Thursday, October 29, 2009

Third Quarter GDP: Cautious Optimism

The third quarter real GDP report that showed an annualized rate of growth of 3.5% has been widely described so far as "stronger-than-expected" and confirming that the recession is indeed over.

The first such assessment is of relatively limited material value (as today's number was only an advance estimate which is is almost always revised, at times appreciably, in the two subsequent months), while the second simply makes something that had already become pretty evident, simply even more so.

The true importance though in the Q3 GDP data lies in their composition, which shows a number of elements coming together to provide some reason for optimism.

It is the combination of a 3.4% rebound in personal spending, a much slower pace of inventory liquidation (making inventories a net contributor to Q3 GDP by 0.9 percentage points), a modest 1.1% gain in residential construction, and a 2.3% increase in government spending that give a preview of an economic recovery with the potential to gain traction in the next couple of quarters. Sure, personal consumption was boosted by a surge in spending on durables ("cash-for-clunkers"), and the gain in government spending reflects the fiscal stimulus program still very much in the pipeline. But somewhat artificial as these two sources of vigor in Q3 may seem, those programs were originally designed precisely to ignite the first sparks of a self-sustaining expansionary dynamic- and they seem to be playing that role well for the time being. That conclusion is reinforced by the fact that the "cash-for-clunkers" program continued to drive inventory levels lower last quarter, therefore setting the stage for a pick up in auto production in the next few quarters.

Even capital spending that had posted alarmingly steep declines in the previous three quarters (-19.5% in Q4 2008, -39.2% in Q1, and -9.6% in Q2), fell by only 2.5%, suggesting that the earlier retrenchment has probably already run its course.

As we have argued before, the various components of GDP and overall pattern of growth can be somewhat muddled around the inflection point of the cycle and this is likely to be validated again in the current quarter, where the unwinding of the "cash-for-clunkers" program could cause personal spending to be flat or even negative. Some of that will be offset by an even stronger contribution to growth from inventories and a small pick up in capital spending.

At this early point, a 2.0-2.5% annualized growth rate for Q4 is not an unreasonable estimate.

Anthony Karydakis

Tuesday, October 27, 2009


The issue of whether monetary policy is an appropriate tool to try to burst asset bubbles, or prevent them from actually forming, has been the subject of an ongoing debate since the meltdown of the stock market in 2001 and the most recent nosedive of the housing sector and its well-known by now devastating implications for the financial system and the economy. In that context, Alan Greenspan's infamous "hands off" approach has been called sharply into question in the last couple of years and a steadily growing chorus of policy-makers seems to realize the need for central banks to find ways to better contain asset bubbles.

This issue is now pushing to the forefront of both markets' and analysts' attention, as a number of central banks around the world are already moving to tighten monetary policy (Australia, Norway), or gearing up to do so in the foreseeable future. The motivating factor for such an approach is ostensibly a concern that asset bubbles are forming anew in some countries, fueled by the unprecedented amount of liquidity that had been previously injected into their financial systems in the context of dealing with a major financial crisis.

The thinking that naturally flows from that (also reinforced by the realization of how damaging inflated asset prices can be if left unchecked) is that central banks are now on the lookout for early signs of such bubbles forming and, therefore, quicker to switch to a tightening mode to avoid repeating past mistakes. This would presumably apply to the Fed as well, given that the rebound in stock prices since March has been viewed by some- unjustifiably- as excessive.

If things were only that simple...

Central banks of the major industrialized economies (U.S., Euro area, U.K.)- which have, suffered the most from the recent financial crisis- have extremely limited room for maneuver in the midst of the ruins that the events of the last two years have left behind. These economies are only now to starting to emerge from the sharpest economic contraction in many decades and with financial systems which have, to varying degrees, been deeply scarred by it.

It is unrealistic, bordering on plain naivete, to expect any of these central banks to engage in pre-emptive strikes against the potential risk of an asset bubble in their system, in the midst of a generally expected moderate and halting economic recovery, underpowered by far-from-stable banking systems. Those central banks simply do not have that luxury, as their paramount concern remains to ensure that the economic recovery gains some traction first. As a result, their hands are essentially tied by the harsh realities of a complex and unforgiving environment that shows little respect for theoretical economic models or abstract concepts of preventing bubbles. This predicament is probably more applicable in the case of the Fed and the Bank of England and, perhaps, slightly less so in the case of the ECB, which has at times shown signs of and impressive, and calculated, imerviousness to seemingly desperate needs of the Euro economy.

The central banks around the world that can afford at this stage to consider tightening policy out of fear of emerging bubbles domestically are those of countries with overall sound banking systems, and economies which (as a result of the latter) are already showing credible signs of an economic rebound that cannot be derailed by any tightening action in pursuit of bubble containment.

