Weekly Economic Commentary by Scott J. Brown, Ph.D.

China and the submerging market outlook
August 24 – August 28

China’s economic slowdown may not be much of a direct drag on U.S. growth. While U.S. exporters will have a tougher time, the drop in commodity prices should help consumers and domestic producers. However, the country’s difficulties need to be considered in the broader view of emerging market troubles.

China’s stock market appeared to be undervalued in early 2014. The housing market collapse encouraged investors to put money back to work in the stock market. The Shanghai Composite Index rose more than 150% y/y, before beginning a 32% correction on July 8. Most companies in the index are partly state-owned, and the government has made a number of efforts to prevent the market from falling. The drop in Chinese equities does not seem to be related to the slowdown in economic growth (which was apparent when share prices were rising), nor is the market correction likely, by itself, to dampen economic growth. However, China’s economy has slowed, adding to worries about emerging economies in general.

U.S investors typically concentrate on the dollar index, which is based on a basket of six currencies (euro, Canadian dollar, yen, pound, Swiss franc, and Swedish krona). The Federal Reserve constructs another trade-weighted dollar index, which covers the other currencies. While the dollar has been essentially range-bound against the major currencies since mid-March, it has rallied more than 6% against the other currencies in the last three months (up more than 14% y/y). These countries account for about 51% of U.S. exports and about 57% of U.S. imports. Hence, while corporate earnings from the major-currency countries may be stabilizing, we should see a hit to those exporting to the “other” countries (bear in mind that earnings from abroad depend on growth as well as currencies).

The U.S. domestic economy stands to benefit from the drop in commodity prices. Gasoline prices should fall (refinery damage and maintenance may limit that in the near term). Lower costs of raw materials are likely to help shore up manufacturer profits.

China’s ham-handed attempt to prevent its stock market from unraveling and its clumsy, ill-fated attempt to move to a more market-based exchange rate regime have not done much to instill confidence in the country’s leadership. Capital outflows often lead to a worsening of conditions, creating more incentive for capital to flee (a vicious cycle). The direct impact on the U.S. economy may be relatively limited. However, China’s difficulties only add to worries about a broader slowdown in global growth. The longer-term outlook for these countries remains promising, but they’ve all stumbled badly recently. Moreover, China’s slowdown is likely to have a greater impact on other countries (for example, those exporting raw materials) than on the U.S.

These developments complicate the Fed policy outlook. The Fed does need to begin moving toward a less accommodative policy position at some point, but global worries and downward pressure on commodity prices should delay the initial move.


China, the Fed, and commodity prices
August 17 – August 21

The People’s Bank of China, the country’s central bank, moved to allow its exchange rate to be determined by market forces. After two sharp declines in the yuan, the PBOC apparently had had enough and declared that the currency adjustment was “basically completed.” The news from China added to uncertainty about what the Fed will do in September. Concerns about the pace of global growth have put downward pressure on commodity prices, which may keep the Fed on hold.

China’s leadership wants the yuan to become one of the premier reserve currencies, but that means that the exchange rate will have to be set by the free market. The PBOC allows the currency to trade in a 2% range around a level announced before the market open. The PBOC said it would begin setting that level at the previous session’s close (rather than picking it out of thin air). Investors took the currency down 1.9% after the news and the exchange rate dipped further in the following session, before the PBOC intervened to prop it back up.

The decision to move toward a free market confused global financial market participants. The financial press described it as “a devaluation” and some viewed it as “the start of a currency war.” Granted, China’s currency has had a strong tie to the U.S. dollar, which has become harder for the country’s exporters as the greenback has strengthened over the last year. However, the decision to intervene suggests that the PBOC had badly misjudged market forces and the likely reaction to the change. The U.S. market reaction to China’s currency debacle (and to its recent stock market correction) seems way overdone. The more important issue is the slowing in China’s economy.

The market odds of a September 17 rate hike from the Fed have varied considerably in recent weeks. Note that the market odds of a Fed move are not directly observable, because the FOMC will announce a target range for the federal funds rate rather than a specific level. However, if we assume that federal funds will trade around the midpoint of that range, we can use the federal funds futures market to calculate “odds” (I’ll put quotes around that to emphasize the fuzziness of the estimate).

If the trend of improvement in the job market continues, we should be close to normal conditions in late 2016 or in early 2017. Policy is extraordinarily accommodative now and will still be very accommodative after the first few rate hikes, so the Fed would appear to be justified in beginning a gradual process of normalization. However, officials have indicated that they need to be “reasonably confident” that inflation will move toward the 2% goal. Lower commodity prices, lower import prices, and the lack of meaningful wage growth ought to give pause.

Most likely, the FOMC will err on the side of caution and delay. The Fed does not want the initial move to be a surprise for the markets. Fed Chair Yellen will not attend the Kansas City Fed’s annual monetary policy symposium next week, but expect her to add a speech to calendar in the next few weeks.


The July employment report
August 10 – August 14

Job growth remained strong in July. The average monthly gain for May, June, and July was 235,000, or 2.82 million at an annual rate. To remain in line with population growth, we need to add about 1.4 million jobs per year. Slack in the job market is being reduced, but a considerable amount remains. How much? The Fed has to consider the pace and plan ahead.

Nonfarm payrolls rose roughly in line with expectations in July, accounting for a small upward revision to the two previous months. There is a fair amount of statistical noise in the monthly payroll figure (a 90% confidence interval is ±105,000). Figures are often revised. In February, the Bureau of Labor Statistics added the three-month average increases in total payrolls and private-sector payrolls to the highlighted tables at the beginning of the report. These aren’t difficult calculations. Rather, the BLS sought to emphasize the recent trend. The three-month average is less volatile than the individual months (noise in one month often washes out in subsequent data).

The three-month averages really haven’t caught on among financial market participants. We still see oversized reactions to surprises in the monthly numbers. That wasn’t the case in July, as the headline figure was close to the median forecast.

The Federal Reserve has two goals: price stability (interpreted as a 2% annual rate in the PCE Price Index) and maximum sustainable employment. Traditionally, the employment goal is taken as a target unemployment rate. However, the unemployment rate has been distorted by the decline in labor force participation. The employment/population ratio is seen as a better measure of labor utilization, but here’s the puzzle. While growth in nonfarm payrolls has been strong, the employment/population ratio has barely budged over the last year (in fact, unchanged over the last six months).

We lost almost 8.7 million private-sector jobs during the downturn and have added more than 12.8 million jobs in the recovery. That leaves payrolls up by 4.2 million versus the pre-recession peak. However, we ought to have added about 9.8 million if not for the recession. That leaves us over 5 million jobs behind (these calculations are rough, the shortfall may be a lot less than that). At the current pace of job growth, much of that slack will be taken up over the next couple of years.

The percentage of involuntary part-time workers is trending lower. Most of the decline reflects improving economic conditions. Some firms have restricted hours as a strategy to limit labor costs or to avoid an impact from the Affordable Care Act. However, the ACA was supposed to be an issue only for firms with around 50 employees. The fear was likely worse than the reality. With the law in place, the percentage working part-time because that was the only thing offered has declined.

The data suggest a path of further reduction in labor market slack, with normal job conditions likely to be reached in 2017. That’s consistent with a very gradual Fed rate hike path.


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