JWSGS - FEBRUARY 2005 EDITION
Issue Number Four
February 9, 2005
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RECESSION RISKS INTENSIFY AS KEY
INDICATORS FLIRT WITH OUTRIGHT WARNING SIGNAL
SOCIAL SECURITY CRISIS THREATENS U.S. FINANCIAL STABILITY
The current economic picture remains one of stagflation. The view for later in the year, however, increasingly looks like recession, as key indicators keep flirting with generating a recession warning. No solid warning, however, is in place, yet.
Last month's published data continued to show a slowing economy with high inflation. An explosive trade deficit; softening GDP; weak payrolls, help-wanted advertising, consumer confidence and building permits; and tumbling growth in the purchasing managers' new orders index all showed a tendency to disappoint market expectations. Ongoing strength in retail sales, durable goods orders and industrial production should be transient. Although monthly inflation numbers were soft, given the usual year-end machinations and volatile oil prices, annual inflation remained at multi-year highs.
Where signals from the good-quality (and some of the other) leading indicators can be combined to generate early warnings of major upturns and downturns in business activity, the growth levels that trigger a recession signal still are close but have not been breached. Based on current trends, the first solid warning signals of a new recession are possible any time within the next couple of rounds of monthly reports.
If such a warning were signaled, it would indicate a protracted period of contracting commercial activity beginning in second-quarter 2005. While the downturn would be reflected in vital indicators such as federal tax receipts, corporate profits, payroll employment and industrial production, GDP growth would slow but not turn negative, unless the contraction were particularly severe. The early warning system will be explored in next month's "Reporting Focus" on retail sales.
The general trends of economic reports coming in below market expectations and of inflation reports coming in above expectations will continue. These results also suggest that the federal budget deficit in the year ahead will exceed popular projections.
As explored last month, GAAP-reporting on U.S. government operations for fiscal 2004 showed a shortfall of $615.6 billion without accounting for the annual change in the net present value of unfunded Social Security and Medicare liabilities, and $11.7 trillion when those liabilities were included ($4.7 trillion net of a one-time charge for the Medicare upgrade). These numbers contrast with the official deficit of $412.3 billion. Fiscal 2005 and 2006 will see even worse results on a GAAP-basis.
With the start of the lame-duck Bush administration, at least Social Security is being discussed before the public, but the Republicans and Democrats cannot even openly agree if there is a crisis, or not.
There is indeed a crisis -- a mortal crisis for the U.S. financial system -- with both promised Social Security and Medicare spending out of control. Any solutions have to come from drastic cuts to the programs, since the numbers show there is not enough total income that could possibly be taxed to cover existing commitments. The chances of the Administration and Congress fully addressing the issues and slashing the programs into fiscal balance are nil, as suggested by the level of political nonsense being thrown around for public consumption.
The Administration's developing plan to replace parts of Social Security for the under-55 crowd with mandatory IRAs, funded from a portion of current social taxes, has some problems. In particular, it accelerates the eventual cash flow crisis for Uncle Sam.
The current Social Security cash surplus is used by the government to cover day-to-day expenses and "reduces" the official deficit. Any diversion of the flows of cash from Social Security taxes will be added, dollar-for-dollar, to the official deficit and to the required borrowing from the public (as opposed to the Treasury just issuing paper to the Social Security "Trust Fund").
Selling more debt to the public, however, will become problematic. Foreign investors have been force-fed enough U.S. Treasury debt that they are near the point of regurgitation. In the balance hang the strength of the U.S. dollar and the stability of the U.S. credit and equity markets, along with potential implications for increased Fed monetization of U.S. debt and a devastating monetary inflation.
The crowd in Washington knows very well what the problems are, and Alan Greenspan has made suggestive comments over the last year that indicate his knees knock whenever he contemplates the risks to domestic financial stability. Both major parties and the knee-knocker are complicit in the development of the current system, giving the public ever bigger spending programs, or signing on to same, without worrying about how attendant obligations would be met in the future.
