next twenty years (1987-2007) where inflation remained modest.  However with the onset of highly irregular monetary policy, the Fed pursued drastic measures to stabilize an economy on the brink of collapse due to deteriorating financial institutions that were penalized for its poor lending practices.

Even though the Fed’s efforts during this recent crisis was more extensive than the 1970s and one would expect Fed credibility in managing inflation to diminish, we still have not seen a rise inflation.  While this is puzzling, Cooke and Gavin believe we can look to the Fisher Effect to understand why inflation has been so sluggish.

The Fisher Effect was developed by Irving Fisher in his 1930 publishing of The Theory of Interest.  It basically explains how the nominal interest rate is a function of the real interest rate and inflation expectations through this accounting expression:

Nominal interest rate = Real interest rate + Expected inflation rate

While nominal interest rates are expressed as the rate paid by individuals that want to borrow money or earn on funds held in savings accounts, the real interest rate is adjusted to account for inflation.  Since no one knows what inflation will be in the future, people guess what it will be.  Cooke and Gavin provide an example of how this works through the following example:

Suppose an investor is willing to lend $100 for a real rate of return of 3 percent and they expect inflation to rise by 2 percent next year.  Applying the Fisher Effect, they would agree to a nominal interest rate of 5 percent based on the accounting expression above.  (5.00 = 3.00 + 2.00)

Even though it is difficult to determine the actual real interest rate today, we can determine what it was in the past.  Let us plug in what we know.  If the Fed Funds Rate is between 0 and 0.25 percent, then that is a proxy for the nominal interest rate.  Between 4th quarter of 2007 and the beginning of the 4th quarter of 2010, the average inflation rate is at 1.6 percent.  Therefore, applying the Fisher Effect, we must assume that the real interest rate must be around -1.35 percent.  (0.25 = -1.35 + 1.60)

The negative real interest rate is consistent with the economic decline that we experienced during 2008-2010.  However from the 4th quarter of 2010 and the end of 2013, we experienced an uptick of 2.2 percent in real gross domestic product.  That means the real interest rate should be on the rise.  Since the nominal interest rate remains near zero due to the Fed Funds Rate unchanged, then that would place downward pressure on inflation.  For example, let us assume that the real interest rate increased from -1.35 percent to -0.75 percent, then that would mean the inflation rate would have to fall from 1.6 percent to 1 percent if the nominal interest rate is at 0.25 percent.  (0.25 = -0.75 + 1.00)

Now knowing what we learned above, Cooke and Gavin describes three possible scenarios that will all be driven by the Fed’s credibility with investors.

Scenario 1:  Investors lose credibility and believe inflation will rise significantly.  That would lead to a similar environment of the 1970s where stagflation was the norm.  This is certainly a scenario that we want to avoid.

Scenario 2:  Investors still believe the Fed is credible and inflation remains around 2 percent.  This scenario will allow the Fed to gradual raise interest rates without threatening a recovery.  An increase in nominal interest rates will allow for the real interest rate to rise above zero.  This is the best-case scenario.

Scenario 3:  The Fed continues to keep interest rates low in an environment where the economy remains sluggish.  In this case, nominal interest rates remain near zero and the real interest rate stays negative.  This will cause investors to believe future inflation will fall.  This is the worst-case scenario because deflation is tougher to reverse than inflation.  With businesses forced to lower prices, that will lead to cuts in business spending and result in job losses.

Given the uncertainty caused by turmoil in the Middle East and Eastern Europe, do not be surprised if deflation becomes our biggest threat to a more robust recovery.  Regardless, investors and their take on Fed credibility will be essential to determining our economic fate.

U.S. Economy Picks Up Steam In 2nd Quarter

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The U.S. Bureau of Economic Analysis released 2nd quarter data and it showed better than expected results.  While many expected a significant improvement from the dismal 1st quarter, a growth of 4 percent in real GDP was larger than expected.  Given their propensity to revise economic data at later dates, we should be cautious in relying on it.  For instance, they again revised the economic contraction of last month from 2.9 percent to 2.1 percent.  However, this is certainly evidence that the economy has rebounded from a terrible first quarter.

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Some of this rise can be attributed to severe weather in the previous quarter where consumers stayed in, but started to make up for lost time by resuming their spending habits.  This explained the healthy boost of 2.5 percent between April and June in consumer spending.

Business investment was also healthy.  Gross private investment rose by 17 percent with most of the rise occurring with equipment.  This is a significant improvement over the last quarter where investment declined by 6.9 percent.  These figures are volatile, but we can take comfort that investment spending has risen in five of the last six quarters.

This improvement is consistent with my July 2nd post entitled, “Don’t Worry, Be Cautiously Happy”.  The combination of an improving labor picture and rising manufacturing activity are boosting hopes of a more robust recovery.  However, we are not out of the woods yet and should be concerned with the various world crises that can hamper U.S. economic growth in the future.

