Tim Duy's Fed Watch

On Coordinated Monetary and Fiscal Policy

Note:  This began as an effort to tie together various themes in my writing.  Unfortunately, short and succinct did not work.  So I apologize in advance for the length of this post.

There are certainly trends in my writing.  One is that the Federal Reserve spent much of this year behind the curve by failing to adapt their large scale asset purchase program or their communication strategy to the reality of a persistently weak economy.  The Federal Reserve effectively dealt with that issue at the last FOMC meeting.  

To be sure, I can quibble with some of the specifics, such as a lack of more explicit economic targets and a clear commitment to near term-irresponsibility by allowing inflation to rise above 2 percent when (or if) the economy gathers steam.  On the first issue, I am coming around to the thinking that while explicit targets (other than inflation or nominal GDP) might sound good in theory, in practice trying to tie policy to a constellation of price and output targets risks becoming a communications nightmare.  The Fed needs to tread very carefully on this point; it may be best for them to fall back on that old adage about pornography.  We will know a "sufficient and sustainable" recovery when we see it.

The second issue, a promise to be irresponsible on inflation, remains unlikely as long as the Fed continues to stress it will take actions "in the context of price stability."  I don't view a temporary increase in inflation as necessarily undermining neither the Fed's long-term inflation targets nor a nominal GDP target.  And I think that the failure to make such a promise could very well disrupt a reversion of the economy to pre-recession trends.  This I will discuss further later.

Another trend in my writing is that there needs to be some coordination between fiscal and monetary policy.  Putting aside what I believe will be an aberration in the third quarter, authorities are already engaged in some degree of fiscal austerity:

 

and have effectively promised to do more. Should it even be reached, a compromise to the fiscal cliff will likely still be further austerity.  I think that we should be wary about underestimating the impact of such austerity, especially as it is increasingly evident that multipliers are larger than expected at the zero bound.  Fiscal austerity would likely be a key factor in maintaining the relatively tepid pace of the recovery into 2013.  Moreover, fiscal austerity wastes the opportunity provided by a low interest rate environment.  The Federal Reserve has already promised to buy a steady stream of assets from the financial markets.  All Congress needs to do is sell debt into that stream.  No explicit coordination necessary.

Another issue that I can't run away from is the potentially negative impacts of a sustained zero interest rate environment.  It would be a mistake to believe that monetary policy does not have distributional impacts.  Low interest rates obviously hurt savers:

Moreover, we should be concerned about distortions to the capital allocation process.  Encouraging excessive risk taking now will come back to haunt us later.  That said, it is necessary to balance such negative impacts against the positive impacts.  Nor is it clear that the Federal Reserve is driving this train; the absence of an aggressive monetary policy might very well weaken the economy such that interest rates fall further.  In any event, I am challenged to see how a different monetary policy would be effective; tightening policy at this juncture would likely be disastrous for the economy.  

Finally, another issue to which I have already alluded is a belief that the US economy is on a suboptimal path:

This is obviously controversial.  For example, St. Louis Federal Reserve President James Bullard has repeatedly said there is only one path, and we are on it.  The appropriate monetary and fiscal reaction functions are obviously different in a such a world.  In such a world monetary policy leads only to potentially greater inflation with little impact on growth.

Jumbled as it might seem due to the nature of blogging, somewhere in the background I have a framework that ties this altogether.  And I was reminded by a colleague that I had seen that framework presented by another colleague, George Evans.  The associated paper, "The Stagnation Regime of the New Keynesian Model and Recent US Policy" is here.  

Evans begins with a New Keynesian in which expectations are formed by adaptive learning.  An outcome of the model is that a sufficiently large negative shock can push the economy into a deflationary trap.  Interestingly, agents learn their way into the trap by forming pessimistic expectations of future economic outcomes.  My interpretation is that agents learn to live in what is often called the "new normal" and as a consequence make decisions that ensure the the new normal is a stable equilibrium.  

