FINANCIAL REVIEW

Fed Should Avoid Knee Jerk Hikes

Sinclair Noe — December 8, 2014

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW – 106 = 17,852
SPX – 15 = 2060
NAS – 40 = 4740
10 YR YLD – .05 = 2.26%
OIL – 2.80 = 63.04
GOLD + 11.10 = 1205.20
SILV + .09 = 16.48

No records today. Energy stocks pulled the market lower; 42 of the 43 energy stocks in the S&P 500 posted losses today. Falling oil prices have also hit exchange rates of energy producers, especially in emerging markets. Russia’s ruble continues to slide, and an index tracking 20 key exchange rates has fallen to levels last seen more than a decade ago, down 10.2 percent this year and headed for the biggest annual slide since 2008. While some developing nations may welcome a weaker currency because it makes their exports more competitive, for others the pace of decline is destabilizing their economies by fueling inflation and eroding investor confidence.

While the International Monetary Fund expects developing economies to pick up next year, it still sees them falling short of their longer-term growth. The IMF predicts expansion of 4.95 percent across emerging markets in 2015, up from a forecast of 4.43 percent this year and compared with average growth of 6.44 percent over the past decade.

Let’s start with a quick recap of Friday’s jobs report. The economy added 321,000 jobs in November, well above estimates, the highest monthly gain since January 2010 and the 10th-straight month above 200,000. Payroll gains for October and September were revised up a combined 44,000. The unemployment rate held steady at 5.8%, matching a 6-year low. The average workweek rose to 34.6 hours, the highest since May 2008. Average hourly earnings rose 0.4%, the biggest jump since June 2013, bringing the annual rate of increase to 2.1%.

And suddenly there was talk about the need for the Fed to tighten monetary policy. The Fed has its own measure of the labor market, a 19-point list of various aspects of the labor market, known as the dashboard; it dropped from 3.9 to 2.9. So, don’t expect a knee jerk reaction from the Fed.

One thing we should have learned is that a recovery in the labor market will likely be tougher than many suspect. The reason why I say that is past performance. Seven years ago, the economy slipped into a depression (small “d’ depression, but nasty enough) and we have struggled to recover; although we have made progress, we do not have full employment, and there is a chance we won’t. Long-term unemployment is still very high, more like the days of the Great Depression. Millions of families lost their jobs, lost their homes, their savings, and more. Young Americans looking for a first job in a career, ended up back in their parents’ basement. Some job skills were forgotten and turned rusty while other job skills never developed. Careers that could have been or should have been, instead jumped off the rails and will never really get back on track.

Estimates of the economy’s potential, the amount it can produce if and when it finally reaches full employment, have been ratcheted lower as the economy was unable to recover. In other words, the severity and duration of the downturn damaged future potential. If you need an example, consider Japan, which has now lost a couple of decades to rolling recessions mixed with lethargic growth. Today, Japan revised third quarter GDP lower to negative 1.9%; the second quarter of contractions; the definition of a recession that has seen private consumption drop, which in turn led to businesses cutting production and capital expenditures. Even aggressive monetary policy has been like pushing the proverbial string.

And just as the Great Depression left lifetime scars, so too the small “d” depression has changed the psyche of a generation. More people are more averse to falling into the old debt traps. Today, The Federal Reserve reported that consumers increased their use of credit in October at the slowest pace in a year, despite more jobs and stronger economic growth. Americans increased overall credit by an annual rate of 4.9%, or $13.2 billion, to $3.28 trillion in October. That follows a 5.7% gain in September and 5% in August. The slowdown follows a four-month stretch from the early spring to the start of summer during which credit grew at an 8% average rate. Credit card debt rose by just 1.3%, while non-revolving debt (things like auto and student loans, grew by 6.2%).

When the small “d” depression hit, it did lasting damage, which has taken an inordinate amount of time to repair and which may never be fully repaired. Now, after the strong Friday jobs report, one of the first things we heard about was what the Federal Reserve will do. If we maintain the current pace of job creation, sometime around the middle of 2015 the unemployment rate will be around 5%, which would point to the Fed raising interest rates. Weighing against the Fed tightening is the very low inflation rate. And the Fed has to balance what might be considered full employment versus low-flation. Again, the Fed is expected to raise rates starting around June, but they might want to wait. Here’s why.