In the U.S, irrespective of what the stock market does in the next few months, the Fed can only limit itself to the frustrating role of a passive observer, as it cannot go after it in an attempt to implement lessons that may have been learned from the experience of the last decade (assuming that such lessons are pointing to some sort of clear and useful policy action, in the first place- but this will be the subject of another article).

In other words, the Fed may still not be in a position to do much about any bubble formation in the foreseeable future, as it operates within an environment that is decidedly not under its own control.

To recite a major political philosopher of the 19th century, "Men make their own history but not in circumstances of their own choosing".

Anthony Karydakis

Saturday, October 24, 2009

U.S. and Europe: The Tale of Two Labor markets

By most measures, the recession in the Eurozone countries has been at least as devastating as in the U.S. In fact, GDP is expected to contract by at least one percentage more in the Euro area in 2009 compared to the point estimate of about -2.5% currently used for the U.S. Still, despite the more severe loss of output, the unemployment rate in the Euro countries has risen much less dramatically than in the U.S.

Since the beginning of the recession in the U.S. in December 2007, the unemployment rate has doubled from 4.9% to 9.8% last month. In the Eurozone, during that period, the unemployment rate rose from 7.3% to 9.6% last month. The explanation for that seeming paradox lies in the vastly different structure of the labor markets in those two major economic entities.

To start with, labor mobility in the Euro countries is much lower compared to the U.S., largely due to cultural differences related to the premium Europeans place on the "quality of life" concept. In other words, a Paris-born and bred employee who recently lost his job is highly unlikely to relocate to a medium-sized, provincial city simply because of a job opportunity there, although staying in Paris would prolong his period of unemployment. This obviously leads to a higher "core" in the unemployment rate in the Euro countries compared to an economy like the U.S. where a high degree of labor mobility is the norm.

More importantly, though, the famous social safety net that countries in the Eurozone provide to their citizens- which is the pride of Europe and often a source of scorn in this country- creates a very different dynamic in the functioning of the labor market there vs. here. Precisely because labor laws are structured to offer a fair degree of protection to employees during periods of hardship, it is more difficult for employers in the Euro area to lay off employees during an economic downturn, as there are significant benefits and other compensation that need to be given to those that are laid off. As a result, it is costlier for employers to fire workers compared to the more bare bone benefits provided to laid off employees in the U.S., and companies in Europe often tend to hang on longer to their under-utilized employees until an economic turnaround occurs.

The flip side of that dynamic is that those same employee-friendly labor laws that make it more difficult and expensive to lay off workers in the Eurozone make companies think long and hard before they proceed with a more aggressive pace of hiring when the economy turns around, as expanding their number of employees during the good times may imply a higher burden when the cycle turns sour again.

The implication of those differences in the structure of the labor markets is that in the down part of a business cycle, the unemployment rate in the U.S can shoot up past that in the Euro area and that is exactly the situation currently. This gap is likely to persist over the next six to twelve months, as the relatively moderate economic recovery in both the U.S. and Eurozone is unlikely to lead to a significant pick up in hiring in either economy. However, over a 2- to 4-year horizon, the unemployment rate in the U.S. will most probably decline faster than that in Europe, confirming the familiar pattern where the Euro countries experience an overall higher rate of unemployment than the U.S. during the more mature phase of the business cycle. (This was also reflected in the 4.9% unemployment rate that the U.S. had just prior to the latest recession vs. a 7.3% unemployment rate that prevailed in the Euro area ta the same time).

Still, it is questionable whether, as this economic expansion unfolds over the next few years, the unemployment rate in the U.S. can move that sharply below that of the Euro zone, as GDP growth in this country may fall behind that of previous economic expansions, therefore failing to reduce the unemployment rate as sharply as in the past. In other words, it is an open question as to whether the U.S.unemployment rate can decline again, over the medium-term, in the 4% to 5% range. If the latter were indeed not to happen again in this new cycle., then the social safety net that protects workers in the Euro zone so much better during the difficult economic times will then also be causing less harm compared to the U.S., when the good times are rolling once again.

Anthony Karydakis

Thursday, October 22, 2009

Layoffs Are Still Slowing

Despite a small increase by 11,000 in the latest week's initial unemployment claims data reported this morning, the cooling trend in layoffs remains practically intact.