The model is subsequently modified to account for nominal wage rigidities such that the low equilibrium trap, the stagnation regime, has an inflation floor.  Another characteristic of the regime is low levels of output and consumption in which welfare is potentially much lower than the preferred equilibrium.  

How can we break out of the stagnation regime?  A temporary increase in government spending that is sufficiently large to allow a self-sustaining process to take over.  The economy reaches an escape velocity such that agents learn there way allow a dynamic path to the preferred locally stable, higher equilibrium.  At such a point, government spending can revert to normal without threatening a recession.  

Monetary policy can also come into play, but Evans is less optimistic that the Federal Reserve is capable of breaking the US economy out of the trap.  He notes that even promises of low rates forever may not be enough if the economy has suffered a sufficiently large negative shock.  Evans adds that quantitative easing can support the economy via lowering long-term rates and stimulating demand, but also warns:

An additional problem, however, is that there are some distributional consequences that are not benign. Households that are savers, with a portfolio consisting primarily in safe assets like short maturity government bonds, have already been adversely affected by a monetary policy in which the nominal returns on these assets has been pushed down to near zero. A policy commitment at this juncture, which pairs an extended period of continued near zero interest rates with a commitment to use quantitative easing aggressively in order to increase inflation, has a downside of adversely affecting the wealth position of households who are savers aiming for a low risk portfolio.

There is a lot to digest in a short paper, but I encourage making the effort. 

Thinking in terms of this model, it is immediately clear that one should be very concerned with impending fiscal austerity unless you believed the economy had already reached escape velocity (I don't).  Moreover, you should be concerned about austerity even in context of the evolution of monetary policy into QE3 as it is not clear that the Fed can by itself push the economy to escape velocity.  The Fed is literally stuck between a rock and a hard place, with the stimulative force of lower rates for borrowers traded off against lower income for savers, a point that Ed Harrison often makes.  And the more we lean on monetary policy, the tighter that space gets. Yet we have little choice with a political environment that favors austerity over stimulus.

In addition, one should be concerned about the fragility of any recovery based upon a Fed-induced effort to achieve escape velocity.  This is especially the case if the Fed has not promised (and whether such a promise is credible is another question) to be irresponsible in the transition to the higher equilibrium.  Consider that the CBO projection for GDP growth is 4.8% in 2015.  This, I suspect, is the kind of number needed to achieve escape velocity.  But consider the Fed's reaction function in the face of such growth in the context of 1.) price stability and 2.) internal concerns about the ability to unwind quantitative easing.  I think under those circumstance policymakers would error on the of tighter, faster rather than allowing a temporary acceleration of inflation.

The last paragraph brings up an interesting question.  Even if the Fed promised to allow inflation to accelerate and did so, eventually they would tighten policy just the same.  Which means the same recession, just a year later.  2015 or 2016. 2017 at the latest. 

The problem is that the recovery is pretty much held together by debt refinancing, cheap mortgages and higher asset prices; by such measures, monetary policy has been successful! To be sure, there has been some debt reduction on the part of households:

 

But it is limited in comparison of the ability of households to utilize lower interest rates to reduce the cost of financing that debt:

I think in the near-term those who believe the monetary authority is the only answer will appear correct as the recovery progresses.  Indeed, Annie Lowrey at the New York Times reports that household debt is now increasing for the first time since the Great Recession began.  From a broad macroeconomic perspective, this is a near-term positive, and creates reason to believe that monetary policy will cushion the impacts of whatever flavor of the fiscal cliff we experience.

But I don't think this will be a stable long-term result. Obviously, I could be wrong, but it seems to me that we are using the same trick we have been using since the mid-1980's - lowering debt financing costs, thus allowing for a greater debt burden.  This trick will continue to work as long as there is room to push interest rates further down.  Now that we are at the zero bound in short-term rates and the Fed has been forced to move quite far out the yield curve to implement monetary policy, it is likely this is the last time that trick will work.  There will not be much room to refinance our way out of trouble the next time around.  Hence why I concerned about still being at the zero bound when the next recession hits.