World Crises Can Lead To Stock Market Crash

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Alex Christensen of Global Risk Insights offers a warning to global investors dealing with the global turmoil and U.S. stock markets.  Developments in Ukraine and the Middle East can prove harmful to the U.S. stock market.  With the unfortunate Malaysian Airlines crash being a result of actions of Russian-tied rebel factions, there is increased pressure on the European Union to impose economic sanctions on Russia.  Even though the U.S. will likely press for crippling actions on the Kremlin, Europe had a lower appetite for this move because their economic prosperity is tied to access to plentiful Russian energy sources.  Now with this distasteful event, Europe will face more outward pressure to respond to their neighboring menace even if it contributes to a recession for them.

Then there are rising tensions in the Middle East where ISIS are gaining ground in Syria and Iraq, while Israel is expanding operations in rooting out Hamas in Gaza.  This is also spooking global investors that are concerned about about free flowing oil.  If access to oil is compromised by these developments, then that can dampen economic growth because businesses and consumers rely on crude oil to keep their energy prices low.  If crude oil becomes scarce, then that will drive up the cost of gasoline and causes both consumers and businesses to downsize.

Global investors are aware of the risks associated with Eastern Europe and the Middle East and have sent their funds to safe U.S. Treasury securities.  Even though Standard and Poor’s have reaffirmed the U.S. credit rating at AA+ due to high budget deficits and Congressional gridlock, they still remain a safe haven for investors seeking safety.  When investors start buying bonds, this drives down their yields and thus bring down other interest rates associated with it, such as the prime interest rate and the mortgage rate.

With interest rates remaining low, there is enhanced risk of asset bubbles. As implied by Christensen, the Fed has been trying to normalize interest rates, which have been artificially lowered by Fed policy aimed at boosting employment.  Even though the Fed actions have undoubtedly improved labor markets with U.S. unemployment rate on the decline, it has roiled foreign markets, who are struggling to tamp down inflation and prevent asset bubbles themselves.  Eventually, these same symptoms could be felt in the U.S., especially if signs of a more robust recovery becomes more consistent.  Stronger labor markets will provide U.S. consumers with more security and income, thus resulting in more savings.  If U.S. consumers decide to shift their increased savings to the U.S. stock market, then there is concerned that this could push equity prices to unsustainable levels and cause a market crash.

All of these events can compromise Fed policy and end up swallowing wealth in the long-run.

Sometimes Being Rich Is No Accident

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Jocelyn Black Hodes of Marketwatch.com lists 10 ways where the behavior of wealthy individuals differ from most.  When looking at these methods, they are something that we can all do.  It just takes discipline, focus, and perseverance.

Step 1:  Start early.  While it is ideal to start early in life, you can start at any time.  The quicker you begin the process, the better off you will be at retirement.

Step 2:  Automate.  Go to your financial institution and ensure that a specific portion of your check (ideally 10 percent or more) goes to savings.  First, build up your emergency savings where you have a minimum of one monthly paycheck, if not two or three months.  Then, it is recommended that you align yourself with a certified financial planner and direct a portion of your future savings toward prudent investment products based on your financial goals.

Step 3:  Maximize your contributions.  Seek your benefits specialist at your job to determine whether your employer makes any contributions.  If so, you will want to deduct from your check whatever they are willing to match, which could be up to 5 percent.

Step 4:  Never carry credit card balances.  This means an end to impulse buying.  When going to the mall or an electronics store, never buy an item that you initially like.  Instead, make a mental note of it, then go back and plan within your budget whether it can be reasonably purchased at a later date.  If you carry a credit card debt and you have established an emergency savings fund, then redirect your savings to draw down your credit card debt.  Make sure to focus on eliminating balances with the highest interest rate, rather than the lowest balance.

Step 5:  Live like you’re poor.  Rather than ‘live within your means’, make sure to live BENEATH your means. Keep your eyes on the prize and keep a visual image of your financial goals where you are constantly reminded of what you are hoping to accomplish.

Step 6:  Avoid temptation.  The worst thing to do is try and emulate your neighbors.  Resist trying to match their car, high-definition TV, or immaculate wardrobe.  Recognize that it is where you end up and not where you start.  You do not want to reach retirement age with the realization that you must continue working.  Instead, think about how thankful you will be about the sacrifices you made early in life, so that you can live comfortably in your twilight years.

Step 7:  Be goal-oriented.  Rather than think paycheck to paycheck, think year to year and even decade to decade.  If you are single and just started working, then you should be thinking about saving for a home.  If you have young kids, realize that college tuition continues to rise, so set up goals for establishing a college savings fund.  Otherwise, your financial goals should center on retirement and not worrying about the daily necessities of life.

Step 8:  Get educated.  We need to stop making excuses about not understanding money.  Check out MyMoney.gov which was created by Congress and the Federal Financial Literacy and Education Commission.  Learn the basics and then regularly read news from the web, such as Marketwatch, CNNMoney, and Yahoo Finance.