New filings for unemployment benefits (not to be confused with the total number of people actually receiving unemployment benefits) currently stand at 531,000, which is sharply below the peak of approximately 670,000 reached in the first quarter of the year. Given that this is a notoriously noisy series (probably an even worse offender, in that regard, than the famously volatile monthly nonfarm payrolls data), the only sensible way to interpret it is on a 4-week moving average basis. The latter measure was essentially unchanged at 532,000 in the latest week, sustaining the seven-month old downtrend of the series. Still, despite this decline, weekly initial claims still have a long way to go before they returned to the level prevailing just prior to the beginning of the recession, which was around 350,000.

Source: Bloomberg, Haver Analytics

There is practically no correlation between the weekly claims numbers for a certain month and the nonfarm payrolls data for that month, as the sources of the two series and methodologies used are vastly different. More importantly, though, initial claims provide us information regarding layoffs, while nonfarm payrolls are the net result of both layoffs and hiring. Both series have shown a significantly more encouraging trend in recent months. Ultimately, with the downtrend in claims continuing, a moderate acceleration in the pace of hiring cannot be too far behind.

Anthony Karydakis

Tuesday, October 20, 2009

Nothing Wrong With the Stock Market

In a world of 24/7 cable news, the rally in the stock market over the last several months is often described by various self-proclaimed experts as suspect, unjustified, and unsustainable, given the broader economic environment we are in. Such a downbeat take, which is meant to raise alarm bells and the audience's anxiety level, certainly helps ensure some extra face time of those "analysts" in front of the cameras. The only trouble is that they are misguided and, most probably, wrong.

The seemingly dire assessment of the current state of the stock market and its medium-term prospects is based on a potent mix of a half-truth and lack of understanding of what is historically an essentially normal behavior of the stocks for this phase of the business cycle.

The half-truth in question is that those who are skeptical of the stock market's performance are focusing exclusively on the fact that prices have risen by approximately 40% (S&P 500) since March. This disguises the reality that March was actually the absolute bottom of a very sharp decline in the midst of a major recession and broader financial market turmoil, and that stock prices are still about 45% below their level of two years ago. In other words, yes, the stock market's rebound since the spring has been impressive, but from an extremely depressed level and has only recouped less than half of the losses it had suffered in the prior 18 months or so. Some perspective is always useful.

The other critical part that seems to be missing from the analysis of those who doubt the legitimacy of the stock market rally this year is that, historically, stock prices start rallying in the middle of a recession, with such a turning point preceding an economic recovery by roughly six to twelve months. This is only reasonable, as with most of the bad news associated with an economic downturn having already been discounted as the market takes a dive in the early phase of a recession, prices subsequently start looking ahead at the prospect that an improvement in the overall environment is not too far down the road; recessions do ultimately end.

With the prevailing view currently that the emerging economic recovery is likely to be of the moderate kind, there is little reason to believe that the stock market has incorporated a radically more optimistic scenario into its recent behavior. It is simply staging a rally in anticipation of an already steadily materializing end of a particularly dark period for both the economy and financial markets.

None of this suggests that stocks cannot experience temporary setbacks in the period ahead, as market perceptions about the tone of the economic recovery will inevitably oscillate. Markets, after all, do go up and down, while they may still be in the midst of a broader trend. But there is nothing to suggest that, against the realities of the current economic environment and its medium-term prospects, there is something fundamentally wrong with the behavior of stock prices so far this year.

Anthony Karydakis

Friday, October 16, 2009

The Sweet Payoff of Prudent Policies

In surveying the economic landscape around the world, three countries stand out in terms of showing credible signs of having shaken off the recent misadventures of the global financial system with minimal damage and are already well on the way toward a solid comeback: China, Australia, and Brazil.

On the face of it, the structure of those countries' economies could not have been more different: China is -for all intents and purposes- a state-controlled economy, while Australia's falls squarely in to the group of developed, free market-oriented, industrialized ones. As for Brazil, its economy is powered by a hybrid of tightly government-regulated sectors and private sector mechanisms. However, despite their sharp differences, they all had one critical element in common that allowed them to weather the financial turmoil of the last 1 1/2 year quite well and escape relatively unscathed: overall sound banking systems.

In the case of China, the explanation for that is fairly transparent. Banks are government-controlled and essentially implement "guidelines" and policies regarding lending practices and types of assets on their balance sheets issued by the economic authorities and the State Council. This structure, although it did not insulate them completely from some exposure to bad real estate loans once China's construction boom ended, prevented the banking system from getting buried under a pile of toxic assets that caused the near meltdown of the financial system in the West. The result is that, after taking a big initial hit in the immediate post-Lehman stage of the global financial crisis last year, the Chinese economy is already coming back on line and is on track to grow in excess of 9% this year and return to double-digit growth in 2010.