Moreover, I would find it unlikely that we pass through another two or more years of zero interest rates without seeing capital mis-allocations, assets bubbles, and excessive risk taking.  In such an environment, I don't think the Fed is going to be particularly successful in moving the economy off the zero bound without triggering a fresh recession.  

Now, it would be easy to take this as criticism of the Federal Reserve.  It isn't.  The Fed should have moved to open-ended QE long ago to end the problem of arbitrary end dates to policy and needed to clean up its communication strategy to make clear the economic outcomes would define when QE would end.  And, probably most importantly, the Fed is compensating for a dysfunctional US political process.  I know there is one view (see Raghuram Rajan) that the Fed is simply enabling that process.  Perhaps Congress would do the "right" thing if push comes to shove.  But what is the "right" thing?  If Congress were left to its own devices, would it take us down the road of fiscal stimulus sufficient to spring the economy from the stagnation trap?  Or would they continue down the road of additional fiscal stimulus austerity, driving the economy deeper into the trap?  My sense is that Congress would find additional austerity to be the path of least resistance.  Pete Peterson has won.  The Congressional deck is stacked against the economy.  And I think Federal Reserve Chairman Ben Bernanke knows this.

Putting all the piece together, I tend to think that neither fiscal nor monetary policy by itself will support a sustained recovery in which the interest rate environment normalizes and fiscal stimulus can be eliminated without fear of renewed recession.  The two need to work hand in hand; the Federal Reserve has provided the monetary environment conducive to additional fiscal stimulus.  Congress and the Administration now need to take advantage of the environment.  Or, alternatively, if the fiscal authorities are not issuing sufficient new financial assets such that there is upward pressure on interest rates, they need to be issuing more. 

In conclusion, the above framework both praises the direction of monetary policy without discounting concerns about the dangers of the permanent zero bound policy.  A framework that allows for both accepting near-term growth on the back of monetary policy but also concern about the sustainability of that policy.  A framework that decisively rejects additional austerity on a simple basis that it will not help normalize the interest rate environment.   If nominal rates were 8% then yes, fiscal austerity would help normalize the interest rate environment.  But that simply isn't the current situation.  Perhaps, if we are lucky, it will be a problem in the future.

I realize that it would probably be easier if I could find myself either advocating the primacy of monetary policy in determining the level of output or deriding the Federal Reserve for the evils of the quantitative easing.  Or if I could fully embrace fiscal stimulus as the only solution or austerity as the only solution.  Picking one of those quadrant and defending it absolutely would probably make me more friends that straddling all four quadrants at once.  But absolute devotion to one quadrant is probably not the right answer.  I tend to believe that the right answer is a more complicated mix of monetary and fiscal policy than is currently employed.  And don't think we can get to that right mix if we lock ourselves into an ideological box. Hence why I try to avoid such boxes.

Again, sorry for the long post.

Still The Scariest Data

I tend to view the data as being modestly optimistic in that it has generally surprised on the upside of late, enough to drive away fears that the slow patch this summer would evolve into a recession in the near future.  Still, the data has not been sufficiently optimistic to sway me from my general view that underlying growth continues to be slow and steady.  

For example, I would like to see initial unemployment claims make another push lower to cement a stronger outlook:

That said, I remain unsettled by the core manufacturing data, which I would say is clearly in recession territory:

I think this is the scariest near-term indicator at the moment.  Of course, one piece of data in no way makes a recession.  I attribute the decline to three factors.  First, expiring tax credits pulled some investment into 2011.  Second, the drag from international weakness.  Third, uncertainty about the extent of fiscal tightening in 2013.  At least the second, and probably the third, of these three factors is weighing on earnings growth, which in turn has brought the bull market in equities to at least a pause.  From Neil Irwin at the Washington Post:

The CEO mindset on the fiscal cliff has been evident in a spate of third-quarter earnings announcements in the past two weeks. Almost uniformly, company executives discuss the looming threat to the economy, usually offering only vague comments that it has been a drag on their confidence and that they don’t know exactly what a resolution would look like....

