Good News about the US economy

With all the turmoil in global financial markets, there have been positive signs about the US economy.  This morning, the ADP report indicated that the private sector added over 200,000 jobs.  Though the ADP report has not been a reliable predictor of the official employment report, it still reflects a hopeful trend.  In addition, the latest measure of consumer confidence showed significant improvement, though from an extremely weak level to a somewhat weak level.  Also, sales during Black Friday and Cyber Monday increased significantly compared to last year, though as discussed elsewhere, this may not mean that holiday sales will also rise at a similar rate.  Thus, there are some indications that the US economy is improving somewhat; not strong economic growth, but not teetering on a recession.  However, if the situation in Europe leads to global financial contagion, the US economy is clearly at risk.

Response of Central Banks to the European Crisis

Though there is a lot of economic news, the most important news still revolves around the European debt crisis.  As stress in the global financial system increase, major central banks around the world announced a coordinated response to ensure that there is enough liquidity in the financial system in order to avoid a repeat of 2008.  Optimists can be hopeful that policymakers are taking pre-emptive action to avoid a severe crisis.  Pessimists can worry that the situation is dire enough to require a coordinated global response.  Evidence of the seriousness of the situation include S&P's downgrade of major banks, lack of interbanking lending in Europe (reflecting lack of trusts in the European banking system), rising risk premiums throughout the eurozone (record high bond yields in Italy, Spain, etc.), a significant increase in German bond yields (what used to be considered the risk-free benchmark in Europe), high risk premiums on investment-grade corporate bonds in the US, etc.  For more details on how credit has tightened globally, check out the NY Times article, "Crisis in Europe Tightens Credit Across the Globe."  Meanwhile, leaders in Europe have recognized the need for an expanded role for the IMF and ECB to deal with the crisis.  In addition, Germany is pushing for stricter enforcement of budget rules for countries in the eurozone.

Meanwhile, the Chinese central bank announced a reduction in reserve requirements (the amount of despotsbanks need to maintain) for the first time in nearly 3 years in an attempt to bolster its economy.  Clearly, policymakers throughout the world are very concerned about another severe financial crisis and are being more pre-emptive to avoid a repeat of the financial and economic disaster that took place in late 2008 and early 2009.

Black Friday vs. Holiday Sales

Reports indicate that Black Friday sales increased significantly compared to last year, rising 6.6% according to Shopper Track.  What does that indicate about holiday sales and consumption for the fourth quarter of 2011?  Below is a chart showing the growth in Black Friday sales according to Shopper Track and the growth in Holiday Sales according to the National Retail Federation from 2006 to the present, both in nominal terms and adjusted for inflation using the PCE index (in parentheses).  The final column shows the growth in the consumption component of GDP for the fourth quarter:

Year	Black Friday	Holiday Sales	Consumption Q4
2011	+6.6% (+3.7%)	?	?
2010	+0.3% (-1.0%)	+5.2% (+3.9%)	+3.6%
2009	+0.5% (-1.0%)	-0.4% (-1.9%)	+0.4%
2008	+3% (+1.3%)	-2.8% (-4.5%)	-5.1%
2007	+8% (+4.5%)	+2.4% (-1.1%)	+1.2%
2006	+6% (+4.1%)	+4.6% (+2.7%)	+3.8%

Given the above, what do Black Friday sales tell us about holiday sales and consumer spending for the fourth quarter?  Not too much.  Strong Black Friday sales in 2006 were followed by reasonably strong holiday sales while weak Black Friday sales in 2009 were followed by weak holiday sales.  However, the growth in Black Friday sales were a poor predictor of holiday sales in 2007, 2008 and 2010; providing an overly optimistic forecast in 2007-2008 and overly pessimistic in 2010.  Do strong Black Friday sales mean that holiday sales and consumer spending will be strong in 2011?  Only time will tell.

Stress Tests for Banks, More Bad News from Europe, and Weakness in China

Income and Spending: Plenty of news this morning, much of it raising serious concerns, so let's start with "pretty good" news.  After declining for 3 straight months, disposable income adjusted for inflation rose in October.  However, growth in consumer spending slowed down to 0.1%, increasing the personal savings rate to 3.5% (still a very low rate).

Stress Test: Late yesterday, the Fed announced a new stress test for the 31 largest banks.  The test involves determining if the banks will be able to handle various severe economic and financial  situations including (1) a recession similar to 2008-2009 when economic growth shrank in excess of 8% for a quarter at an annualized rate with an overall decline of 5% before beginning a recovery; (2) a worsening of the European debt crisis; and (3) a 52% decline in stock prices over the next year.  Banks that don't pass the test will be required to boost their capital.  The Fed wants to ensure that US banks will be ready for any potential crisis so as to limit the damage to the economy and avoid a repear of 2008.