Although the stability of the banking system in a country where the economy remains largely centralized may sound like an unimpressive achievement at first, there was an additional reason for the quick turnaround of the Chinese economy, which deserves considerable attention: the famously "front-loaded" fiscal stimulus package of approximately 4 trillion yuan announced last November. The package was geared toward stimulating domestic consumption, and its highly efficient implementation caused a turnaround in consumer spending by the second quarter of this year, helping the overall economy make a quick comeback. One cannot, at least for a fleeting moment, avoid the sad comparison here with the highly inefficient way the $787 billion fiscal stimulus package in the U.S. has been handled so far, with nearly 2/3 of the funds not having been disbursed yet, eight full months after it was signed into law earlier this year.

Although Australia is undeniably a free-market based economy, part of the tradition in that country has always viewed the government as having the responsibility to take measures to protect its citizens against the pitfalls of the impulsive greed its own corporate sector. Against that backdrop, the banking system in that country has typically been closely supervised and banks never strayed too far from their more conventional role and had very limited exposure to toxic assets. As a result, the Australian economy skirted the global recession and is already on the rebound- so much so that earlier in the month it became the first G-20 economy to raise short-term rates (by 25 basis points to 3.25%) with another hike expected before the end of the year.

Brazil's famously tight banking regulatory environment- that had often attracted criticism in the last decade as burdensome- became the country's savior in the midst of the recent financial crisis.
Although Brazil's economy experienced a major slowdown this year (unavoidable, given that it is a major commodities exporter feeling the brunt of the global downturn), the economy itself has impressed with its resilience and GDP growth is likely to be flat this year with a widely expected return to the 4% to 5% range next year.

President Lula's steadily rising stock as a successful leader on a continent where countries (including his own) had a long history of blowing up in some fashion, received another major boost by the way Brazil handled the global financial turmoil. His sensible, moderate policies, which have consistently resisted a free-for-all brand of capitalism in order to achieve the temporary illusion of faster growth, have been nicely rewarded in the current environment and helped solidify Brazil's standing as an emerging powerhouse on the global scene.

It is hardly surprising that the countries that had a consistently prudent approach to managing their financial system and broader domestic economic policies ( are now the ones that are emerging from the crisis in the best shape. Another such case is Norway, the solid economic prospects of which are now widely expected to lead the Norges Bank (central bank of Norway) to hike short-term rates later this month. Nor is it surprising that two of the G-20 countries that have suffered the most in the last 18 months are those that had banking systems that nearly collapsed under the weight of unfettered free-market, essentially unregulated, raw version of capitalism: the U.S. and the U.K.

One can only wonder whether there is some lesson to be learned here.

Anthony Karydakis

Thursday, October 15, 2009

Two Messages From September's Consumer Price Index

There are two messages to be taken away from today's release of the September CPI.

1) Core inflation continues to show no evidence that would support the concerns of those who argue that there is a considerable risk of deflation ahead. That measure of inflation actually rose a solid 0.2% last month, leaving its year-on-year increase at 1.5%. In the last six months, core inflation has been running at 1.9%, while its 3-month annual rate (by definition, given the shorter period, more prone to noise) is running at a 1.3% rate.

While it is true that the overall CPI is down 1.4% from a year ago (a significantly smaller decline compared to a couple of months ago, when its year-on-year reading was -2.1%), that much less meaningful measure of inflation has still risen at an annual rate of 2.9% in the last six months and 2.5% in the last three months. The reason for the attention-getting discrepancy between the year-on-year reading of the headline CPI and its most recent annualized rates is that the former reflects the dramatic collapse in energy and commodity prices in the second half of 2008, as the global recession was settling in. Those negative year-on-year readings for the headline inflation are likely to evaporate by early 2010. In any event, it is always of course core inflation that matters, and this is, predictably, softening- but not nearly at a pace that could raise the anxiety level over the possibility of deflation.

2) The medical care component of the CPI (representing approximately 6.5% of the total index) rose by a robust 0.4% in September, bringing its year-on-year increase to 3.6%. In the last six months- in the midst of the recession that has generated an overall unmistakably disinflationary dynamic- medical care has risen by 3.6%, with the "hospital and related services" sub-category rising by 6.6%.

This should put to rest any lingering doubt that heath care costs are defying gravity and are disconnected from the broader economic environment and overall price trends in this country, screaming to be brought under control. Credible press reports that (during the unfolding open-enrollment period when employees are selecting their health plan for next year) the cost of coverage is up by double-digit numbers compared to last year, are rounding out the bleak state of spiraling health care costs in this country. Congress has already done a frustratingly inadequate job at addressing the cost containment aspect of health care reform legislation in the various bills thus far in the process. One would only be justified to feel dispirited by the prospect of ultimate success on that front in any final legislation , now that the free-for-all among a myriad of special interest groups has been unleashed to influence the ultimate outcome over the coming weeks.