First, the more accurate measure of unemployment is the U-6, which measures underutilized workers; U-6 unemployment rate is 11.4% and dropping, which is still high. As workers are more fully utilized and the labor market gets tighter, the long-term unemployed and discouraged workers are more likely to re-enter the labor market, expanding the labor pool, and effectively creating a floor for the unemployment rate and reversing the loss of potential output brought about by the prolonged period the economy spent depressed. In other words, we are still a very long way from full employment, even as the headline rate gets closer to 5%.

The monetary concern about full employment is that it will result in cost-push inflation; higher wages resulting in inflation. And we started to see a little increase in wages in November, up 0.4%; one month does not make a trend. The other part of cost-push inflation calls for an increase in raw materials. In other words, general price levels rise (which would be inflation) due to increases in the cost of wages and raw materials. But we are not seeing an increase in the prices of raw materials; just the opposite, raw material prices are disinflationary, just look at the oil market, and most of the commodity markets where prices seem to have turned to a secular bear. Also consider that profit margins are so wide right now that it will take several years of stronger wage growth to generate cost-push wage inflation.

And if we get to the point where there is cost-push inflation, so what? The Fed has shown that it can tamp down inflation fairly quickly by tightening monetary policy. The Fed can put the brakes on inflation but they have a much harder time reversing dis-inflation, and they get downright desperate to do anything about deflation. Which is to say the Fed is better at slowing growth than creating growth. So, if the Fed should allow a period of full employment that results in cost-push inflation, so what? It is much better than underutilized the potential workforce. And the Fed might just discover that the natural rate of unemployment is actually lower than 5%, and it would be very glad not to have tightened too soon.

It looks like Congress has come to some sort of agreement on a spending bill. Congressional negotiators will wait until tomorrow to release the legislation which is expected to keep most of the government open through September 2015; the Department of Homeland Security will likely only be financed through February. Republicans are trying to use a funding debate over the agency responsible for immigration to roll back President Obama’s action easing deportation for undocumented immigrants. There are a variety of smaller issues that may or may not be tacked onto the spending bill including a possible repeal of part of the Dodd-Frank financial-services law to allow more swaps trading to be conducted at banks that have federal insurance, which basically means the banksters could continue to gamble with taxpayer money.

The Supreme Court rejected BP’s challenge to a multi-billion settlement related to the 2010 Gulf of Mexico oil spill. BP had appealed the settlement, claiming that it let businesses collect despite being unable to prove their damages were linked to the spill. The company had lost previous appeals in lower courts. Today’s decision marks a major setback for BP, which wanted to reduce the amount of damages it would pay. Plaintiffs accused the company of merely trying to nullify a settlement it had already agreed to. It’s expected that BPP may need to pay an additional $4.2 billion in claims to businesses and individuals affected by the oil spill. So far, the company has paid about $2.3 billion. BP already settled U.S. criminal charges and agreed to pay $4.5 billion in fines related to that. In January, BP will go on trial for penalties associated with the U.S. Clean Water Act. It could pay as much as $18 billion for that.

In economic news: The Congressional Budget Office reports the government ran a budget deficit of $59 billion in November, $76 billion less than in November 2013. Receipts for the month were $191 billion, up $8 billion from the same month a year ago. The government spent $249 billion in November, $68 billion less than a year ago.

This week’s economic calendar report on retail sales on Thursday which should provide more detail on Black Friday and how holiday shopping is shaping up. On Friday we get the producer price index, a look at inflation on the wholesale level; also consumer sentiment will be reported Friday. We’ll also find out more about the labor market with the JOLTS report tomorrow; that report measures job openings and labor turnover, or how many people are leaving current jobs for greener pastures.

We have a few companies reporting earnings this week, including,: Costco, Burlington Stores, Mens’ Warehouse, and Adobe.

Also tomorrow, the Norwegian Nobel Committee will formally award the 2014 Nobel Peace Prize to Kailash Satyarthi and Malala Yousafzai in Oslo. The two were commended for their struggle to secure the right to education for children and young people around the world.