Step 9:  Diversify your portfolio.  When developing your investment portfolio, emphasize time horizon and risk allocation.  Regardless of your age, you need to choose investment products based on the timing of your investment goals.  If your goal must be met within five years, then choose more bonds and money market accounts where they will have a lower return, but less risk.  If your goal reaches beyond ten years, then choose more stocks where the return is higher, but also the risk.  With stocks, make sure that you also diversify within industry because some do well even when the economy is tanking, such as consumer staples, such as Family Dollar, Walmart, and Proctor and Gamble.

Step 10:  Spend money to make money.  As you accumulate more wealth, it is wise to start hiring professionals with expertise in investment and tax planning.  They will provide you an edge in getting the most bang from your buck.

Rather than allow circumstances dictate your ability to generate wealth, take control of your finances by being disciplined in money matters.


Why Deficits No Longer Matter

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William Gale of Brookings Institute provides six takeaways from the Congressional Budget Office (CBO) 2014 Long-Term Budget Outlook.  Its findings suggest that not much has changed.  First, the size of the federal budget deficit is not a problem now or even the rest of the decade.  However if Congressional action is not taken soon, then the pain of deficit reduction will only worsen.  Unfortunately, that means more of the same with deficit spending continuing to spiral into the future.

Here are three reasons why proactively addressing deficit reduction is politically a poor one:

  1. Attacking the deficit by either restraining spending or raising taxes will be vigorously attacked by special interests.
  2. Politicians recognize that voters have short-term memories, so while significant deficit reduction will yield long-term benefits, it will likely cause short-term economic pain.
  3. They have been emboldened by Federal Open Market Committee (Fed) policies, whose expansionary monetary policies, have made deficit spending attractive.

The last point is most poignant.  While theory suggests that high deficits will lead to “crowding out” private sector borrowing, that has not happened.  Even though the debt to gross domestic product is historically high at 74 percent, current interest rates remain very low.  We can see this through a graph of the average U.S. prime interest rate, which is the interest rate charged to borrowers with good credit.

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A look at the graph above shows that the current prime interest rate of 3.25 percent is the lowest rate experienced since 1970.  If not for the Fed’s actions, the prime rate would undoubtedly be much higher.  On the surface, this appears to be attractive.  A lower interest rate will encourage more purchases of homes and boost employment rates.  That is true during the short run, but it is not without cost.

First, by artificially keeping interest rates low, we have discouraged saving and encouraged reckless borrowing.  A cursory look at saving rates show that the rate for a savings account is meager at 0.49 percent as of July 17th, 2014.  On the other hand, consumer debt has been higher at almost $3.195 trillion.  While that points to a bright present, it portends a dim future.  Lastly, this policy has exacerbated inequality where U.S. aggregate household wealth increased from $81.8 trillion from $59 trillion in 2009.

On the other hand, if Federal Reserve Chairman Janet Yellen were to adopt John Taylor’s prescription of stable pricing through use of the “Taylor Rule”, then markets will eventually correct themselves and the economy will be poised for more dynamic growth.  If implemented, then that would raise the fed funds rate from 0 percent to approximately 2 percent.

A higher fed funds rate would raise borrowing costs, thus spooking equity markets that could result in huge declines in wealth.  However, the upside is that it might strengthen the dollar and ease pressure on developing countries who have been forced to devalue their currencies to maintain their exports.  That would be a positive to global economic growth.  The other positive is that it will likely boost saving incentives with banks probably offering higher rates on saving.  Lastly with higher interest rates, consumers and businesses will be less likely to take on more debt, thus improving their long-term economic outlook.

John Taylor’s prescription is a risky one with much downside risk, but Congress will only respond to our deficit situation when they have incentive to do so.  Right now, interest rates are low, so much of the benefits of deficit reduction will not be enjoyed.  That will change if the Fed allows interest rates to move according to market conditions.

Unless the Fed changes course, it appears that the U.S. fiscal situation will likely remain the same.  While that might be comforting to those advancing in age, it is a dire signal for our youth.

Don’t Worry, Be Cautiously Happy About U.S. Economic Growth

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The U.S. Bureau of Economic Analysis provided yet another revision to their first quarter numbers.  In a third revision, we now learned that the economy declined by 2.9 percent, as measured by real gross domestic product (real GDP).  That would rate as the second sharpest decline during the Obama administration and that worse decline was when we were in the midst of a steep financial crisis in the first quarter of 2009 when the economy contracted by 5.4 percent.  Even though that is a depressing rate, many analysts still believe that it will be a temporary bump.

Here are the three reasons why we should not worry:

  1. Weather was particularly bad across the U.S., so we should see a healthy rebound during second quarter.
  2. Job growth remains healthy with June private sector job growth estimated at 281,000, which would be the highest since November 2012.
  3. U.S. manufacturing continues its healthy trend in 2014 with its latest reading at 55.3.  (Note:  Any number above 50 represents expansion)

Take a deep breath and take comfort that the U.S. economy should rebound strong in the 2nd quarter.  Having said that, our economic recovery remains relatively soft with  the International Monetary Fund downgrading U.S. economic growth prospects for 2014 from 2.8 percent to 2 percent.