Europe: Speaking about Europe, add Germany to the list of countries having difficulty selling its bonds.  At an auction this morning, Germany had to pull just over one-third of its bond offering due to a lack of interest (rather than pay a significantly higher yield).  Given that Germany is supposed to be the risk-free benchmark in Europe, if investors perceive risk in Germany, the debt crisis is reaching a new stage.  Meanwhile, the aggregate purhcasing manager's index for Europe continued to indicate a contraction in European manufacturing.

China: Finally, China's purchasing manager's index came in at its lowest level since 2009 (48), indicating contraction in its manufacturing sector.  This raises concern as to whether China will experience a soft or hard landing in the months to come.  Given sluggishness in the US and extreme weakness in Europe, a significant slowdown in China would add to risks to the global economy.

Debt, Yields, and Ratings Agencies

With the failure of the Super Committee in terms of coming up with a deficit reduction proposal, there's some talk as to whether this will lead to a downgrade of the credit rating of the US.  Do investors rely on credit ratings agencies to make decisions as to where to invest?  The experience of the US and Europe help to provide an answer to that question.  When S&P downgraded the US in August, some feared that this would cause investors to shy away from US bonds, leading to a spike in interest rates, but it didn't happen.  Active participants in financial markets, particularly the bond market, do their research before investing.  Investors know that the US budget deficit is extremely high and the national debt is rising at an unsustainable rate.  The downgrade by S&P didn't contain any information that wasn't already widely understood and thus had little effect.

Similarly, the credit ratings of France and Ireland have not been changed recently, but yields on each nation's bonds have changed significantly.  In the case of Ireland, yields have declined quite a bit since the summer, indicating that financial markets are less pessimistic about Ireland's debt situation.  Meanwhile, yields on French bonds have risen considerably, reflecting increased concern about French debt (despite France still having a AAA credit rating).  Clearly, investors make decisions based on their research and don't wait for credit rating agencies to act.

Changes in credit ratings have an impact when they reveal new information about a country's or company's financial condition.  However, the more important issue is the bond market's perception as to the sustainability of a country's debt situation.  Though the US doesn't seem to be at risk in the near term, the debt situation becomes more unsustainable the longer it waits to deal with its deficit. 

Latest Report on GDP

This morning's GDP report surprised on the downside.  Instead of growth of 2.5% in Q3, it's now estimated to have grown by 2%.  The good news is that the primary reason for the downward revision was slower growth in inventories, which subtracted 1.5% from economic growth.  This suggests that firms are being cautious in terms of inventory management, reducing the likelihood of future cutbacks in production (and increasing the chance of slightly stronger growth in Q4).  Typically, one cause of recessions is companies having excess inventories that they need to reduce to get them back in line with sales.  Of course the weak growth in Q3 confirms that the economy was continuing to struggle heading into the end of the year.  After being propped up in Q1 by the payroll tax cut, disposable income adjusted for inflation has declined in Q2 and Q3.  If the payroll tax cut is not renewed for 2012 (resulting in a 2% tax hike for workers, averaging about $1000 per worker), disposable income and consumer spending will be hurt early in 2012, contributing to economic weakness.

Links for November 19

Rather than discuss the implications of the economic news from this week, I'll point you to Bill McBride's summary for the week ending November 18 (Bill McBride maintains the site, calculated risk).  The news for the US economy was generally pretty good, indicating slightly faster economic growth and slightly lower inflation (a nice combination!).

When it comes to thoughtful analysis of the big picture, it's hard to beat Mohamed El-Erian of PIMCO.  He wrote an article for project syndicate yesterday that examines the "Anatomy of Global Economic Uncertainty."  He highlights the role of four interrelated dynamics (1) the need for many governments to get their balance sheets in order; (2) the need for structural reform to promote economic growth; (3) the need for inclusive growth that doesn't worsen income inequality; and (4) the lack of leadership in addressing the changing economic dynamics.

On a more lighthearted note, here's a link to a video from the Daily Show in which a Labor Economist from the University of Texas (Daniel Hamermesh) discusses his research on discrimination against ugly people (the link is from Greg Mankiw's blog).

All Eyes on Europe

There has been some reasonably good news about the US economy in recent weeks (for example, higher retail sales, increased industrial production, and fewer new claims for unemployment), but all eyes are on Europe.  Economists generally think much of the eurozone is or soon will be in recession. The size of the impact depends on how deep a recession takes place.  Economists at Wells Fargo have released a study examining the exposure of each state to the European economy.  More importantly, the debt crisis is beginning to spread, resulting in higher risk premiums for virtually the entire eurozone other than Germany.  MoneyWeek, a financial magazine based in the UK, provides nice charts of bond yields on European sovereign debt, updated several times day.  Not only have bond yields risen for the "hish-risk" countries (Greece and Portugal), but Italy and Spain have seen significant increases and now France is experiencing a spike in the spread of its bond yields relative to Germany, reflecting significant increases in perceived risk (see chart from Bloomberg below): 



The contagion is spreading.  High debt, weak economic growth, and rising yields are a lethal combination for an economy.  There's many more difficult decisions to make and much more pain to come in Europe and possibly elsewhere.

