The Phillips Curve

September 27, 2015

Worries about economic growth in China, in the EuroZone and in emerging markets have prompted fears of a recession in the U.S.  It could happen – it will happen – at some point in the future but not in the near future.  The Fed likes to use a Personal Consumption chain weighted inflation index called the PCE Price Index which more reliably captures underlying inflation trends.  Preceding each recession we see the rate of economic growth fall below the annual growth rate of the PCE index, multiplied by a 1.5 factor.  While GDP growth is not robust, it is far above the growth of the PCE price level.

Speaking of growth, inflation-adjusted GDP growth for the second quarter was revised upwards to a 3.9% annual rate.  Consumer spending was revised higher and inventory growth – a bit worrisome, as I noted earlier – was revised lower.

The SP500 index began the year at a price level ($2068) that was just a bit above the inflation adjusted price level ($2018) of 2000 (Graph here).  Oops! we’re back below that year 2000 level. A sense of pessimism since mid-August has led to an 8% decline in the broad stock index, or 6% below the price level at the beginning of 2015.  A broad composite of bonds, Vanguard’s BND ETF, is also down -about 1.5% – since early 2015.

Some sectors of the market can not find a bottom.  XME, a blend of mining stocks, is down 45% for the year.  Brazil’s index, EWZ, is down a similar amount – about 40%.  Emerging Market stocks (VWO) in general have lost about 17% this year, and are at June 2009 prices.  After losing 5% of their value in the first week of September, they appeared to have found a bottom, regaining that lost 5% in the next two weeks.  This past week they gave up those gains, touching the bottom again.  The second time is a charm.  If this market draws in buyers a second time, this might be a good time to put some long term money to work.


Phillips – the curve, not the screwdriver

In a speech/lecture at U. of Massachusetts this week, Federal Reserve Chair Janet Yellen voiced her desire to raise interest rates sometime this year.  She included in her remarks some comments on the Phillips curve, a mainstay of economics textbooks during the past 50 years.  In the 1950s Bill Phillips presented one hundred years of unemployment and inflation data in the United Kingdom and showed that there was a trade-off between unemployment and inflation.  Higher inflation = lower unemployment.  Lower inflation = higher unemployment.  When the number of unemployed workers are low, workers can press employers for higher wages.  Higher wages lead to a higher inflation rate.

As you can see in the graph above (included in the Wikipedia article on the Phillips curve), the regression estimate, the red line, shows a tenuous inverse relationship between unemployment and inflation.  The standard error S of the regression estimate is a guide to the reliability of the estimate to predict future relationships in the data. The S in this regression is not shown but looks to be rather large; a lot of the data points are pretty far away from the red estimate line and so the regression model is unreliable.

Within fifteen years after the Phillips curve became an accepted tenet of economics, the stagflation of the 1970s disproved the central thesis of the Phillips curve.  During that decade, there was both high inflation and high unemployment.  This led economists to revise their thinking; the relationship described by the Phillips curve may have some validity in the short run but not in the long run.

For those of you who might like to go down the rabbit hole on this issue, there are several fascinating but challenging perspectives on the relationship between unemployment, the labor market, and inflation, the price level of goods in an economy.  One is Jason Smith’s Information Transfer model version of the Phillips curve.  Jason is a physicist by education and training who uses the tools of information theory to bring fresh insights to economic data, trends and models.

Roger Farmer (whose blog I link to in my blog links on the right hand side) has developed another perspective based on a sometimes overlooked insight in Keynes’ General Theory published in 1936. Roger is the Department Chair at UCLA’s Dept of Economics.  For the general reader, I heartily recommend his book “How the Economy Works”, a small book which presents his ideas in clear, simple terms. His history of the development of central economic theories weaves a concise narrative of ideas and people that may be the best I have read.

For those of you with the background and math chops, his paper “Expectations, Employment and Prices” (also a book) contains a well-developed mathematical model of longer term economical and business cycles that find an equilibrium at various levels of unemployment. Roger undermines an idea predominant in economics and monetary policy: the so called natural rate of unemployment, or NAIRU, that guides policy decisions at the Fed and is often mentioned by Yellen and others at the Fed.

Holding Pattern

September 20, 2015

The big news this week was the decision by the Fed to not raise interest rates this month.  Big mistake.  The Fed’s decision signaled a lack of confidence in the global economy.  Are we to believe that the continuing strength of the American economy is so weak that it can not weather even a 1/4% interest rate increase?

