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Thursday, June 30, 2011

Ho-Hum Thursday

NACM Update. This sounds a cautionary note. The strong drop in favorable indicators on manufacturing is not that good a sign. Both the combined index and the manufacturing index are negative this month, although the decline is much, much less than last month's reading. Indications of financial stress remain, but at least one can say that this month's survey does not show a cartwheel into disaster. We will have to see how this shapes up over the summer. Since April, the index of favorable factors for mfrg: 62.7 > 59.5 > 56.9. This should be strongly associated with production pace.

K.C. Update: This one rebounds as well, hardly surprising since it is strongly correlated to Chicago PMI. Inventory build, but production, etc, go back to April levels. Below March, but a recovery from May's unhappiness.

Update: I KNEW THERE WOULD BE A PONY IN HERE SOMEWHERE. Chicago PMI. Inventory cleared, and it probably is mostly on autos. There is a large rebound in headline, employment is growing but at a slower pace, and order backlogs fell to SA negative territory at 49.3. Still, as long as inventory is cycling through there is no need to panic and run screaming. This report is quite consistent with slowing growth trends in manufacturing, but not collapsing growth trends. A huge distinction. End update.

Well, at least it's no worse.

Initial claims advance was 428,000 from last week's unrevised 429,000. The four week moving average for initial claims moved up slightly to 426,750. The four week trajectory is 430,000 > 420,000 > 429,000 > 428,000. For a series so volatile, this is oddly consistent. There don't seem to be any distorting effects in here - it just is at this pace.

The pace suggests weakness in the job market this summer, mostly in services. Services tend to be more stable employment so that is probably why the series is so oddly even at this point. Nothing ever happens quickly in services, but jobs lost tend to take a long while before they are replaced, so that is not necessarily a good thing.

Later today Chicago PMI comes out, followed by K. C. Manufacturing survey.

Since we have indications of service weakness (concentrated in service directly to somewhat strapped consumers, with some residual weakness in services to state and local governments), I am watching the inventory portions of the manufacturing surveys with great attention. The natural response to building inventories is to scale back production, and if we see enough of a scale back conjoined to enough weakness in services, that will put us into a contraction cycle. The actual mechanisms causing a contraction cycle don't develop quickly - by the time it is overt you usually are six to eight months into the contraction cycle. Specifically, what I am looking for in these surveys is this progression (from May Chicago PMI):

Many analysts are predicting a better economy, but in reality it will all depend on inventories.

Ford made cheerful comments about car sales later this year, which is encouraging, although Ford also said it did not expect June sales to be all that great. Weakness in car sales is one of the factors that tends to push the economy into a contraction cycle, so I am waiting for June car sales in great anxiety. Ford did pretty well last month compared to GM. Ford's production lines are running all out.

My view can best be summed up by the observation that I am seeing a spate of absurdly optimistic economic projections. For example, Germany's economy is, by most standards, doing just great, with unemployment continuing to drop to a multi-decade low. But in May German retail sales fell 2.8%. German inflation is around 2.4% currently - households are just tight on energy costs, which now include electricity costs from Germany's foray into wind and solar power, which are jacking up German household's utility bills.

This is a regressive trend - most wealthier German households can install solar panels, which carry such a huge feed-in subsidy that they can essentially exempt themselves from this portion of inflation. So household that can do this have done it in great numbers - the revenue stream is guaranteed for over a decade. But the poorer households end up paying for it because the tab for extremely costly electricity generation is distributed on all their bills.

Expectations of some sort of surge in consumer spending on gas prices in the US are idiotic. It's not going to happen; in fact gas prices hugely rebounded yesterday on currency trends. Inflation is also raising auto prices in the US along with everything else, and I think affordability is one of the factors in what seems to be a somewhat weaker sales trend there.

Australia will probably raise rates next. ECB may not do it in June, but probably will by the fall. China is fighting its inflation war with little success to date, so it is letting its currency rise to help with import costs. This is not going to work out all that well for China, because most Chinese inflation is internally sourced at this point. The Fed ought to start raising US rates, paradoxically it would improve our economy in the short term. But it is too dangerous - the Fed does not have the guts to try it.

Given the global situation, commodities cannot adjust downwards significantly in pricing, but must continue to press on real incomes. So economic growth varies pretty much in proportion to each economy's individual consumption/production balance. The only short-term fix for the US is to raise interest rates, which will both suppress commodity pricing by making it more expensive to play in the market and adjust away some of the currency effect now very obvious in dollar-priced commodities.

Not to mention it might give retirees some income on their savings, and provide an incentive for banks to lend...
Neil - Oh, no, we wouldn't want retirees to have income. They'd pollute with it.
Rates can't be raised 'by fiat' unless there is a corresponding increased demand at the long end of the curve. Unless this condition is met raising short rates would simply flatten the yield curve, and we'd get a flat (er) curve anchored at the short end at some positive value, which would go very badly wrong.

Long duration demand can only really come from government borrowing, mortgage borrowing and very long term debt issuance which is not very liquid.

All the above are set to fall, so rates, while they could be raised for a short while as a token gesture can't be sustained at levels above actual demand for borrowing, since market rates (e.g. what savers could actually get for their savings as opposed to what the CB says they should get) would simply fall below the official rate.
Liminal - I agree absolutely that rates can't be raised above the market. The Fed is really only powerful when it gets out ahead of where the market has to go anyway.

Nonetheless, if you look at the movements in rates today (anticipating the end of Fed purchases, plus other factors), you see long rates rising.

There is space to raise rates; at these inflation rates, there is ample space to raise effective rates.
Agreed MOMA! If they had a reality TV show called Fed Chairman for a day...and I won it. I would put the Fed Funds rate up to 2% first thing in the morning. Sure there would be lots of moaning from the zero-interest rate carry crowd but the benefits to the real economy far out-weigh their losses. Heck the oil moving back to $60 alone would be worth it. Though Obama might get re-elected, so that would be a negative. And if it took out a TBTF bank in the process, that would just be icing on the cake...Anon
And Liminal - if you think about it, the Fed has exerted heroic efforts to dry to drop rates below the market.

They just halted the AIG auctions, which were giving the market collywobbles. This situation is unstable, and it's largely because the Fed has decided to do something that defies the market.

There is a snap-back potential I just don't like, even with the ongoing reinvesting of the bond payouts each month. The Fed is still buying.

I hate to see this sort of situation develop, because it generally indicates future losses.
"There is space to raise rates; at these inflation rates, there is ample space to raise effective rates."

That is pure opinion. Where is the evidence?

Inflation arising from factors other than wage increases cannot be addressed with interest rates.

There are undoubtedly many other policy options that could mitigate inflation but in the current scenario interest rate manipulation won't help.
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