Unemployment and interest rate confusion: What next?

from Peter Radford

If we ever needed evidence that economic forecasts can be confusing, the reaction to this week’s reported numbers is more than enough. One day the fact that lone term interest rates are rising is cited as a warning that the deficit is a major problem. The next those rates are rising because we have stimulated the economy by keeping taxes low and thus bulking up the debt. Then today we have the weekly figures for new applications for unemployment assistance, which despite being fairly good, is blithely ignored by everyone. It makes my head spin. 

First that unemployment claims number.

During the middle months of the year we saw clear evidence that the economy’s progress had stalled. These weekly claims figures started to edge back up rather than continuing to fall. If ever there was a time for us all to realize that this recovery was going to be a long slow slog that was it. From the low to mid 400,000 level per week claims rose steadily and even above 500,000 for a short while. The consensus is that a weekly claims figure of between 325,000 and 375,000 signals a very healthy economy, while anything below 400,000 is considered good and illustrative of near normal growth. So today’s report of a 17,000 improvement to 421,000 is good news. Especially as it brings the four week moving average – always a better measure – down to 427,500. So we are approaching, albeit after far too many months, a better job market. Couple this news with the fact that unfilled job postings are also rising, and it looks as if the truly dire part of the unemployment cycle will be past us sometime in the new year.

Why the markets didn’t focus on this is anyone’s guess.

Now a word of caution: this improvement in no way implies that the unemployment rate is about to drop quickly. The economy is simply not expanding fast enough for that to happen. Instead we can confirm our view that the long shallow curve of the cycle will play out as forecast many times. All that today’s report tells us is that we are still on that track.

But what of those bumpy interest rates? Is the sky falling? Or are we onto more solid ground?

The best way to look the rise in rates is that the markets took the tax deal and factored it into their GDP forecasts. The result was that most people now peg 2011 growth 0.5% to 1.0% higher than previously thought. One ramification of that is the Fed’s ability to move short term interest rates away from the zero boundary where they now languish increases. So those same forecasters saw rates ticking up in 2011 a bit earlier than they had thought before. A more rapidly growing economy implies rising rates more often than not. Couple this with the ongoing impact of QE2 on medium to long term rates and suddenly we seem to be looking at a yield curve both stepper and generally higher than today’s. So the market bid up rates in a flurry of self-fulfilling expectations.

Of course there is another view. There always is. That is the deficit hawk view. In this interpretation rates are rising because the market fears the tax deal does nothing to impose austerity on us all, and thus adds to our long term budget woes. Inevitably, according to this perspective, the credit markets will start to impose both an inflationary and credit quality penalty on US debt. This implies bidding up bond rates, not in anticipation of higher growth, but in anticipation of collapsing confidence.

What are we sensible folk supposed to think?

Well, in a way they are all correct. What emphasis you decide to place depends on your faith rather than on your analysis.

There is no doubt that the tax deal failed to address the long term budget problem, such as it is. Remember, there is only a problem to the extent that the economy grows less quickly than the debt itself. Debt per se is not a problem. It is our ability to pay for it we need to worry about. Faster growth lessens the debt burden and so shrinks the so-called problem away. Plus, the fiscal imbalance we are all focused on has two very different components. One is the result of projected outlays growing faster than projected income, especially as health care and defense spending remain uncontrolled. The other is the permanent reduction in income created by the ill advised tax cuts back in 2001 and 2003.

Those tax cuts were justified – I use the word loosely – by the fact that we had accumulated a large annual surplus at the end of the Clinton era, and were apparently going to run surpluses for a while longer. So reducing income to get back into balance was both reasonable and politically sensible. Also, after the 2001 recession kicked into gear, another justification was that a tax cut would spur growth. In other words the Republican mantra of the day was that we needed a massive stimulus to shore up GDP. That seems like a long time ago.

Those tax cuts were a total fiscal disaster. They opened up a vast funding gap without providing any substantial stimulus.

You will notice that I am ignoring a third cause of our current deficit: the recession itself. This is because as we look into the future to rebuild a sound fiscal balance we must assume the recession will fade and that any cyclical fiscal imbalance it caused due to the drop in revenues, inevitable during a downturn, will also fade.

So, back to interest rates.

The fact that we did not address the deficit is a good thing. That’s what we need to do as we continue to provide support to the economy. When we view the tax deal as a form of stimulus because it continues to flood the economy with government money, then we can project higher growth and thus higher rates. And, yes, the larger deficit will require funding through the issuance of more debt, so the markets will occasionally get a little skittish in the run up to big US bond auctions. But this week is ample evidence that the markets are less worried about the rising debt than they are about the lack of growth. However temperamental, nutty and short term focused we may accuse our creditors of being they have the same goal as we do: getting the economy humming again.

So long term rates have risen because our prospects have improved and the stimulus is perceived to be beneficial. Everyone is happy except the deficit hawks who openly focus on the debt side of the effort. Oh, and don’t get carried away about rates. They are merely back where they were before the onset of the midsummer gloom. They haven’t suddenly exploded out of control. In fact today’s successful bond auction set them back a little.

I hope that straightens out your confusion.

But.

Of course I would be remiss were I not to throw my own version of confusion into the ring. Those more upbeat forecasts for 2011 have to include a counter movement in 2012. The tax deal may well produce a slow down in growth as we head into the election year. Why?

Because none of the fundamental conditions change and thus once the extra demand created by the deal ebbs away we will be left with some version of our current economy chugging along, still in debt reduction mode, and still with high unemployment. It is not until the de-leveraging has run its course and demand has picked up that we can forecast solid growth. That is still a long way off. Tinkering with the supply side by reducing business taxes or encouraging investment just won’t work. We need to fix the demand side of our economy. That takes time if you don’t plunge into the effort with gusto. And gusto is in short supply in Washington.