...Some of the gloomiest assessments of economic conditions have come from companies that do extensive business overseas. By many accounts, as troubled as the U.S. economy has been in recent months, it looks better than many of its counterparts. 

Yes, sad as it seems, across the globe the US is a bright spot at the moment.  

 Bottom Line:  The core manufacturing data stands out as an aberration.  While arguably a recessionary indicator, it also comes at a time of an improving housing market.  It would be unusual, to say the least, to experience a recession when housing is trending up.  Moreover, I remain skeptical that trade channels are sufficient to trip the economy into recession.  Still, I can't discount the recession threat entirely; to do so would be ludicrous in the face of the looming fiscal cliff.  On average, Congress and the Administration have tended to limp things along, and hence the median bet should be that they will continue to do so.  But all bets wear thin after awhile.  Assuming monetary policy remains on hold (which it will), the degree of fiscal austerity in 2013 remains my chief concern.  

Buyer's Remorse?

Unavoidable work obligations took priority over blogging during the past week.  Of course, blogging or not, the data flow continues uninterrupted.  And the tenor of that data has been generally positive.  In the near-term, the upbeat news will have limited impact on monetary policy.  The Fed will remain committed to the path laid out at the last FOMC meeting.  That said, I have to imagine some of the moderates on the FOMC - those pulled into Federal Reserve Chairman Ben Bernanke's gravity with the softening of data this summer - will be starting to feel a little bit of buyer's remorse, thinking that maybe, just maybe, they pulled the trigger a little too soon.  The doves, of course, should be ecstatic that the FOMC locked in an easier policy at beginning of an upswing.  Rather than threatening to withdraw stimulus at the slightest sign of recovery, now we have a commitment to keep monetary momentum until the economy is clearly on firmer ground. This will be supportive of the upswing in activity.

The death of the consumer continues to be more myth than reality.  The retail sales report revealed that households have shaken off the summer doldrums:

While the year over year trend is not particularly strong:

 

the last three months have packed a bit of a punch: 

While industrial production was up somewhat, the trend over the past year is basically flat:

 

The underlying story, I think, remains two-fold.  First, some investment was likely pulled forward into 2011 by now-expired tax credits.  Second, the global slowdown is also weighing on manufacturing growth.  That said, note that the current scenario continues to look more like 1998 than 2008: 

To be sure, core new orders have been a little unnerving of late, and certainly something to watch.  But this would not be the first time that an external shock failed to deliver a US recession.  For now, I expect that to continue to be the case.

And one reason to believe that the US will escape recession is the obviously improving housing market.  Starts exceeded expectations in September:

And while the gains in multi-family relative to past trends look more pronounced, single-family homes are trending up as well:

Can we attribute September's strength to QE3?  I think it is somewhat of a stretch to believe that builders were sitting around waiting for the go-ahead from the Fed; this is especially true of multi-family housing, a category that requires a bit of lead time before shovels break earth.  Still, I think that you can argue that the build-up to QE3 supported expectations that monetary policy would tend toward easier rather than tighter, reducing uncertainty that the Fed would pull the plug just as new projects were taking off.  

What else can we say about housing?  The Wall Street Journal offered up three views of the data.  First:

This move forward from the bottom was inevitable, says Patrick Newport of IHS Global Insight. “Housing has a self-correcting mechanism — it’s called population growth. Every year, the U.S. population increases by about 3 million, and the number of households increases by 1.1-1.3 million. New homes have to be built to meet demand from this segment. In recent years, housing construction has been depressed, first because of overbuilding during the boom years, then, because the Great Recession forced many Americans to move in with friends and family,” he said.