The reason for the dearth of comments, in the current debate, about the crisis in Medicare is that the system was "fixed" last year. Thanks largely to that fix, the GAAP-basis deficit, including the entitlements, jumped from $3.7 trillion in 2003 to $11.7 trillion in 2004. If the Administration and Congress can agree on a Social Security "solution," it likely will be along the lines of the Medicare fix, meeting political needs without improving, and possibly severely exacerbating, the government's fiscal crisis. If so, watch out for a serious tumble in the value of the U.S. dollar, along with accompanying distress in the U.S. financial markets.
This month's "Reporting Focus" examines initial claims for unemployment, a series that can be used to provide a good signal of economic activity.
THE BIG THREE MARKET MOVERS
(Each of these series is explored in the background article "A Primer On Government Economic Reports," available on the home page.)
Employment/Unemployment -- The January 2005 popularly followed unemployment rate U-3 declined from 5.43% to 5.23% in November, seasonally adjusted, at the published +/- 0.2% margin of error of the household survey. The improvement, however, appears to have been due largely to poor-quality seasonal adjustments at a time of large seasonal gyration. Unadjusted, U-3 widened from 5.1% to 5.7%. In like manner, the broader U-6 unemployment measure widened from 9.1% to 10.2%, unadjusted, and it held at 9.3% in January, seasonally adjusted. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remained roughly 12.3%.
Setting the tone for a weak payroll survey, the January household survey showed a seasonally-adjusted employment gain of 85,000, after a 137,000 decline in December. The Bureau of Labor Statistics has never been able to reconcile household and payroll survey results to within a million aggregate jobs.
The January payroll survey showed a weaker than expected, seasonally-adjusted gain of 146,000, including all adjustments related to the annual benchmark revision. December's previously reported 157,000 jobs gain was revised to 133,000, with annual growth rising from 1.66% in December to 1.69% in January.
The benchmark revision, centered on March 2004, was an upward shift of 203,000, instead of the pre-announced 236,000, and the BLS applied it weakly. Before the revision, the December 2003 to December 2004 adjusted jobs again was 2.231 million. After revision, the gain was reduced to 2.172 million, an unusual shift with an upward revision being installed in the annual re-jiggering of the numbers.
Next Release (March 4): Look for a near-term reversal of January's bad seasonals in the household survey, with the unemployment rate turning higher in February and the months ahead.
In contrast, February payrolls are due for an upside surprise, given a positive swing in the bias factors. Last year, the bias factor (the "Net Birth/Death Adjustment" modeled for imaginary companies) swung from -321,000 in January 2004 to +115,000 in February. The January 2005 bias was -280,000. Although these numbers are not seasonally adjusted, they pretty much flow through to the adjusted data and should be roughly parallel in movement this year.
Gross Domestic Product (GDP) -- The "advance" estimate of fourth-quarter 2004 annualized real GDP growth came in at 3.1% +/- 3.1%, down from the third quarter's 4.0%. The wide error margin around the guesstimate means that the reported inflation-adjusted fourth-quarter growth was not significantly different from 0.0%. The relative softening of the growth rate partially reflected the widening trade deficit.
Fourth-quarter year-to-year growth dropped to 3.7% from 4.0% in the third-quarter and was down from the cyclical peak of 5.0% in first-quarter 2004. Average annual growth for 2004 was reported at 4.4% versus 3.0% in 2003.
The GDP implicit price deflator (the inflation rate used to deflate the GDP) rose from 1.4% in the third-quarter to 2.0% in the fourth. Those rates compared with respective annualized quarterly inflation reported in the CPI of 1.9% in the third quarter and 3.4% in the fourth. The higher the rate of inflation used for the deflator, the weaker will be the resulting inflation-adjusted growth. A fourth-quarter deflator at the CPI inflation rate would have knocked the 3.1% GDP growth down to 1.7%.
