The Oser View

Fuel to the Fire

Yields on Treasury notes hit five-year highs yesterday on fears that the world as we know it has changed. (Yields and prices move in opposite directions, so a big increase in bond yields means a big decline in bond prices.) The change investors fear is that inflation worldwide is rising, spurred by growing consumer demand. Today, as if in confirmation of these fears, the Commerce Department reported that retail spending in May unexpectedly jumped 1.4% from April. Gasoline sales, of course, rose sharply, but so did everything else from clothing (up 2.7%) to building materials (up 2.1%) to automobiles (up 1.8%). In fact, spending in all major retail categories increased to a greater or lesser extent. Meanwhile, prices of imported goods also rose more than expected, propelled by the weaker buying power of the dollar and overseas competition for resources and materials. News from China illustrates the forces of international competition at work. The Chinese government’s Statistics Bureau reported that retail sales rose 15.9% from a year ago, led by high-end items. Furniture sales rose 42%. Jewelry sales rose 37%. Automobile sales rose 34%. China is now the third largest consumer goods market in the world, and it’s gaining on number two Japan. It’s got an awfully long way to go even to get close to good old number 1, but the race certainly is on.

Out of Focus

Economies, like ecosystems, evolve.  Evolution is an asymmetrical process; things happen at different speeds.  But a critical mass can be reached when, all of a sudden, enough has changed that the old measures and descriptions no longer provide the insights they once did.  The American economy evolved from a farming economy to an industrial economy after the Civil War and then to a service economy after World War II.  We are now hitting critical mass in the evolution to an information economy, which the copious and detailed economic data released almost daily, has not quite caught up with.

This month’s commentary will explore some of the difficulties involved in adequately interpreting the emerging information economy and how those difficulties are playing out in market interest rates.  The first difficulty is with the act of measurement itself. 

On the first Friday of each month, the BLS reports on the employment situation for the prior month and revises data for the two months previous to that. Other revisions follow periodically.  For example, the net increase in private payrolls during September 2006 was first reported as 59,000 jobs.  It was subsequently revised to 120,000 jobs, then 147,000, and 145,000 by February 2007.  This was a change of 86,000 from first to last.  There were similarly large revisions in the August and July data.  None of the individual month’s revisions showed any coherent pattern but the net result was a continual increase in the number of jobs created during the third quarter, beginning at 325,000 and ending at 498,000.  Then, last month, the BLS released its quarterly Business Employment Dynamics report.  Based on far more complete data, it showed that only 19,000 net new private jobs were created during the quarter!

The constant outsized changes in the BLS’ estimates have evoked lots of criticism, which I think misses the point.  The really important message is that difference to the economy between 498,000 new jobs and 19,000 new jobs was imperceptible.  Had the revised number been reported initially, there would have been a clamor for the Fed to cut the fed funds rate.  It wasn’t, so there was no clamor.  Fortunes were made and lost in the financial markets based on economic analysis based on incorrect data   Meanwhile, the economy—the real economy we live and work in—felt the same. Why? The answer is that in an information economy, quality of work more than quantity of work influences the strength and growth of the economy.   

Productivity is another crucial economic indicator.  It’s defined as how much an employee produces for each hour of work.  Productivity is spiky from quarter to quarter, but it has generally been trending downward over the last few years.  How can this be when corporations are earning record profits and stock market averages are making record highs?  Again, the answer is that in an information economy, the value of work bears less relationship to the time worked.  In an agricultural economy, the farmer who wastes time risks not bringing in a crop.  In an industrial economy, a factory that takes twice as long as its rivals to produce a ton of pins goes under.  Only artists in these economies produce work whose value is truly independent of time.  Today, more and more of us are, in our own way, artists.

But if the nature of what a job is and what productivity is changing, we still can’t get away from the facts that consumer spending is the key to the US economy and consumers need jobs to spend.  Everyone knows consumers are being buffeted by all-time high gasoline prices and stagnant or falling home values; there is no problem with data measurement here!  So why has consumer spending remained consistently robust? 

It’s true today as it’s been for decades that the vast majority of Americans’ personal income comes from salaries and wages.   But personal income as a predictor of consumer spending means something different in a cash-based society than it does now.  A job still provides access to current income, but, more importantly, it provides access to credit.  Again, our challenge is the interpretation of work and productivity in the information economy.  The “work” consumers do is to consume, and consumers use information to become better at this work.  In particular, consumers have become extremely savvy users of credit, a skill that has revolutionized the way the economy works.  Americans are adept at moving from one credit card to another, drawing on home equity lines, borrowing from 401(k) accounts, retrenching for a month or two, refinancing their homes, and starting all over again. 

The data will catch up to the new reality, and probably sooner rather than later, but we are not wholly in the dark now.  As facts become less reliable predictors, the best guides, oddly enough, may well be opinions, by which I mean not random musings such as this, but scientifically designed surveys conducted by private research organizations.  The Institute for Supply Management, a trade group for purchasing executives, polls its members monthly to compile indices of economic growth in the manufacturing and non-manufacturing economies.  Both indices were surprisingly strong for April and May.  The Conference Board and the University of Michigan produce monthly indices of consumer sentiment, and both of these are trending up as well. 

The confidence exhibited by business and consumers alike is behind the rise in US Treasury interest rates that began in mid-May.  They are signs that production and consumption are increasing.  A strengthening economy typically produces inflation as people are willing and able to pay more for scarce goods and services they desire.  Market interest rates rise when investors begin to fear that inflation will erode the value of fixed income securities.  Commerce Department data indicates, however, that inflation is retreating.  The latest reading for year-over-year core personal consumption expenditures showed a rise of just 2%.  The is the smallest increase since March 2006 and on the verge of the Federal Reserve’s comfort level of 1% to 2% annual inflation growth.  But the bond markets are voting with their dollars against the government’s data and for the opinion surveys.  They are saying that the portrait of the economy presented by the official information is too blurry to be reliable.

Revival

The Bureau of Labor Statistics announced an increase of 157,000 net new jobs in May. Growth was particularly robust in the education, health care, leisure and hospitality sectors, which accounted for a total of 100,000 new jobs. Construction employment was unchanged after a net decline of 47,000 jobs over the last three months. Manufacturing employment continues its long-term decline. The sector lost 19,000 jobs in May and has not enjoyed a net monthly increase for a year. In total, since the beginning of the century, over three million US-based manufacturing jobs have been eliminated. A bit over 14 million manufacturing jobs remain, barely 10% of all jobs.

Despite the decline in employment, manufacturers are not complaining. The Institute of Supply Management survey for May indicates that manufacturers are rebuilding inventories, planning purchases of new machinery and equipment, and even expecting to hire more workers. This survey, national in scope, confirmed yesterday’s surprisingly strong Chicago regional report.

Market interest rates continue their upward trend in the wake of this resurgence. Both the two-year and 10-year Treasury note yields are at their highest levels since last August and are approaching 5%. Market movements reflect a growing consensus that the Fed is unlikely to decrease the fed funds target anytime this year. Core consumer inflation, which excludes food and energy prices, dipped to 2.0%, the lowest year-over-year reading since March 2006, but the Fed will not act to spur growth when the economy seems to be improving on its own.