All eyes on Italy

In recent years, the concern was for the debt crisis involving the three little pigs (Portugal, Ireland and Greece); little in terms of the relative size of the economies. A big fear was whether it would be spread to the larger economies of Spain and Italy. Now it's spread to Italy and action needs to take place quickly to limit the damage.

The European Debt Crisis spread to Italy a little fast than some anticipated.  Much has written about it elsewhere (for example, here's a Bloomberg story about the crisis and the impact on growth in Europe), but let's summarize the key issues.  Italy is the third largest economy in the eurozone (behind Germany and France), much larger than Greece and there aren't enough funds currently available to "bail" it out.  Though the Italian budget deficit is "only" about 4% (high by pre-crisis standards, not that high by current standards), it's national debt is about 120% of GDP (very high, second to Greece in the eurozone).  In addition, growth is expected to be very weak for years to come, limiting its ability to finance its debt.  Combine that with a lack of confidence in the Italian government to adequately address the problem (contain debt while promoting economic growth) and you have the next round of the debt crisis.  In recent days, interest rates on Italian debt soared passed the critical 7% threhold.  Each of the other pigs needed bailouts after yields on their bonds rose past 7%.  So what matters is the amount of debt, the cost of financing the debt, and the ability to finance the debt.

Reuters has a nice debt spiral calculator for Italian debt.  You can use it to estimate the policy response necessary to stabilize Italy's debt-GDP ratio given certain assumptions which you can adjust.  For example, if nominal GDP grows by 2.5%, current policy would stabilize debt at its current high level (120%) at an interest rate of 5.6%.  At an interest rate of 7%, it would need to make significantly more budget cuts just to keep the debt from rising (reduce spending on other items in order to pay the higher interest on the debt).

As of this morning, things have stabilized a little as the European Central Bank intervened in financial markets by purchasing existing Italian bonds (it's prohibited from buying new bonds), helping to push rates on some bonds to below 7% (one-year, five-year).  This doesn't solve the problem, but may help to buy a little more time to try to develop a solution.  Meanwhile, Italy was able to auction new one-year bonds at a rate of 6% (compared to market rates of 8% yesterday, but 3.5% at the previous action).  Also, the Italian government is putting approval of its budget on the fast track (try to approve it this weekend) and plans to follow its passage with the formation of a new government.  Unfortunately, this story is still unfolding.

Revisions to Employment Reports: From No Change to +104,000 in August

You may remember the news reports from a few months ago of no change in jobs for the month of August, the first time in more than 50 years.  However, that number has been revised twice and now shows an increase of 104,000 jobs! 

A change of 104,000 seems large, but the number actually estimated is total employment, which changed by less than 0.1%, which is a very small change.  However, since people pay attention to the change in employment, it looks like a big number (104,000).  Why are there revisions?  The numbers are based on a survey and like any survey, some responses come in late.  If the late responses differ significantly from earlier responses, the estimated amount of employment may change  (for example, the late responders show significantly more job growth than those that responded on time).  Also, there’s something called the birth-death model which is designed to capture the effect of new businesses being created and existing businesses disappearing.  They used to adjust the model once a year, but now adjust it quarterly, so revisions are incorporated more quickly.  Most significant revisions take place at turning points in the economy.  For example, at the beginning of the Great Recession, the existing birth-death model was overly optimistic, reflecting the pre-recession behavior of the economy. The revision for August was historically high (higher than just a handful of revisions outside of turning points).

So the numbers are subject to revision and a minor revision to overall employment (such as 0.07% in August) appears to be large when one looks at the change in employment.  For more information on revisions to employment data, click here.

October job report

There was some good news in this morning's job report despite the number of jobs created being below expectations (80,000 vs. a consensus expectation of 100,000).  Revisions added about 100,000 jobs to prior months with private sector employment in September now estimated to have risen by 191,000.  Beneath the surface, there is better news in October, though it only reversses weakening from recent months.  For example, those working part time for economic reasons declined significantly in October, but that just offset the increase in September. Also, those working full time has risen by about 900,000 in the last 3 months.  However, there has only been an increase of 3000 full-time jobs since March; thus the gain in recent months reversed the decline that took place in the Spring.  Similarly, the decline in the employment-population ratio that took place in the Spring has been reversed, but it still remains near a 30-year low of 58.4%.

