Jobs, Inflation, and Bonds. Mixed News.

The various reports published this week paint a decidedly mixed picture. I haven’t talked about them because individually they are fairly self explanatory, but together they are beginning to make some sense in a different way.

Take today’s unemployment insurance weekly claims report. This is the second week in a row that claims have risen, this time by 7,000 to 473,000. At the same time the four week moving average dropped 5,250 to 472,750. What do we make of this? Obviously there is a slight hitch in the economy’s march towards a better job market. It was never much of a march – more a stagger – but the fact that we have seen two weeks of mild increase after several of decrease suggests that the steam is going from whatever momentum we may have had. The fact that last week’s number and the four week average are virtually identical also supports this notion of the economy having hit a plateau. The critical question then becomes how do we move off the plateau? Up or down?

The evidence all supports a continued improvement, but it is all still fairly weak.

That weak activity also shows up in the inflation figures. The headline number was daunting with a jump of 0.4% in November, but when we parse out the very volatile energy and food parts of the index, prices were unchanged for the month. Plus for the last twelve months as a whole the consumer prices have risen only 1.8%, even with food and energy added back in. Clearly there is little inflationary pressure building in the economy. This is entirely consistent with the overall weak, but improving, tone of the major measures of growth. The energy component of inflation bounces all over the place, which is why we strip it out to get a view of how widespread inflation is within the economy, but we still need to pay it heed. In November energy costs rose 4.1%, which is a huge one month jump, and was fueled [excuse the pun] by a massive 6.4% hike in gasoline prices which have now risen 23.6% since last year. For our purposes, though, we need to watch that broader non-volatile part of the index because it provides a better gauge of the inflationary outlook and therefore Federal Reserve interest rate strategy.

This leads to our third report: the Fed’s own assessment of the economy and its attitude towards rates.

Once again all we seem to hear is caution. The Fed’s view remains very circumspect with an upward bias. This is about as optimistic as they can get given the information they receive from around the country. The key is that the see no inflationary pressure building and therefore see no reason to raise interest rates. This is critical. They would like to keep rates at their current levels for a very long time. I have commented here before that, according to the ‘Taylor Rule’, which is an ad hoc device for setting interest rates given an outlook for unemployment and inflation, the actual rate the Fed would like to have is something in the range of -5%. Since they cannot go below zero they would like to do the next best thing which is to keep as close to zero as they can. Using the consensus projection for the economy and unemployment the Taylor Rule would still be negative as far off in the future as early 2011, so it seems unlikely that Fed policy will change much between now and then. Unless some outside event forces its hand.

That outside event could be brewing up currently. The bond market is going through one of its periodic bouts of jitters. If this uneasiness grows into a more fully fledged panic it could force central banks the world over to react by raising rates. The world economy would then slide quickly into depression.

The jitteriness is being caused by the somewhat sensational collapse of the Greek public finances, and the ongoing fears sparked by the implosion of the Dubai construction spending spree. Neither alone would be sufficient to cause much of a ripple through the market, but together they cause alarm. Particularly when we add in the increasing unease over sovereign debt generally.

There continues to be constant chatter in the world’s financial media about an imminent sovereign debt crisis. This is said to be the logical outcome from all the deficit financing made necessary by the crisis and the attempts by governments to employ Keyensian style policies. Apparently bond holders don’t like Keynes. Or at least we are led to believe so. This leads me to wonder whether bond holders actually think through the consequences of the alternative to Keynes: depression. For that is the stark choice.

If we leave economies to ‘self correct’ – to use the sanitized wording of Milton Friedman and his acolytes – we would have to tolerate a much deeper and longer downturn. The point of which would be to correct the misalignment of resources, to re-arrange asset values, and to force wages down to the point that firms start re-hiring. No one knows how much this adjustment may cost in terms of unemployment or business failure. No one. But advocates of the self-correcting method of recession combat should do us all a favor and comes up with such an estimate. If for no other reason than to stop the bleating in the bond market.

Were we to follow the self-correction crowd over the cliff none of us would have a clue as to when we would hit terra firma again. This uncertainty should surely scare the pants off bond holders – conservative and risk averse as they are. So the chattering unease amongst bond traders about how sovereign debt is now high risk seems to put the cart before the horse. The alternative is much worse. They would counter, naturally, that bonds have greater value in a depression than they do during a bout of debt expansion. They would be right. But that greater value is relative, by definition. So my suggestion to all of them is that, if they now see sovereign debt as horribly unstable and thus high risk, they should invest elsewhere. In some of those really safe emerging markets maybe. Or gold. Or … The point being that in circumstances like ours nothing is particularly safe, and undermining bond prices based upon a distaste for policies and their short term ramifications – i.e. high sovereign debt loads – is a self defeating past time fit only for Chicago School economists. We know they all live in never never land. I would hate to think bond trades lived there too.

What do conclude from all of this?

That the economy is growing, but barely. That we have hit a tough patch. That the bond market is getting fearful of the cost of bailing us out and is beginning to waver. Meanwhile the Fed seems bent upon staying the course and supporting growth as best it can.

All in all we are still in the middle of the fight. Nothing is yet cast in stone. If stimulus ‘fatigue’ wins the day we are doomed. Current policies at the Fed and with respect to the Federal deficit are about right. If anything we could do with another bout of stimulus.

Meanwhile hang in there: 2010 is going to be a rough and tumble year that could go either way.