The alternate GDP measures of Gross National Product (GNP) and Gross Domestic Income (GDI) will not be released until next month, when better underlying data will be available for the guesstimation process.
As discussed in the background articles, the GDP is the most heavily politicized of the popularly followed series and has little meaning other than as political propaganda, or for the impact it may have on the financial markets. It rarely indicates actual economic activity, except for an occasional coincidence. GDP reporting is overstated by about 3%, which would place actual annualized real growth at roughly 0% plus or minus about 3%, given published 90% confidence intervals.
Next Release (February 25): Expectations for the "preliminary" estimate revision of fourth-quarter 2004 GDP likely will move with the results of the December Trade Deficit (to be reported February 10). A stronger than expected deficit should mean a weaker GDP report in revision. Otherwise, there should be a small tendency towards a downward revision, anyway, given the practice of the Bureau of Economic Analysis in moving the "advance" GDP estimate towards consensus forecasts. This practice would have meant something of an overstatement in the first guesstimate.
Consumer Price Index (CPI) -- Again, following something of non-official seasonal pattern the seasonally-adjusted December CPI-U declined by 0.1% (a decline of 0.4% unadjusted), after rising 0.2% in December. That resulted in December year-to-year inflation easing to 3.3% from November's 3.5%, but up from 1.8% in December 2003 and at the highest year-end annual inflation rate since 3.4% in December 2000.
The average annual CPI-U inflation rate was 2.7% for 2004, up from 2.3% in 2003 and the highest since 2.8% in 2001.
Using the CPI's original (pre-Clinton Era) methodological approach of a fixed basket of goods (vs. substitution of hamburgers for steak as estimated by geometric weighting) would leave year-to-year inflation at about 6.0% instead of 3.3%, with the annual average inflation rate at 5.4% instead of 2.7%.
The "experimental" Chained Consumer Price Index (C-CPI-U), the fully substitution based CPI that presumably is the eventual replacement for current CPI reporting, showed a 2.9% year-to-year gain, down from 3.1% in November. The annual average inflation rate for the experimental series in 2004 was 2.5%, up from 2.0% the year before.
Next Release (February 23): Inflation pressures will continue to offer upside surprises in many reports, and the January CPI report may offer one of them. Many companies raise prices effective January 1st, and the Bureau of Labor Statistics has never done very well in seasonally adjusting for same.
Any seasonally-adjusted monthly change below or above roughly 0.5% should subtract from or add directly to the currently reported annual growth of 3.3%.
OTHER TROUBLED KEY SERIES
To varying degrees, the following series have significant reporting problems. Each series will be addressed in a monthly "Reporting Focus," with Weekly Initial Unemployment Claims covered this month. In addition to the big three, other series that have been detailed are The Federal Deficit (background article), Consumer Confidence (November 2004 SGS), the Trade Balance (December 2004 SGS) and Industrial Production (January 2005 SGS).
Federal Deficit -- The official deficit for the fiscal year ended September 30, 2004 was $412.3 billion, up from $374.8 billion the year before. For the twelve months ended December 2004, the rolling deficit was $400.7 billion, versus $394.7 billion in December 2003. Gross federal debt as of the end of September was $7.379 trillion, up $596 billion from a year earlier; at month-end January 2005, gross federal debt was $7.628 trillion, up $619 billion from January 2004, which, in turn, was up by $608 billion from 2003. (See the opening comments on issues that will affect these numbers.)
Producer Price Index (PPI) -- The seasonally adjusted December Finished Goods PPI fell by 0.7% (down by 0.9% unadjusted), after a 0.5% increase in November. December's 4.1% year-to-year inflation eased back from November's 14-year high of 5.0%.
The annual average inflation for PPI finished goods was 3.6% in 2004, up from 3.2% in 2003 and was at its highest level since 2000, when it hit 3.9%.
