Market Analysis

Bonds markets are calmer this morning with the release of the November Consumer Price Index (CPI) which came in up .1% vs expectations of up .2%.  The Core CPI (excluding food and energy) was up .1% which matched expectations.  The take away is that for now increasing prices at the wholesale level are not being passed through to the consumer.  In separate news, the Empire State Manufacturing Survey (NY) came in much better than expected with an index reading of 10.57 vs expecations of a 3.0 to 4.0 reading.

The question now is whether the recent run up in rates (the 10 yr treasury yield has increased approx 1% since QE2 was announced) is a result of true optimism about economic recovery or whether it is the first signs of investor nervousness about the inability of Washington politicians to stem deficit spending.

Those who argue for the run up being a sign of optimism point to the US dollar which as remained relatively stable and to improvement in measures of volatility such as the VIX.  The VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index.  It is a popular measure of the implied volatility of S&P 500 index options and is often referred to as the fear index or the fear gauge because it represents one measure of the market's expectation of stock market volatility over the next 30 day period. 

On the flip side are those who say that the bump in yields reflects real concerns about Washington.  The most recent deal to extend tax cuts and reduce the payroll tax, in and of itself, is not the issue.  The issue is that there are not corresponding budget cuts to offset the decrease in revenue. 

Economists seem to agree that the deal cut in Washington is the best for the economy and that for the next several years, figuring out how to spark economic growth to a level that reduces the unemployment rate must be the #1 priority of government economic policy.

What is becoming interesting to note is that it is possible the the entire tool box of economic fixes ranging from lowering of the Fed funds rate to Fed asset purchases to loan guarantees to payroll tax cuts to cash for clunkers to one-time payments for social security recipients etc., may not be the right tool to fix the employment problem.  This discussion has already occurred.  Below is a portion of the speech made on August 17, 2010 by Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis:

"......... the lack of vitality in the U.S. labor market can only be termed disturbing. The national unemployment rate remains at 9.5 percent in July. Private sector job creation remains weak—only 71,000 net private sector jobs were created in July.

If one digs deeper into the data, the situation seems even more troubling. Since December 2000, the Bureau of Labor Statistics has been keeping data on the job openings rate, which is defined as the number of job openings divided by the sum of job openings and employment. Not surprisingly, when job openings rise, the unemployed can find jobs more readily, and the unemployment rate typically falls. The inverse relationship between unemployment and job openings was extremely stable throughout the 2000-01 recession, the subsequent recovery, and on through the early part of this recession.

Beginning in June 2008, this stable relationship began to break down, as the unemployment rate rose much faster than could be rationalized by the fall in the job openings rate. Over the past year, the relationship has completely shattered. The job openings rate has risen by about 20 percent between July 2009 and June 2010. Under this scenario, we would expect unemployment to fall because people find it easier to get jobs. However, the unemployment rate actually went up slightly over this period.

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.1

Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012. "