Message received.  When the news was announced on Thursday, the initial reaction was good.  Yaay!  no rate increase.  Then, the reality sunk in.  Does the Fed know something that the rest of us don’t? The buyers went to the back of the bus.  The sellers started driving the bus.  Pessimism wiped out the gains in the early part of the week and ended the week down 7/10%.  When in doubt, traders get out.

There are many aspects of the labor market.  The Fed crafts a composite of over 20 factors, called the Labor Market Conditions Index (LMCI).  The latest reading was released on September 9th, a week before this month’s Fed meeting.  This may have contributed to the caution in the Fed’s decision making.  The overall labor market has still not fully recovered from the downturn this past spring.


Will your job become automated?  In this fast morphing economy, the demand for a particular skill set can change quickly.  Younger people, whether working or still in school, need to focus on developing transferable skills.   Here’s a list of the nine criteria that some researchers determined were important to keeping a job from being automated: “social perceptiveness, negotiation, persuasion, assisting and caring for others, originality, fine arts, finger dexterity, manual dexterity and the need to work in a cramped work space.”

When the first Boomers were born at the end of World War II, 16% of the workforce was employed in agriculture.  Millions of agricultural jobs have been lost in the past 70 years. Now it is less than 2%. (USDA source)

Computerization has led to the loss of millions of clerical and accounting jobs in the back offices of businesses throughout this country. Despite those job losses of the past 25 years, there are almost twice as many professional and business employees now as there were in 1990 (Source )

In contrast, construction employment is about the same as it was 20 years ago – an example of an industry that boomed and busted in the past two decades.  Despite that lack of growth, construction employment is still almost twice what it was in the go-go years of the 1960s. (Source)

Despite all these job losses due to automation and more efficient production methods, there are 350% more people working now (140 million) than there were at the end of WW2 (40 million). (Source)

Those who get left behind are those who have a narrow set of skills.

Labor Market Analysis

Each August the Federal Reserve hosts an economic summit for central bankers, economists and academics.  In 2014, Fed chair woman Janet Yellen commented on several aspects of the labor market:

Labor force participation peaked in early 2000, so its decline began well before the Great Recession. A portion of that decline clearly relates to the aging of the baby boom generation. But the pace of decline accelerated with the recession. As an accounting matter, the drop in the participation rate since 2008 can be attributed to increases in four factors: retirement, disability, school enrollment, and other reasons, including worker discouragement.

As Yellen noted, some changes were structural, some cyclical:
Over the past several years, wage inflation, as measured by several different indexes, has averaged about 2 percent, and there has been little evidence of any broad-based acceleration in either wages or compensation. Indeed, in real terms, wages have been about flat, growing less than labor productivity.

Ms. Yellen agrees that the headline unemployment rate, the U-3 rate, does not reflect current labor market conditions:  “the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate.

Since unemployment peaked at 25% during the Great Depression in the 1930s there has been an ongoing debate about unemployment during recessions.  Why don’t employees simply offer to work for less when the economy starts slowing down? Yellen offered some insights [my comments in brackets below]:

the sluggish pace of nominal [current dollars] and real [inflation-adjusted] wage growth in recent years may reflect the phenomenon of ‘pent-up wage deflation.’ The evidence suggests that many firms faced significant constraints in lowering compensation during the recession and the earlier part of the recovery because of ‘downward nominal wage rigidity’–namely, an inability or unwillingness on the part of firms to cut nominal wages. To the extent that firms faced limits in reducing real and nominal wages when the labor market was exceptionally weak, they may find that now they do not need to raise wages to attract qualified workers. As a result, wages might rise relatively slowly as the labor market strengthens. If pent-up wage deflation is holding down wage growth, the current very moderate wage growth could be a misleading signal of the degree of remaining slack. Further, wages could begin to rise at a noticeably more rapid pace once pent-up wage deflation has been absorbed.”


September 13, 2015

The SP500 index is very close to crossing below its 25 month average this month, four years after a similar downward crossing in September 2011.  Worries over the economy and political battles over the budget had created a mood of caution during that summer of 2011.  The market immediately rebounded with a 10% gain in October 2011 and has remained above the 25 month average in the four years since.   Previous crossings, however – in November 2000 and January 2008 – have marked the beginnings of multi-year downturns.

These long term crossings are coincident with extended periods of re-assessment of both value and risk.  Sometimes the price recovery after a crossing below the 25 month average is just a few months as in August 1990, and October 1987, or the quick rebound in 2011.  More often the price of the index takes a year or more to recover, as in 1977, 1981, 2000 and 2008.