I agree; the long period of bouncing along the bottom was starting to look excessive.  It couldn't last forever.  Second:

But that correction doesn’t mean that housing is going to lead a broader recovery. “The sector is much less important than it used to be,” said economist Jim O’Sullivan atHigh Frequency Economics, Ltd. “Total residential investment directly accounts for 2.4% of GDP now, down from a 6.3% peak in 2005. Within that, new home construction, the part tracked by housing starts, accounts for 0.9% of GDP now, vs. a peak of 3.9% in 2005.”

True, housing is a relatively small part of the economy.  And I can argue that the emphasis on multi-family units will be yield less of an economic boost compared to single-family housing.  Moreover, I have yet to be convinced that we are on the verge of another price bubble that will swell net worth and trigger a jump in mortgage equity withdrawal.  But, even an additional 0.5 percentage point contribution from residential housing is meaningful when the economy is bouncing along at 2% growth.  I am not expecting miracles, but a recovering housing sector is certainly a step in the right direction.  Finally, we have this:

The housing recovery has materialized, but the strength of that recovery is an open question. “How far can the rebound go with unemployment where it is? From our perspective, not much farther,” said economist Steve Blitz at ITG Investment Research, Inc. “The notion housing will now lead rather than reflect the overall economy is a bit too optimistic. The demographics lean against a national boom in home construction as does the limited availability of mortgage credit.”

Traditionally, housing has led the economy.  I wouldn't bet against it.  Moreover, this analysis appears to assume that unemployment rates stay constant, which seems like something of a heroic assumption given the steady decline in the unemployment rate experienced over the last three years:

Moreover, mortgage credit will loosen up as the housing recovery broadens and deepens.  Lender confidence will improve as prices stabilize.  Ultimately, they want to lend money; it's how they make more money.

I am not sure that the FOMC would have moved on QE3 if the data then was what we are seeing now.  If this data flow continuous - a big "if" considering the propensity of the data to swing from optimistic to pessimistic throughout the course of the year - some moderates will likely question their decision.  But the die has been cast, and will not be shattered easily.  New York Federal Reserve President William Dudley reminds us:

Even over the next few years, while there are significant downside risks relating to the fiscal cliff and the eurozone, it is possible that the recovery could turn out stronger than expected. The underlying process of balance sheet repair is considerably advanced, housing is recovering and, as that occurs, our newly recalibrated monetary policy could gain additional traction. Thus, if uncertainties about the U.S. fiscal path and the future of the eurozone were resolved in a constructive manner, growth could pick up more vigorously than anticipated.

This would be a wonderful outcome. The September FOMC statement noted: the Committee expects "that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the recovery strengthens". Consistent with this, if we were to see some good news on growth I would not expect us to respond in a hasty manner.  Only as we became confident that the recovery was securely established, would I expect our monetary policy stance to evolve to ensure that it remained appropriate to achievement of our objective: maximum sustainable employment in the context of price stability.

For now, price stability is on the side of the Federal Reserve, allowing for policymakers to keep pressure on the gas pedal despite improving data. While the headline CPI jumped 0.6%, core gained just 0.1% in September, suggesting that the headline gains remain a transitory artifact of higher gas prices.  The year-over-year trends are not worrisome:

Remember that CPI inflation tends to run a bit above the Fed's PCE target.  Moreover, note that wage growth remains constrained, limiting the ability of inflationary pressures to spread.  The recovery has room to run before we see sufficient pressure on wage growth to raise the specter of tighter policy.  Note that the Fed's commitment to supportive policy stands in stark contrast to their almost eager desire to shift to tighter policy after previous upswings in activity. In short, Fed policy is ramping up in line with the housing market and the broader economy, hopefully providing the boost that is capable of breaking the economy free of the zero bound.  This bodes well for growth in 2013.

That is, unless Congress lets the economy fall off the fiscal cliff.  No, nothing is written in stone at the moment.  Plenty of things can go wrong with fiscal policy, Europe, war in the Middle East, etc.  The usual suspects.  But for now these are risks, not reality.  I think the reality is that the economy looks a little brighter than just three months ago.