Anthony Karydakis

Tuesday, October 13, 2009

Reviewing the Latest Evidence

Based on the available data so far, annualized GDP growth is likely to come in close to 3.0% in the third quarter (release scheduled for October 29th). As we have argued before, the GDP numbers do not always tell an accurate story and can, at times, even be misleading, as they are largely a mechanical exercise that can be subject to various distortions. But it is fair to say that a quarterly annualized growth rate of close to 3% is a much more encouraging outcome than, say, a 1 % contraction.

The available information upon which such a GDP estimate for Q3 is currently based is incomplete, as key pieces of data (consumption, residential investment, international trade, and inventory data for September) have not been released yet. On that score, this week's retail sales numbers for September (and any accompanying revisions to the August sales data) will go a long way toward shaping the key personal consumption component for the quarter. Consumption is slated to rebound at a rate of about 3% in Q3, supported, to a considerable extent, by the "cash-for-clunkers" program. A much slower pace of inventory liquidation last quarter is likely to be the other major contributor to growth for that period, helping offset a modest decline in capital spending.

But moving away from the intricate details of the various categories in GDP, the most encouraging aspect of the various economic reports recently is their relative consistency in pointing to a steady improvement in the broader economic environment. The manufacturing sector is staging a comeback (with the ISM having returned solidly to pre-recession levels despite shrinking auto output), consumer spending is perking up (beyond the recent auto incentives program) and initial unemployment claims continue to drift lower on a trend basis. In addition, the economic climate is turning up globally, with the Euro-zone, Japan, and China all showing credible signs of rebounding from their respective troughs.

Skeptics of the legitimacy of the unfolding economic recovery continue to point to the still considerable monthly net losses in nonfarm payrolls (albeit dramatically smaller compared to the early part of the year) and the still tight bank lending conditions as evidence that the sustainability of the recent improvement should be viewed as suspect.

While both of these factors are undeniable characteristics of the current economic landscape, it is important to recognize two things: a) It is a well-established fact that the economic data often tend to send mixed signals at major inflection points of the business cycle, as achieving an unimpeachable consistency in such data is something that takes quite some time to emerge after the trough of the cycle. The mixed tone of the various employment statistics may not dissipate until the first quarter of next year, when monthly payrolls start growing again. b) The bank lending situation is far more likely to have a moderating effect on the forward momentum of the recovery rather than impeding the recovery from taking hold altogether in the first place.

Without underestimating the challenges ahead, quietly, but steadily, an economic recovery is already taking hold.

Anthony Karydakis

Friday, October 9, 2009

Cudos to the Nobel Peace Prize Committee

As the subtitle of this space above suggests, commentary in these pages will be focusing on the "economy, markets, and more". It is in that context that I am presenting the following thoughts, in the wake of the announcement that President Obama has been awarded the Nobel Peace Prize for 2009. (Fair warning: this post is not for everyone).



As the high-decibel media pundit machine is already going on overdrive over the surprise announcement that President Obama has won the Nobel Peace Prize, and the vitriolic attacks against that decision are already piling up quickly, and predictably, by a segment of the political spectrum, it is important to realize a simple fact that often goes painfully unrecognized in this country.

The decision reflects the, at times, vastly different view that people outside this country have of the U.S. than many Americans do.

It is a brave decision that, on the face of it, goes against the conventional wisdom that the Nobel Peace Prize is awarded to someone as recognition of that person's achievement in bringing about peace in a troubled part of the world. By that criterion, Obama was not eligible for that honor. But his being awarded the Prize reflects an incredibly intense appreciation by the Nobel Committee and a large part of the international community, that the U.S. is now turning the page on its recent history of war-mongering around the globe and unconditional bullying and intimidation of other countries that happen to have a different perspective on a certain issue.

It is a decision that expresses the thirst that the rest of the world has to see the U.S. play a constructive and inspiring role in helping resolve the numerous, complex, and often menacing, issues around the globe. It is a decision that shows a deep appreciation for an emerging process of deliberate and rational decision-making on critical global problems, as opposed to impulsive, ill-informed and ideologically-driven decisions by leaders who had shown in recent years a scary and embarrassing inability to grasp- let alone articulate any thinking about anything.

Yes, it is a decision about rewarding hope- the hope the Obama's still young presidency is projecting to many around the globe that the U.S. has a new face and is ushering in a new way of engaging the world.

Rewarding and nurturing that hope, in such a high profile manner, is at least as important, and perhaps more so, than rewarding someone who has already made a tangible contribution toward a peace agreement in a troubled spot of the world. That was the spirit of the Nobel Peace Prize Committee's decision and no one can personify it more than President Obama in these unsettled times.

