Chart updates

The outlook hasn't changed much this month, and I've been doing some traveling (this week I'm in Park City to attend a Cato conference), so that explains the lack of posts. What follows are some updated charts and commentary:

The September payroll report was consistent with what I've been saying in recent months: jobs growth has downshifted, from a 2% annual pace to now 1.7% or so. That's not a huge deal, but I think it reflects the uncertainty surrounding the elections and the eventual policy outcome. Those with investment decisions to make on the margin are most likely to hold off until next year before deciding to move ahead with new investment/expansion/hiring plans. We therefore are unlikely to see any meaningful improvement in the economy this year.

Jobs growth is slowing, but the growth of the labor force is picking up. More and more people are deciding they would prefer to work than to sit on the sidelines. The gap between the two lines in the above chart suggests that there are as many as 10 million people potentially available to re-enter the workforce.

There is a similar gap between the current size of the economy and its potential size, as the chart above shows. That gap is now equivalent to about $3 trillion in "lost" income per year. In other words, there is tremendous untapped potential in the U.S. economy. That potential could be tapped if policies become more growth-friendly (e.g., lower tax rates, reduced regulatory burdens). That's what this election should be about, but the degree of acrimony that exists between the two parties and their candidates is an unfortunate distraction. I wish I knew how it will all play out.

The unemployment rate has stopped declining and looks set to increase a bit in coming months. Traditionally, a rising unemployment rate only happens as the economy slides into a recession. Things are very different this time around, however. The unemployment rate is moving higher not because more and more people are getting laid off, but because more and more people are deciding they'd rather work than sit on the sidelines. This is arguably the first time this has happened in modern times. Don't be worried, therefore, by a rising unemployment rate—it doesn't mean what it used to mean.

In the currency market, the big news is the abrupt decline of the pound. According to my PPP analysis, the pound is now "cheap" relative to the dollar, for the first time in more than a decade. Time to make plans to visit the U.K.! The most likely cause of the pound's weakness is the U.K.'s decision to exit the European Union. There are lots of things in play, and thus the outcome is fraught with uncertainty. In the long run I think a Brexit is good for the U.K. (since it will free up markets), but in the near term the uncertainty is not surprisingly bad for markets.

The U.S. stock market is more nervous these days, as indicated by the Vix index in recent months rising from a low of 11.3 to now about 16. But the Vix/10-yr ratio hasn't increased much at all, because 10-yr yields have risen from a low of 1.36% to now about 1.8%. Investors are more nervous, but yields are rising because there is less pessimism surrounding the outlook for growth. As a result, the stock market has been relatively stable.

The Fed is on the minds of nearly everyone these days, but I don't see major problems ahead. The chart above tells us that the market only expects a very modest rise in real short-term interest rates in coming years. (That's the message of the blue line in the chart above.) And that makes sense given the sluggish economy and the relatively low and stable rate of inflation. Things could change in the future, of course, but interest rates are likely to surprise on the upside only if the economy strengthens meaningfully and/or inflation rises. 

It's important to keep in mind that there are two ways the Fed can "tighten" monetary policy: 1) they can take steps that result in an increase in the nominal Fed funds rate, and/or 2) they can take steps that result in an increase in the real Fed funds rate. It's the change in the real Fed funds rate that is the most important, since that affects real borrowing costs (and real returns on savings) for everyone. Traditionally, the Fed has increased the nominal funds rate by draining bank reserves, which the Fed accomplishes by selling bonds that it owns. Prior to late 2008, any reduction in the supply of bank reserves would force banks to curtail their lending, since banks had a strong incentive to avoid holding excess reserves. With a shortage of reserves, banks were forced to pay up to borrow needed reserves (needed to collateralize their deposits), and that is what caused short-term interest rates to rise.

Since 2008 that has all changed, for the first time ever. Today there are over $2 trillion in excess reserves in the banking system. As a practical matter, the Fed can't possibly drain enough reserves on the margin to cause a shortage of reserves. Instead, in order to push short-term rates higher all the Fed has to do today is declare that it will pay more interest on the reserves held by the banking system. 

So as the current "tightening" cycle proceeds, the banking system will almost certainly not experience any shortage of reserves or any shortage of essential liquidity. Today, higher short-term rates will mean only that borrowing costs increase marginally and the rewards to savings increases marginally. It's more of a zero-sum game now, whereas "tightening" in prior cycles meant the banking system was being squeezed and money and liquidity were becoming scarce. Of course, we've never experienced a tightening cycle under the current IOER regime, so it's impossible to predict how things will play out. But it is safe to say that this time things will be different. The Fed won't really be tightening in the sense of limiting bank liquidity; rather, it will acting directly to raise the level of short-term interest rates. A quarter-point increase in short-term borrowing costs and a similar increase in the interest rate paid on bank savings deposits and money market funds is not likely to create more than a minor ripple in the U.S. economy. Lots of people (e.g. savers) will likely cheer, while few (borrowers) will grumble. As long as liquidity is plentiful, the banking system and the financial markets will be able to play the role of "financial shock-absorber," and that in turn will mitigate the risk of recession.

In the chart above we see that the prices of 5-yr TIPS and gold have been flat to down in recent months. This suggests that the market's demand for safe-have assets has stabilized or declined, and that further suggests that the general level of uncertainty has improved a bit. Nothing wrong here.

UPDATE: Here is a chart of excess reserves (reserves held by banks that are not needed to collateralize deposits). Excess reserves have declined in line with a decline in total reserves; apparently the Fed is slowly (and quietly) unwinding some of its QE efforts. But there are still plenty of reserves out there.