Bottom Line:  I fear becoming too optimistic.  During the recovery, excessive optimism has tend to result in disappointment.  A month of data, after all, is just a month of data.  At the same time, however, the pessimistic story is fading further into the distance.  So far that some monetary policymakers might be having second thoughts about QE3.  But even if they have such thoughts, and even if the hawks start chirping louder, the Fed is now committed to this path. Assuming inflation remains contained, at this point I suspect that we would need to see sustainable growth well above 3 percent in 2013 (the Fed's central forecast is 2.5-3%) before policymakers are willing to consider pulling their foot off the gas anytime soon.

The Disingenuous James Bullard

St. Louis Federal Reserve President James Bullard is making some headlines today.  He fears that inflation expectations are becoming unglued:

Is this happening? Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target. 

He seeks to prove this claim with this chart:

I just can't let this one go.  I honestly don't know if I should laugh or cry.  I have a whole new respect for Federal Reserve Chairman Ben Bernanke if this is any indication of the kind of grief he needs to deal with on a regular basis.

This is disingenuous on two levels.  The first is that TIPS returns are based on CPI inflation, not the Fed's PCE inflation target.  I find it hard to believe that Bullard does not understand the distinction.  Putting the Fed's inflation target on this chart is comparing apples to oranges.  Bullard should know this.  If he does, he is deliberately misleading his audience.  If he doesn't...well, I don't really know what to say about a top monetary policymaker that can't identify the proper inflation target.  

To understand why the TIPS breakeven rate will be above the Fed's PCE inflation target, simply note that CPI inflation tends to run above PCE inflation, on the average of about 44bp since 1990:

The second reason this is disingenuous is the length of the time series. Bullard begins his chart at the beginning of this year, leaving the audience to believe that these high inflation expectations are a new phenomenon.  Again, deliberating misleading the audience.  Let's go to the tape:

Nothing to see here, folks.  Move along.

Bullard starts down this path as a response to suggestions for higher inflation to reduce real debt burdens.  This appears at least partly in response to his realization that the work of Professors Reinhart and Rogoff is not as obviously supportive of his position as he previously believed.  Rogoff has offered up the possibility of higher inflation to address the debt load. Bullard offers a number of bullet points in response:

The partial default would occur against savers, mostly older U.S. households, and against foreign creditors. 

Alas, in economics there is no free lunch. 

A partial default today through higher inflation would be paid for via higher inflation premiums in future borrowing. 

There is an important point here - a partial default will have winners and losers.  But guess what? So will no default, hard or soft.  Just ask the people of Greece (worst of all worlds, partial hard default).  Or Ireland.  Or Spain.  As I said with regard to the Japanese situation:

They are all taxpayers and bondholders.  They take the hit in taxes, spending, or capital position.  The longer they wait to take that hit, the bigger it will be....

...In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once.  But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger. 

Pay attention to the last line; Bullard is already identifying older households as a class resistant to taking a capital loss.  But they are also struggling with low returns.  Now they can't win.  This is exactly the trap Japan found itself in - those who initially lost from the zero bound lose again if they were to exit the zero bound.  The zero bound is a very bad place to be for an extended time.  I don't think the Federal Reserve takes this problem seriously enough.

In short, Bullard wants to pretend that the only costless option is the strict low inflation option.  That's simply not true.  It has a cost as well, in a particular distribution of winners and losers.  A higher inflation target will result in a different distribution of winners and losers that may be more beneficial to domestic residents if, for example, the burden of higher inflation were to fall disproportionately on foreign central banks who have acquired large holdings of dollar assets for mercantilistic reasons (hint, hint).  There is also the issue of using inflation to lower the real rate at the zero bound.