Next Release (February 18th): As seen in the latest reporting, the monthly variations in this series have a large component of random volatility. Nonetheless, PPI inflation reporting over the next three-to-six months still should average above consensus forecasts. The markets are looking for a monthly gain of about 0.2% in the January PPI.
Initial Claims for Unemployment Insurance -- The series is detailed in this month's "Reporting Focus." The volatility of the seasonally adjusted weekly numbers is due partially to the seasonal-adjustment process. Used in terms of the year-to-year change in the 17-week (three-month) moving average, the series is a fair indicator of current economic activity.
The annual change on a smoothed basis, for the 17-weeks ended January 29th, is an annual decline of 8.3%. While this means that fewer new unemployment claims are being filed than last year, the rate of decline has narrowed steadily from 15.6% at the end of September. If claims hold at current levels, growth will turn positive by mid-year, possibly signaling the onset of a recession.
Real Average Weekly Earnings -- Thanks largely to a 0.1% reported decline in the CPI-W (used to deflate real earnings), December's seasonally-adjusted real average weekly earnings rose 0.5% versus November but still fell 0.2% against December 2004. Allowing for the biases built into the CPI series used to deflate the weekly earnings, annual change in this series continues on the brink of generating a recession warning signal.
Retail Sales -- Seasonally-adjusted December retail sales rose 1.2% +/- 0.8% (1.5% net of revisions) from November, which showed a 0.1% monthly gain. December retail sales were up a still robust 8.9% from the year before. The report showed a surprisingly strong holiday shopping season, which was not fully supported by anecdotal evidence.
Where inflation-adjusted growth in retail sales below 1.8% (using the standard CPI for deflation) signals recession, annual growth still is holding comfortably above that level. This series and its relationship to recession forecasting will be the topic of next month's "Reporting Focus."
Next Release (February 15): The January report should come in on the weak side of expectations, which already are soft.
Industrial Production -- Trailing a softening purchasing managers' survey, and spiked by unusually frigid weather, December industrial production rose by 0.8% (0.7% net of revisions), after a 0.2% gain in November. Year-to-year growth was a strong 4.4%.
Next Release (February 16): January production is likely to slow sharply, with milder weather reducing relative utility demand and the production numbers estimated from utility consumption.
New Orders for Durable Goods -- Seasonally-adjusted new orders for durable goods in December increased 0.6% (0.7% net of revisions), after November's 1.8% (previously 1.6%) gain. Year-to-year growth eased to 9.0% in December following November's 10.8%. The widely followed Nondefense Capital Goods Orders, however, fell by 1.9%, after a gain of 7.5% in November.
Monthly volatility is high for this series, which used to be one of the better leading indicators of broad economic activity, when smoothed using a three-month moving average. After the semi-conductor industry stopped reporting new orders, and the series' quality fell apart.
Purchasing Managers Survey (Non-Manufacturing) -- Published by the Institute for Supply Management (ISM), there is nothing unusually wrong with this survey of the service industry, except it does not have much meaning. Unlike its older counterpart, the manufacturing survey, if service companies such as law firms, hospitals or fast-food restaurants have "increased orders," that does not necessarily mean the economy is picking up.
That said, the overall index fell from 63.9 in December to 59.2 in January. The index is a diffusion index, where a reading above 50 indicates a growing service economy, in theory.
The Prices Paid component diffusion index, however, is a general indicator of inflationary pressures, and the January measure was 9.5% year-to-year after an 18.5% increase in December. On a three-month-moving-average basis, the January prices index was up 16.9% from January 2004, versus a 22.3% annual gain in December.
Trade Balance -- The November trade deficit in goods and services exploded to a record $60.3 billion, after an upwardly revised $56.0 (was $55.5 billion) in October. The current data show extraordinary trade deterioration that helped to soften up fourth-quarter 2004 GDP growth.