Anthony Karydakis

Wednesday, October 7, 2009


When PIMCO's super-star CIO, Bill Gross, speaks, the bond market always pays attention. This is so, not only because of the stunning track record he has built over many years managing the firm's flagship Total Return fund but also because of the impressive muscle that the sheer size of PIMCO's funds under management allows him to flex in the fixed income markets.

So, Mr. Gross' latest offering (link below) is that he is buying Treasuries as protection against deflation.


His view, and, by extension, that of PIMCO's, has been recently that the economy is likely to experience a below-trend rate of growth over the next few years- in the vicinity of 1% to 2%-, as a result of a new paradigm that he believes is emerging, which will lead to a historically elevated saving rate at the expense of consumption. Under that scenario, the persistent moderation in the pace of GDP growth over the medium-term will sustain a slack built-up, which may convert the year-long disinflationary trend into a full-fledged deflation story.

This is not a perspective uniquely promoted by Bill Gross, as others have also argued that the rise in the savings rate and consumer de-leveraging since the onset of the current recession will prevent the economic recovery from acquiring a strong forward momentum over the next year or two. It is not, on the face of it, a totally irrational argument either.

The trouble though is the "higher savings rate" argument is not nearly as "clean" as those who promote it seem to assume.

To begin with, history is heavily against it, as the Chart below shows. In nearly all of the past recessions depicted, the savings rate has risen, as a natural defense of consumers in the face of an anxiety-filled economic environment. The trouble is that it has almost invariably tended to resume its secular downtrend (at least since the '70s) once the recession is over, households regain their deeply entrenched spending habits under the advertising blitz of an irrepressibly consumerist society, and everything returns to its old, merry ways. Assuming that, somehow, things will be different this time and consumers will adopt more prudent spending patterns on a sustainable basis once the recession is over, requires a leap of of faith- and not a small one at that.

The other problem with the concept of a savings rate as a gauge of recent, current, or soon-to-be-adopted spending habits is that it is an atrociously revisable series, to the point that such revisions can alter in a major way past impressions and end up portraying, in retrospect, an entirely different picture. For example, the savings rate for 1981, after a series of revisions over the years, today shows as approximately 11% but it was originally reported as slightly over 5% at the time; and this is only one tiny example in a long history of consistently upward revisions that the personal savings rate series has undergone in the last 20 years or so. Against that backdrop, one wonders whether the recent rise in the savings rate (to a still unimpressive 3% to 4% range) is credible, or sustainable, enough to build a longer-term scenario around the premise that there is indeed a new paradigm emerging here.

The final grounds upon which PIMCO's bet can be called into question is whether one can expect the disinflationary trend in the U.S. to continue relentlessly in the face of nearly 2% GDP growth (the upper limit of Bill Gross's anticipated range) and a likely upturn in global commodity prices. The latter would be a reflection of the vigorous comeback of the economies in China, the rest of Asia, and parts of Latin America (most notably, Brazil) as well as a moderate rebound in the Euro-zone. That dynamic does have the inherent potential to stem the slowing core rate of inflation in the U.S. moving forward and cause a reversal of the circumstantial decline in the overall CPI in the last 12 months.

Bill Gross has certainly earned his stripes in a notoriously brutal business over a long number of years and his views, at times against conventional wisdom, always deserve a fair hearing. He has also shown a remarkable ability in the past to keep an open mind and recognize his own "off" calls early enough and change tack before disaster hits- a quality that should earn him even greater respect. It is that latter quality that may ultimately come in handy with regard to his latest bet.

Anthony Karydakis

Monday, October 5, 2009

The 1970s Inflation Experience: An Unlikely Comeback

By Scott Tolep

There is considerable concern in some quarters that, over the medium-term, the US faces a sharp rise in inflation similar to the 1970s.

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This view is based primarily on the fact that the Fed will be unable to remove the massive amount of liquidity from the system before higher inflation becomes entrenched in the economy and inflation expectations adjust upward. This process will undoubtedly require precise technical judgment on the part of the Fed, given the lag between the increase in the money supply and its effects on the economy and the overall price level. However, to suggest that the US will experience 1970s-like inflation may be overlooking the following key distinctions between now and then:

1) The experience in the late 1970s was preceded by nearly a decade of rising inflation stemming from the Fed’s willingness to trade higher inflation for less unemployment. By the time the Fed was given a mandate (in 1979) to control inflation at all costs, the public’s inflation expectations were firmly anchored at a very high level. This led to the vicious cycle of monetary restraint and ease where rates fluctuated within a range of 1,000 basis points between March-1980 and July-1981. In contrast, inflation over the past decade has been in the 2-3% range, longer-term inflation expectations are currently stable, and the Fed’s mandate to maintain price stability is now a well-established policy that has been around for 30 years.