It very well may be the case that the US economy normalizes such that output returns to a level that the fiscal impulse can be lessened and debt to GDP ratios level off and decline while interest rates climb such that the Fed returns to using the fed funds rate as their primary tool throughout the next cycle.  In such a scenario, there may be no need to exercise the inflation option.  But other equilibriums are possible.  Japan never experienced sufficient lift-off to break its reliance on fiscal stimulus.  Policymakers should be aware of the possibility and adopt a flexible response, one that does not a priori rule out what may be the most cost-effective options.

Bottom Line:  If Bullard wants to take a hard line against higher inflation, so be it.  In reality, that hard line has been adopted by the vast majority of Fed officials.  They aren't inclined to touch the inflation option for fear, I think, that it would work.  Then what's to stop 4% from becoming 6%?  And 6% from becoming 8%? And I do believe this question would need to be addressed.  But don't pretend that not pursuing the inflation option is costless.  Just different costs.  And please don't use an obviously disingenuous data analysis to fuel inflation fears.  We expect better from our policymakers.  Or at least we should.

 

On The Surface Better, But Underneath The Same

The jobs numbers are out, and they are reasonably solid.  Reasonably solid as long as you weren't expecting miracles.  Very strong if you thought the economy was heading into recession.  But just about where they should be if you think the economy is just sort of grinding along at a slow but steady pace.

Nonfarm payrolls gained by 114k, about consensus, but both July and August were revised, adding 40k and 46k jobs, respectively.  As upward revisions tend to follow upward revisions, we can expect the final September number will print higher as well.  The average of the past three months is 146k.  The average of the past twelve months is 150k.  In short, ignoring the twists and turns of the data leaves you with pretty consistent job growth over the past year:

In my mind, the policy significance of the twists and turns is not so much that the economy was threatened with excessive slowing this spring, but that the Fed's anticipated acceleration in activity was to be unrealized.  The continuation of slow and steady is what prompted open-ended QE (although the downside risks didn't hurt either).

Note that hours worked, which had flattened out, are again on the rise:

Likewise, the unemployment rate unexpectedly dropped to 7.8% after holding steady for much of the year:

Again, look through the twists and turns.  On average, the economy is adding about 150k jobs a month.  At the moment, holding the unemployment rate constant probably takes something closer to 100k jobs.  As a consequence, the  unemployment rate grinds lower.

This slow rate of unemployment decline presents some interesting challenges for policymakers.  My first thought is that Chicago Federal Reserve President Charles Evans should be thankful that his colleagues did not take him up on his 7% target as minimum rate to consider a policy shift.  We could get there sooner than expected.  Evans should shift gears and join with Minneapolis Federal Reserve President Narayana Kocherlakota and his 5.5% rate (putting aside the issue of "price stability" for the moment).

Why is this important?  Because 7% unemployment could be met with considerable slack left over in the labor market.  Wage growth remains anemic, for both production and nonsupervisory employees:

and all employees:

A distressingly large portion of the unemployed are long-term unemployed:

Those employed part time for economic reasons continues hold at high levels:

And the employment to population ration remains stagnant:

Bill McBride notes that there has been some gains in the employment to population ratio for persons in their prime working years (25-54), but much ground still needs to be covered.

The point is that it would be very likely premature to tighten policy even when the unemployment rate breaches 7%.  But tighter policy may be needed before 5.5%.  It is this kind of complexity that shows up in the minutes of the last Federal Reserve meeting as:

Many participants thought that more-effective forward guidance could be provided by specifying numerical thresholds for labor market and inflation indicators that would be consistent with maintaining the federal funds rate at exceptionally low levels. However, reaching agreement on specific thresholds could be challenging given the diversity of participants' views, and some were reluctant to specify explicit numerical thresholds out of concern that such thresholds would necessarily be too simple to fully capture the complexities of the economy and the policy process or could be incorrectly interpreted as triggers prompting an automatic policy response. 