The downward crossings of 2000 and 2008 preceded extended periods of price weakness.  Recovery after the popping of the dot-com bubble lasted till the fall of 2006.  In January 2008, just over a year after the end of the last recovery, another downward crossing below the 25 month average occurred.  Later on that year, it got really ugly.

As the saying goes, we can’t time the market.  However, we can listen to the market.  For the fourth year in a row the bond market continues to set records.  The issuance of investment grade and higher risk “junk” corporate bonds has totaled $1.2 trillion so far this year.  Ahead of a possible rate hike by the Federal Reserve this month, Wednesday’s single day bond issuance set an all time record. The reason for the high bond issuance is understandable – companies want to take advantage of historically low interest rates.  The demand for this low interest debt is a gauge of the long term expectations of low inflation.


The Purchasing Manager’s Index presents a somewhat contradictory note to the recent volatility in the stock market.  The CWPI, a composite of the manufacturing and services surveys, shows strong growth.  The manufacturing sector has weakened somewhat.  The strong dollar has made U.S. exports more expensive.

On the other hand…the ratio of inventory to sales remains elevated at 1.37, meaning that merchants have 37% more product on hand than sales.  The particularly harsh winter was unexpected and hurt sales, helping to boost inventories.  Five months after the winter ended, there should have been a notable decline in this ratio.

Has some of the strong economic growth gone to inventory build-up?


In  the blog links to the right was an article written by Wade Pfau on the mechanics of income annuities.  Even if you are not considering annuities, this is a good chance to expose yourself to some basic concepts about these financial products.


September 6, 2015

I am not going to say a lot about the August employment numbers, reported at 173,000,   since August’s numbers are routinely revised.  The BLS survey was 20,000 less than the ADP survey of private payrolls.  The revised figure will probably be closer to 210,000 jobs gained in August.  We can see the more important trends when we look at the annual job gains averaged over 12 months.

The slowdown in China and other markets and the selloff in markets around the world inevitably prompts talk of recession.  Since WW2 there has been only one recession – the one that followed the 1973 oil embargo –  that occurred when monthly job gains were above 200,000.   There have been 12 recessions since WW2. The work force was very much smaller fifty years ago.  There has been only one exception to this “rule” and when we look at this exception in closer detail we see that it was very much like the prelude to other recessions. Averaged monthly job gains were declining sharply as they do before every recession.  Job gains are NOT declining sharply today.


Resource Countries On Sale

Monday came the news that the Canadian economy was officially in recession.  California, the most populous of fifty U.S. states, has two million more people than all of Canada, whose economic vitality relies on its vast stores of timber, oil, gas and minerals.  Australia, Russia, Norway and New Zealand also ride the roller coaster of commodity prices. (WSJ article )  An ETF that captures a composite of Canadian stocks, EWC, is down almost 30% from its high of August 2014.  The 50 week (not day, but week) average is about to cross below the 200 week average.

These long term downward crossings are often bullish, indicating that prices are near a low point in the multi-year cycle.  An ETF composite of Australian stocks, EWA, is down a bit more than 30% and its 50 week average just crossed below the 200 week average.

A Vanguard ETF composite of energy stocks is near the lows of 2011.

Subprime Mortgages

Conventional wisdom: subprime mortgages started the recent financial crisis in 2008.  A recent National Bureau of Economic Research (NBER) analysis (A short summary ) of home foreclosures overturns that misconception.  The authors found that twice as many prime borrowers lost their homes to foreclosure as subprime borrowers.


In 2007, the Social Security Administration estimated that prices would be 20% higher in 2015. Then came the severe recession of 2008-09 and persistently low inflation.  Prices this year are only 15% higher than those in 2007.  Social Security payments will total almost $900 billion this fiscal year (FRED series), more than 20% of Federal spending, and are indexed to inflation.  Low inflation “saves” the Federal government about $40 billion each year when compared with earlier projections.  Sounds good?  Life is a trade-off.  The 60 million (SSA) people who receive social security spend most of it.  That savings of $40 billion is money not spent.  In addition, low interest rates have reduced income for many retirees, who depend on safer investments for an income stream.  These safer accounts, which include savings, CDs, short and mid-term bond funds, have paid historically low interest rates since the Federal Reserve lowered its target interest rate to near-zero (ZIRP) in 2008.