2) The unprecedented shock in oil prices between 1973 and 1980 reinforced the already well-anchored, high inflation expectations. This adversely impacted the Fed’s ability to use monetary policy as a tool in resetting inflation expectations. No one knows exactly where oil prices are headed, but it seems reasonable to assume that when the Fed starts raising rates, it will not follow a 7-year period in which oil prices had increased by 500%.

3) The fundamental outlook on unemployment is different now than it was in the 1970s. Compared to the 1973-1975 recession, there is now a much higher probability for a “jobless recovery”. Capacity utilization rates today are lower, the banking sector is in appreciably worse condition, and households are more likely to save and de-leverage. There seems to be a growing acceptance that going forward, the baseline level of structural unemployment in the US may be in excess of the 5-6% range it has been accustomed to over the past 15 years. After the 1973-1975 recession, unemployment was gradually reduced to pre-recessionary levels. A drive by monetary policy to achieve a similar objective this time around does not appear to be a realistic prospect, which should alleviate some of the political opposition the Fed may face in its decision to withdraw liquidity from the system.

Once the economic recovery is well underway, it is reasonable to assume that inflation will, at least initially, drift above the 2-3% implied target. But predicting a return to the days of 10%+ inflation does not take into account some fundamental differences in the economy and the role of the Fed today as compared to the 1970s.

Mr. Greenspan's "Prediction" and The Media

In an interview Alan Greenspan gave on one of the Sunday morning TV shows, he made the comment that he "suspects" that the unemployment rate will rise above 10% and stay there for a while before it subsequently starts coming down.


This was actually a comment devoid of any insightful content. Mr. Greenspan simply stated something that is widely acknowledged as an extremely high probability outcome (bordering on self-evident) at this point, that is, that the unemployment rate- already at 9.8%- is poised to cross the 10% mark in the foreseeable future.

The unemployment rate is a lagging indicator and the past pattern of its behavior shows a strong tendency of it peaking, by a varying lag, after the end of a recession. The reason for that is that with the first signs of improvement that emerge toward the beginning of an economic recovery, previously discouraged workers that had dropped out of the labor force are coming back, therefore swelling the size of the labor force faster than the pace at which the economy can absorb them.

For example, in the 2001 recession, the rate did not peak until 19 months after its official end, while in the 1990-91 recession, it peaked 15 months after it ended. The 1981-82 recession was somewhat of an exception, as there was a synchronized peak of the unemployment rate with the trough of the business cycle in November 1982. In the highly peculiar recession of 1980, the peak in the rate also coincided with the low point of that unusual cycle. The 1973-75 recession led to a peak in the unemployment rate just a couple of months after its end.

The reason for which, in some cases, the rate has peaked almost simultaneously with the trough in economic activity is that the economy came roaring back at very robust rates of GDP growth (5%, 6% or higher, in the first year of the recovery), allowing it to absorb fully the workers re-entering the labor force. It has already been established that, given the array of headwinds at work, this recovery is not likely to be of sufficient vigor to generate enough jobs early on to prevent the rate from rising.

Mr. Greenspan certainly understands all of that extremely well, as he has always been a diligent student of economic history. In fairness to him, he most likely, did not even think he was making a particularly novel prediction by saying that the unemployment rate will rise above 10%. (True, he used a particularly cautious tone "My own suspicion is that we're going to penetrate the 10% barrier and stay there for a while...", but this can be chalked up to his many years of having perfected a unique brand of impressively careful and convoluted statements, which he evidently has a hard time shedding now).

The somewhat amusing thing is not as much that Mr. Greenspan offered that bland observation about the direction of the unemployment rate, but that his comment has received quite a bit of play in the media in the last 24 hours, financial and otherwise, with headlines of the kind "Alan Greenspan predicts that the unemployment rate will rise to 10%" etc. One simply has to assume that, given the transparent banality of Mr. Greenspan's so-called "forecast", the media either did not recognize that as such or it has been a particularly slow news cycle this weekend that sent them to a desperate search for a "headline".

Anthony Karydakis

Friday, October 2, 2009

September Employment Report: A Few Thoughts

The disappointing employment report- with its 263K decline in September, the small net downward revision to the prior two months' declines, the drop in the labor force participation rate to 65.2% and the dip of the workweek to its cycle-low of 33.0 hours- highlights starkly the obstacles that the fledgling recovery is facing. An uncharacteristically big decline in government jobs last month (-53K versus a long-term trend of an average monthly gain of 10K to 20K) can only serve as a partial explanation for the magnitude of the drop in total payrolls. It was, after all, the sizable declines in manufacturing, construction and service jobs together that accounted for the lion's share of the overall drop.