The report seems to confirm what has been seen in other data.  The economy slowed down considerably earlier this year, causing not only a slowdown in job creation, but also a reduction in hours for many workers (a shift from full-time jobs to part-time jobs).  Since the summer, economic growth increased somewhat, leading to moderate growth in employment as well as restoring the number of hours worked that had previously been reduced.  the big picture is that the economy continues to experience a sluggish recovery with modest job creation and little change in the unemployment rate.  The good news is that the US has added 2.27 million jobs since February 2010.  The bad news is that there are still nearly 6.5 million fewer jobs than before the recession.

Update on Greece and Europe

The situation in Europe is changing quickly today.  In the aftermath of yesterday's meeting with European leaders, Greece has now moved up the date of the proposed referendum on the bailout package to December 4.  As discussed in a post yesterday, the original date in January didn't make sense since Greece needs part of the bailout in December and, without agreeing to the plan, it probably wouldn't receive any funds.  However, it now appears that the Greek government is may fall, leading to new elections.  If this takes place, there won't be a referendum and things will be on hold until a new government is put in place.  Depending on who runs the next government, new negotiations may need to take place to revise the proposed bailout.

Meanwhile, there is increasing evidence that the eurozone economy is slowing down with more countries probably entering a recession.  In response, the European Central Bank (ECB) made a surprise cut in its benchmark interest rate.  This was the first meeting under the new chair, Mario Draghi, and may reflect a more balanced approach to monetary policy than that under his predecessor, Jean-Claude Trichet.  Whereas Trichet was rigid in his interpretation of the ECB's inflation mandate (keeping inflation close to 2%), Draghi appears to have a more flexible interpretation of the inflation mandate.  I will discuss the differences and how it relates to the Fed's approach to monetary policy in a future post.  In practical terms, the ECB is likely to implement more stimulus in the future as it tries to limit any downturn in the economy of the eurozone while also keeping inflation under control.

update: Greece has scrapped the referendum after the Prime Minister obtained the backing of the opposition party for the bailout proposal.  Next up is a vote of confidence in the government on Friday.

Fed's policy decision

The Fed didn't make any changes in policy; leaving in place Operation Twist, reinvestment of interest on US Treasury bonds into mortgage-backed securities, and reiterating that it expects economic conditions to warrant exceptionally low interest rates through mid-2013.  A couple of items of note in the FOMC statement are that economic growth did pick up somewhat in the third quarter, but that "there are significant downside risks including strains in global financial markets."  In other words, it's paying close attention to what's going on in Europe and how it's affecting the global financial system.  In addition to its statement, the Fed released its latest economic forecast (actually, the forecasts of the 12 regional Fed districts).  Economic growth is expected to pick up slightly in 2012 (2.5-2.9%) and increase further in 2013 (3-3.5%), resulting in a slight decline in the unemployment rate to 8.5-8.7% by the end of 2012 and 7.8-8.2% by late 2013.  Inflation is expected to moderate in the coming years, with both core and overall inflation coming in at 2% or less through at least 2014.

Is there any big news coming out of the meeting?  Not really.  The Fed's forecast is now inline with those of private forecasters (it updated its forecast months ago but didn't make it public until today).  If its forecast holds true, the Fed will probably continue its current policy, so QE3 or any other significant easing is unlikely, barring a surprise.  What could go wrong?  The Fed remains quite concerned with what's going on in Europe and is prepared to act in the event that the European debt crisis significantly hurts the US economy.

Greece - Now What??

Just a few days after agreeing to a deal, the Greek Prime Minister announced that he plans to hold a referendum on the deal, probably in January.  Other European leaders as well as financial markets were caught by surprise, leading to renewed concern about whether Greece would experience a disorderly default.  The latest estimates are that Greece needs funding by December, otherwise it may have difficulty making debt payments.  Obviously, delaying approval of the agreement until January poses a problem.  In addition, it is generally agreed that if the vote to approve the deal was held today, it would fail.  Prime Minister Papandreou is counting on convincing Greeks that this is the best deal possible and is essential to helping Greece make it through the next few years.  In the short term, two key events stand out.  European leaders are meeting today (Wednesday) to discuss the situation.  On Friday, the Greek parliament is going to have a vote of no confidence.  The Prime Minster's party holds a 2-seat majority and, if he loses the vote, the government will fall and elections for a new government will need to take place.  The likely result would be continued uncertainty until a new government is in place.  How will financial markets respond to such an event?

How risky is Greece?  The yield (interest rate) on one-year Greek government bonds is 227% (note: the yield on the one-year US government bond is 0.1%).  The question is whether there will be an orderly haircut or disorderly default by Greece and how will that affect the global financial system.