Admittedly, differentiating between cyclical and structural unemployment will become increasingly difficult as the unemployment rate continues to fall.  I think that I would fall back on wage growth as a key signal of labor market tightness.  Until wage growth is "substantially and sustainably" higher, we really shouldn't worry much about the inflation risk.

Bottom Line:  A solid report, but basically consistent with the trends of the past year. 

Data Update

A few data thoughts ahead of the employment report.  To recap, we are now in watch and wait mode.  For now, US monetary policy has faded into the background.  For the foreseeable future - until labor markets make substantial and sustainable improvements in the context of price stability - we can assume the Fed is on hold.  If we do not see measurable improvement within six to nine months, I suspect Bernanke & Co. will turn their attention to increasing the pace of balance sheet expansion.  

It would be unlikely, however, to see any impact from QE3 in the near term.  Instead of looking for the positive impact of QE, I am looking for signs that the underlying path of activity is set to deviate from the slow and steady trend of the past two years:

The current fear is that the path will deviate to the downside, putting the US economy precariously close to recession.  And no, I don't think the economy is near recession just yet - see Menzie Chinn and Bill McBride for more.  That said, a few warning signs are flashing.  In particular, core manufacturing orders (nondefense, non aircraft capital goods), while up slightly in August, were revised down sharply for July.  The picture isn't exactly pretty: 

Year-over-year declines are clearly consistent with the past two recessions, but note that this has not yet translated into a substantially weaker ISM survey as might have been expected:

 

My working hypothesis is that the core manufacturing orders are being negatively impact by overseas events, and that these external shocks have not propagated sufficiently within the domestic economy to tip aggregate manufacturing into a tailspin.  In other words this If that story holds, we will not see the core orders weakness translate into overall industrial production declines - similar to the experience of the Asian Financial Crisis:

 

Obviously, if the external weakness spreads internally, we will be telling a different story. That said, while the longer run slow and steady story might still hold, the capital goods shipments data, which feed into the calculation of GDP, is not exactly supportive of the Q3 numbers:

Note again the behavior of the series around the time of the Asian Financial Crisis.  Of course, unlike then, the US doesn't have quite the energy from the tech boom to pull the economy along, which is why the current situation is a little more precarious.  That and the fiscal cliff.  I am relatively confident the economy can withstand one shock, not so confident it could handle two or more.  Unfortunately, it is all too easy to see two or more shocks on the horizon.

Separately, consumer spending continues to limp along, gaining a scant 0.1% in real terms August.  Bill McBride notes that this puts the consumer on track for a 1.3% gain in Q3, another drag on the overall numbers.  It may seem odd that consumer confidence has been generally stronger, with the University of Michigan sentiment measure climbing to 78.3, but I don't see much in that other than a convergence of spending and confidence to their historical relationship:

 

Gas prices are down a bit:

 

Further declines might be expected in the wake of falling oil prices, but the feed-through may be slow (or even limited) in the face of supply contraints.  Jim Hamilton pointed me to this piece, for example.

 Initial unemployment claims are moving pretty much sideways:

Nothing to believe that a dramatic improvement or deterioration in the labor market is taking place.  Similarly, ADP estimates private jobs climbed by 162k in September, although the value of ADP estimates in projecting the BLS number is questionable.  But perhaps all projections are questionable; I tend to think that attempting to forecast the monthly change in payrolls is a fool's game.  Simply too much month-to-month noise.  With that caveat in mind, my quick and dirty estimate (and quite wrong last month) for tomorrow is 139k; the consensus forecast is 113k.

 Bottom Line:  Not yet seeing a dramatic shift in the direction of the US economy; that doesn't mean such a shift isn't coming.  Underlying growth likely slow and steady, although external factors are clearly working to drag growth even lower, with manufacturing showing stress.  Without a doubt, these are a matter of concern, and "slow and steady" is not obviously enough to allow the economy to shrug off a negative shock.  This is especially true with fiscal cliff looming.  But, overall, nothing to make me believe the Fed would change course anytime soon.  Nothing to make me sleep much easier at night either.