Service sector continues to grow

The January reading of the Business Activity Index is consistent with moderate growth, steady as she goes. The uncertainties surround the "fiscal cliff" late last year appear to have had little impact on the service sector.

The January Services Employment Index was surprisingly strong. Service sector businesses appear to have stepped up their hiring activity, and that augurs well for future economic growth.

As the U.S. service sector continues to post moderate growth, its Eurozone counterpart is slowly shaking off the contractionary pressures that have beset the region since the second half of 2011.

It remains somewhat of a mystery to me why the Federal Reserve needs to keep the monetary pedal to the metal (e.g., keeping short-term interest rates at extremely low levels and continuing to purchases additional Treasury and mortgage-backed securities) when the great majority of economic indicators reflect continued growth and little or no threat of a recession, and have done so for the better part of the past few years.

Consider the above chart of private sector non-farm employment. There have been about six million jobs created in the past three years, and at a fairly steady pace. While the economy has not yet fully recovered all the jobs that were lost in the last recession, it is undoubtedly improving and seems likely to continue to improve. Are we so impatient for recovery that monetary policy needs to spend a fifth year in uncharted waters?

Worst economic policy decision of the year

When it comes to misguided economic policies, Argentina wins the prize more often than not.

Today the government of Argentina announced a two-month price freeze on all products sold at the nation's largest supermarkets, representing about 70% of the Argentine market. It is apparently a voluntary freeze, worked out in a joint accord between the supermarket chains and the government. On its face, this is a blatant attempt to cool the inflationary fires that are slowly consuming the Argentine economy, and it comes on the heels of the IMF chastising Argentina for manipulating its inflation statistics. Now, not only does Argentina manipulate its inflation statistics, it also manipulates its prices.

It won't work, of course, and is only likely to make things worse. It won't take consumers long to figure out that they have two months to stock up on things before prices resume their rise. And that will almost surely lead to shortages and more consumer anxiety and more efforts to stockpile goods with a long shelf life. Thus will begin in earnest the decline in the demand to hold pesos, and their more rapid circulation, which in turn will result in more inflation. Will the politicians never learn?

It's deja vu all over again.

The chart above shows the allegedly manipulated CPI statistics. Note how year over year inflation has been suspiciously flat around 10% per year since early 2007, when the government puts its own man in charge of the statistics office. For the past 36 months, year over year inflation has been almost exactly 10% every single month—something that is nearly impossible in the real world.

The chart above almost surely does not show manipulated data for currency in circulation. For the past 36 months currency in circulation has grown almost 40% per year. It is virtually impossible for currency to grow 40% a year at the same time inflation is only 10% per year. The M2 measure of Argentina's money supply is also growing at breakneck speed, averaging about 32% a year for the past three years. The growth of currency and M2 points strongly to inflation being 25-30% per year, as most independent economists suggest it is.

Inflation in Argentina is not the result of rising supermarket prices, it is the result of a rapid expansion of the Argentine money supply. Argentina is literally "printing money" to pay its bills, even as the central bank's monetary reserves have fallen by almost 20% in the past two years. This will end in tears, in shortages, in more government repression, in more capital flight, and eventually in another big devaluation.

The official exchange rate for the peso is currently 5 per dollar, but the "blue" rate (i.e., the black market rate) has dropped to 8 per dollar, suggesting a potential devaluation of almost 40% is lurking in the wings.

Advice to tourists headed to Argentina: take plenty of $100 dollar bills with you. You'll need to figure out how to exchange your dollars for pesos at the blue rate (something the government is trying hard to discourage), but you have a huge incentive to do so, since otherwise if you use an ATM or your credit card while in the country you will be buying pesos at the official rate.

Jobs and manufacturing point to continued growth

In my estimation, the market continues to underestimate the health of the U.S. economy. To be sure, this recovery still ranks as the worst in modern times. The unemployment rate remains very high. The labor force participation rate remains very low. The number of people working today is still 3 million less than at the peak in early 2008. It's no secret that the economy should be doing a whole lot better. However, the most important thing is what is happening on the margin. The bad news is that the rate of improvement has been disappointing; the good news is that the economy continues to add jobs at a decent pace, and there is no sign of any deterioration. The market is braced for a recession, but there is no sign of a recession; the economy continues to grow, albeit at a disappointingly slow pace.

For the past two years, the private sector has been adding jobs at a 2% pace: about 190K per month on average. That's the same pace as during the 2004-2006 period. According to this chart we are growing just as fast today as we were when the economy was reasonably healthy about 8 years ago. The difference, of course, is that given the depth of the recession we should have been growing much faster.

Both employment surveys show that the private sector of the economy has added a little over 6 million jobs in the past three years. At this pace, jobs will reach a new high within a few years. That will still leave many millions of people unemployed, so it's nothing to cheer. But things are nevertheless improving, not deteriorating. That's critically important, since the markets and the Fed are worrying that the economy is clinging to growth by the skin of its teeth. It's not. It's doing much better than that. Economies are not like airplanes: they don't have a "stall speed." Economies don't collapse if they grow too slowly, they just keep growing slowly.

The January ISM manufacturing report was a good deal stronger than expected (53.1 vs. 50.7). As the above chart suggests, it is reasonable to think that the economy is growing at a 2-3% pace given the health of the manufacturing sector. Things could be a lot better, but they are not getting worse.

As the above chart shows, manufacturing conditions in both the U.S. and the Eurozone are improving on the margin. To be sure, although the survey suggests that Eurozone manufacturing is still shrinking, the pace of deterioration has slowed. On the margin, the outlook is improving both here and in Europe.

Even in Japan the outlook is improving. The Nikkei 225 is up almost 30% since mid-November, thanks to declining deflation risk courtesy of a weaker yen. As the second chart above shows, the January manufacturing surveys in Japan, like in the Eurozone, show a reduction in the rate of deterioration.

It's never smart to let the perfect be the enemy of the good. The economy should be doing better, but it is improving, and that is a far cry from being at risk of recession. Things are likely to continue to improve, albeit slowly.

Markets (and the Fed and most other central banks) are too worried about how things should be better, when they should be encouraged that the outlook is slowly improving.