Since the start of the recession in December, payroll employment has eroded by 7.2 million and, given the current trajectory of hiring, it is quite possible that it will reach the 8 million mark by the time the monthly numbers start turning positive. Still, that seemingly bleak prospect should not be allowed to disguise the key reality that the employment picture has improved markedly in recent months, taking the form of a much slower pace of job erosion. In the third quarter, the average monthly payroll decline was "only" 256K compared to 426K in Q2 and 691K in Q1.

Despite the generally dispiriting tone of today's employment data, it is important not to lose sight of the critical distinction between payroll growth and GDP growth in the next few quarters; the former is not a prerequisite for the latter to occur- at least not for a while. The cyclical rise in productivity that occurs in the early stage of an economic recovery (the result of employers utilizing their existing labor force more intensively at first before they resume hiring more confidently) should be adequate to generate positive GDP growth in the second half of the year and into early 2010. This, provided that hiring will catch up with, and possibly exceed by early 2010, layoffs (therefore, generating positive payroll numbers), should allow for the economic recovery to make a smooth transition into a respectable economic expansion.

There is also an additional factor that allows for that at least temporary disconnect between employment growth and GDP growth to exist. GDP numbers are, after all, a bean-counting exercise; the arithmetic of the whole thing can often play unexpected games. The massive pace of inventory depletion in the first half of the year subtracted an average of nearly two percentage points from real GDP growth in the first two quarters of the year. With inventories having now been much better aligned with sales, they are likely to be an essentially neutral factor for GDP purposes in the second half of the year and early 2010, therefore removing a potent drag on the numerical aspect of economic growth.

Ultimately, a credible economic recovery cannot take hold without payroll employment picking up. But the latter condition is not a necessity for the time being.


Thursday, October 1, 2009

UK Inflation Expectations: Overstated

By: Christopher Hodge
Analyst, Pharo Management

Recently, UK Prime Minister Gordon Brown, and Business Secretary Peter Mandelson announced the extension of the British version of the "cash-for-clunkers" program (, raising the government expenditures associated with this program to £400 million. While this may win the Labour Party some votes in the upcoming election, the increased fiscal obligations resulting from spending of that kind have certainly caught the attention of those concerned with the inflation outlook in the UK.

Inflation expectations have greatly increased with the rampant spending by the British government, and while such massive spending has almost certainly prevented an even more disastrous collapse of the UK economy, the spending is taking its toll on some aspects of the economic fundamentals.

In April, the Treasury projected that in the current fiscal year (ending in March 2010) the deficit will be at a post-war record of 12.4% of GDP, and now even that estimate looks modest. The rise in debt from 2009 to 2010 is the sharpest increase among G-7 nations, and the increase is projected over the medium term as well. In its April budget, the government said that debt will rise to 76.2% of gross domestic product in the fiscal year ending March 2014 from just 36.5% of GDP in the fiscal year ended March 2008 (

There are signs the UK economy is improving, and the IMF announced this week that it expects GDP growth in the UK to be about 1% next year. However, the economy, though poised to show positive growth in Q3, remains fragile and further government spending may be necessary - particularly, in view of an upcoming parliamentary election next spring. While it's highly unlikely that the UK defaults on its debt, investors are concerned that the government may be tempted to decrease the debt burden via inflation.

Evidence of the growing inflation can be found in the bond market, where break-even rates have almost doubled for 10-year bonds since March of this year. (see chart below)

Break-even rates are the spreads between conventional government debt and inflation-protected debt. Higher spreads reflect investors' increased concerns for future inflation. The market is currently pricing the UK inflation-protected bonds at a higher premium than any other G-7 country (see chart below).

Although the recent increases in spending are troublesome, the inflation uneasiness seems overstated by the market. The markets' current pricing of break-even rates, while high, are not unheard of in the UK. The mid-to-late 1990s saw an even greater threat of inflation. Since being granted independence in 1997, however, the Bank of England's Monetary Policy Committee has been quite vigilant in its fight against inflation. In fact, current BoE governor Mervyn King has been criticized for failing to ease monetary policy quickly enough at the onset of the current crisis. Now the market seems to believe that the BoE will miss expectations on the upside. The BoE has had a good track record of being fairly cautious with regards to signs of future inflation and should be trusted as well this time to do the same. To be sure, a watchful eye should be kept on UK deficit spending, but current break-even rates are probably far fetched.