Next Release (February 10): After the sharp increases of the last two months, some pullback is possible, but further sharp deterioration is highly likely over the next six-to-nine months, with most reports consistently coming in wore than market expectations.
Consumer Confidence -- January 2005 confidence measures were mixed, but year-to-year change patterns continued to weaken. The Conference Board's Consumer Confidence rose 0.7%, while the University of Michigan's Consumer Sentiment fell by 1.6%. The three-month moving average for both series continued to slow. Year-to-year, smoothed Confidence was up 6.5% in January, down from 8.4% in December, while Sentiment fell 1.6% in January after a 2.6% gain in December. As lagging, not leading, indicators, these numbers confirm the economy was slowing throughout fourth-quarter 2004 and into early 2005.
BETTER-QUALITY NUMBERS
The following numbers are generally good-quality leading indicators of economic activity and inflation that offer an alternative to the politically hyped numbers when the economy really is not so perfect. In some instances, using a three-month moving average improves the quality of the economic signal and is so noted in the text. In the upcoming March issue, the money supply numbers will be added as a regular feature in this section.
Economic Indicators
Purchasing Managers Survey (Manufacturing) - New Orders -- This looks like it may be the first of the key SGS early warning indicators to signal a recession.
The January index fell 9.7% from 62.6 to 56.5 (December and before were revised with updated seasonal factors). Uncle Sam provides the seasonal factors, and the adjusted monthly numbers often can be misleading in the reporting of month-to-month change. This problem is overcome by using year-to-year change on a three-month-moving-average basis. January's index was down 18.4% from January 2004, compared with December's 8.3% drop, and the three-month moving average annual change keeps notching lower, with annual declines of 4.1% in October, 9.2% in November, 10.6% in December and 13.6% in January.
Published by the Institute for Supply Management (ISM), the New Orders component of the Purchasing Managers Survey is a particularly valuable indicator of economic activity. The index is a diffusion index, where a reading above 50 indicates rising new orders. The overall index dropped from 57.3 in December to 56.4 in January, slowly closing in on the 50.0 that divides a growing versus contracting manufacturing sector. The current year-to-year downturn in the three-month moving average rapidly is nearing a recession warning signal.
Help Wanted Advertising Index (HWA) -- Bottom bouncing continued, with the December index rising from a cyclical nadir of 36 to 38, the same as the reading in December 2003. The year-to-year change in the three-month moving average was down 0.9%, after a fall of 1.8% in November, the fourth decline in five months.
Where weakness in this newspaper-based index has continued to be matched in parallel weakness indicated for Internet-based help-wanted sites, anecdotal evidence suggests that the annual level of Internet help-wanted postings showed a strong annual gain in January.
Published by the Conference Board, the HWA is a reliable leading indicator of employment activity. The series continues to be borderline in signaling a pending recession.
Building Permits -- Seasonally adjusted December building permits fell 0.4% from November, while November growth revised to a 0.5% gain from a 1.5% loss. On a three-month moving average basis, annual growth eased to 2.6% in December from 2.8% in November. Other than for October's smoothed annual growth of 1.1%, the December growth is the weakest since May 2002.
As a leading indicator of economic activity, this volatile series has shown a meaningful slowdown and continues borderline for generating a recession warning.
Inflation Indicators
Purchasing Managers Survey (Manufacturing) - Prices Paid -- The January Prices Paid diffusion index continued to slide, easing to 69.0 from December's 72.0. The index has been signaling a strong rise in inflation since late in 2003 but now has been softening for several months, partially reflecting the temporary pullback in oil prices. On a three-month moving average basis, the year-to-year change in the Prices Paid Index rose by 4.6% in January, down from 19.1% in December.
Published by the Institute for Supply Management (ISM), the Prices Paid component of the Purchasing Managers Survey is a reliable leading indicator of inflation activity. The prices paid index is a diffusion index, where a reading above 50 indicates rising inflation.
Oil Prices -- West Texas Intermediate Spot (St. Louis Fed) turned higher, once again, with January's average price rising 8.1%, following December's 10.6% decline. Year-to-year, the January spot price is still up by a highly inflationary 34.8%, the same as in December.
Oil price changes permeate costs throughout the economy, ranging from transportation and energy costs, to material costs in the plastics, pharmaceutical, fertilizer, chemical industries, etc. Where effects of continued oil price volatility will affect CPI reporting, downside oil price movements tend to be picked up more quickly and fully than are upside movements. Even as currently understated, the, CPI inflation will be stronger than commonly predicted for the next six-to-nine months, as a result of the net run-up in oil prices, to date.
U.S. Dollar -- January's dollar average (the Federal Reserve's Major Currencies U.S. Dollar Index) rebounded 1.1%, fully recovering December's 1.1% decline, while the year-to-year drop narrowed to 3.9% in January from December's 7.0% plunge. New record lows for the dollar remain likely in the months ahead, despite any near-term bouncing and official or unofficial supportive intervention by any central bank(s).
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and the eventual liquidity squeeze in the U.S. capital markets.
CLAIMS FOR UNEMPLOYMENT INSURANCE
Even though the regular Thursday morning reports on initial claims for unemployment insurance are often market movers, the series is heavily misunderstood by the public and frequently abused by those hoping to hype a particular tale on the economy. Nonetheless, when the data are smoothed over three months (17 weeks), the numbers can be used as a meaningful coincident-to-leading economic indicator.
The series is reasonably straightforward. Individuals who have lost their jobs and are eligible for unemployment insurance file a claim with their local unemployment office. Each state aggregates those claims and reports them to the U.S. Department of Labor (DOL). The DOL publishes a weekly total each Thursday for claims in the previous week ended Saturday. The DOL also publishes a total of ongoing claims, the number of individuals receiving unemployment benefits.
As quick clarification, these numbers have no direct relationship to the unemployment rate. The unemployment rate covers all people who are unemployed (in theory), regardless of claims status and is determined by a monthly survey sampling of households (see background paper on employment unemployment).
Weekly variation in the numbers often is touted, falsely, as evidence of a weakening or a strengthening economy, where a lower claims number means a stronger economy and vice versa. Weekly variability usually has nothing to do with economic activity. Claims-level volatility is affected by weather, holidays and other seasonal factors.
In an effort to improve the series, the DOL seasonally adjusts it for holidays, etc. Unfortunately, though, the DOL never has demonstrated an ability to seasonally adjust weekly data. As a result, weekly reports that encompass a legal holiday, such as July 4th, Labor Day, Christmas, New Year's Day, etc., often show unexpected and market-moving swings that have nothing to do with underlying economic activity.
The new claims series, however, can be used as a solid coincident-to-leading indicator of economic activity, when the seasonally-adjusted, weekly numbers are smoothed over 17 weeks (three months) and compared year-to-year.
As discussed earlier in the Initial Claims section, the current environment is one where the annual decline in new claims is steadily narrowing, headed for an upturn by mid-year.
A final note of caution as to data distortions: Occasionally, the government and certain states will change unemployment claims rules, often extending claims in times of recession. Those filing for extended claims tend to get counted as new claims, but the weekly report usually is pretty good in highlighting any such factors.
The Census Bureau's retail sales report is the broadest measure of consumer activity published on a monthly a basis. When viewed in terms of inflation-adjusted, smoothed annual growth, it also can be used as a reasonably good leading indicator to the economy and a warning signal for major economic upturns and downturns. There are a number of problems, though. Auto sales, for example, are "sampled" separately for retail sales and GDP reporting, but both surveys ignore the 100% reporting published by the auto industry.
March's "Shadow Government Statistics" is scheduled for release on Wednesday, March 9, 2005. Its posting on the Web site, and any interim alerts, will be advised immediately by e-mail.