Author: Bonddad

OK People…Yes, I know a Federal Prosecutor is conducting a grand jury investigating the Plame Leak.  There is no way I couldn’t know, BECAUSE IT’S ALL WE SEEM TO TALK ABOUT.  

Fitzgerald appears to be doing a damn good job.  He’s keeping silent.  

We have no idea what he will do.  None.  Zip.  Nada.  We won’t know until he indicts anybody.  That’s the point of a Grand Jury’s secrecy.

All this speculation — so and so said X — means, well, nothing.

We’ll know soon enough.  Let the man do his job — and get back to yours.

I know — it’s not Plamegate.  No indictments, no intrigue.  Just a basic threat to our national existence.  

Those from families with the highest income and education levels finished college at more than double the rate of high-scoring students from the lowest socioeconomic grouping.

Sandy Baum, a College Board analyst, said the data showed that college completion increasingly was “not about academic preparation; it’s about money.”

Let’s stop and think about the above paragraphs.  Family income – not academic potential – is just as important in completing college.  For a middle class family that wants to better the lives of their children, this is simply wrong.  It’s not about the time you study, the sacrifices you make to intellectually prepare yourself for a better life.  It’s about whether your parents can afford the cost.

Not including room, board and books, the tuition and fees at four-year public colleges rose this year by a national average of about 7%, to $5,491.

Private four-year schools raised their tuition by an average of about 6%, to $21,235, the group reported.

Financial aid did not keep pace with tuition increases this year, continuing a trend, the reports said. The average net tuition and fees — the price paid after financial aid is awarded — was $11,600 for private college students, up from an inflation-adjusted $9,500 a decade ago. Public college net tuition and fees averaged $2,200, increasing from a real price of $1,900 a decade ago.

Here’s the short version of what has happened in the last few decades.  States have continually decreased their funding for their own universities.  Instead, they have passed the increase onto students who have to take out larger loans to pay for education.  The result is more graduates are now leaving college either before graduation before they graduate because of the financial burden, or more people are graduating with a larger debt load, thus preventing them from moving up the socio-economic scale.  Here’s the result of this policy:

Within the lowest socioeconomic sample, 75% of the high-scoring eighth-graders eventually enrolled in college, but 29% had earned college degrees eight years after high school graduation. Ninety-nine percent of high-scoring eighth-graders within the highest socioeconomic sample attended college, with 74% earning degrees. High scorers in the middle two socioeconomic groups entered college at a 91% rate, with 47% earning degrees.

If you’re rich, you have a better chance of graduating.  The land of opportunity in action.  

Link

I have serious problems with several popular government economic numbers.  The first of these is the unemployment rate, which several studies have clearly demonstrated under-report the degree of US unemployment.  The second of these is the inflation number.   My own experience simply buying and selling goods over the last few years combined with evidence from the financial press adds up to suspicion.  After doing some digging on the internet, I realize my concerns are well-founded.  The core CPI number has serious flaws that understate inflation, largely because it does not include health insurance premiums and the appreciation of house prices.
Housing

Prior to 1982, the housing cost numbers were based upon what you actually spent for the house and the related mortgage. After 1982, the Bureau of Labor Statistics (BLS) began to use an imputed number. They now use what is known as “owners’ equivalent rent of primary residence” for the housing portion of the CPI. This is based on an economic theory that says that homeowners are essentially leasing the houses from themselves and paying implied rent for that service.

In theory, they are trying to figure out what it would cost you to rent your home. There’s actually a rational reason for doing this and we will talk about that in a minute, but first let’s look at the numbers.

Why are these imputed rents so low? Dean Baker tells us, “The main factor holding down shelter costs is the overbuilding associated with the housing bubble. This has led to record nationwide rental vacancy rates, which is putting downward pressure on rental prices in many of the areas with the biggest bubbles in housing prices. For example, rents in the New York City area rose by just 1.9 percent over the last year. They rose by 1.8 percent in Tampa, Florida and by just 0.3 percent in both Boston and San Francisco. (This is the inflation rate for the owners’ equivalent rent index, which strips out utility prices.)”

How much does using imputed rent affect the CPI? Bill King wrote a few months ago, “In the Q1 GDP data, the US government has housing prices up only 1.1%, yet industry data shows double digit gains. And this week the June existing home sales data shows a 14.7% increase in the median house price. The BLS has ‘owners’ equivalent rent of primary residence’ up only 2.2%.

Since 1982, the housing component of CPI has not included the actual cost of houses.  Simply eyeballing this chart from Prudent Bear indicates the average price of homes sold increased from $180,000 in January 2002 to just below $260,000 in mid-year 2005.  That’s a hefty increase to not include in a price index.

Also of particular interest is the housing bubble’s effect on the CPI numbers.  Because of overbuilding, rents are not escalating nearly as much as the actual price of the underlying property.  In other words, the housing bubble is helping to understate CPI.

Health Insurance

According to the BLS’ website:

The CPI does not publish a health insurance index, although BLS is testing its feasibility with an experimental index. The weights in the CPI do not include employer-paid health insurance premiums or tax-funded health care such as Medicare Part A and Medicaid. Currently, the index employs an indirect method for measuring price changes for health insurance premiums. Under this indirect method, the medical care index will not be affected by changes in policy characteristics, such as modifications to policy benefits and utilization changes. The approach implicitly assumes that the level of service from individual carriers is strictly a function of benefits paid. While other components may affect the index, such as more convenient claims handling or a 24-hour nurse line, their effects are probably small. This indirect approach factors medical insurance premiums into two parts:

Changes in the prices of medical care items covered by health insurance policies

Changes in the cost of administering policies, maintaining reserves and, as appropriate, profits.

Most expenditure for health insurance goes to the first item above, and reflects insurers’ payments for medical treatments. The CPI allocates this portion to the indexes that account for medical care items (i.e. physicians’ services). Thus, the weights for most of MCS indexes reflect out-of-pocket expenditures plus allocated health insurance benefit payments. (It is for this reason that provider’s reimbursements from insurance companies are valid prices for the CPI’s MCS indexes.)

Let’s backtrack through the above paragraph.  

First, they don’t have a health insurance index.  Here’s a big problem.  If this was a small expense, there wouldn’t be a problem.  However, health insurance is a large expense for most Americans.  According to the most recent Kaiser Health survey, the average family yearly premium $2713.  This is one of the largest expenses facing the average American family.  And it’s cost has increased dramatically over the last 5 years.

Secondly, The weights in the CPI do not include employer-paid health insurance premiums.  Here lies another problem.  According to this Kaiser Health survey, health insurance premiums increased 10.9%, 12.9%, 13,9% and 11.2% and 9.2% in 2000-2005, respectively.  Additionally, the average annual premiums for covered workers in 2005 was $10,880.  In other words, this is a large expense the CPI does not consider.

So, two large expense are not included in the national CPI numbers.

So, what is the actual CPI?  I don’t know.  But I feel comfortable in saying it’s higher than reported by the BLS in their CPI numbers.  

For God’s sake, I knew this would happen as soon as the inflation numbers came out.  Some right wing noise machine jackass would claim there was no inflation because the core number was low, completely ignoring the issue of energy based inflation.  Well, someone has taken-up my challenge.  That person is none other than Larry “I just say what they tell me to say” Kudlow.  How anybody can sleep at night spewing the lies he does is completely beyond me.  However, somehow he does.  So, let’s look at his statements, shall we?
The following is from Larry’s website.  Go there only if you must.

There’s a lot of important economic news today but the biggest stat is the core CPI which came in below expectations at only 0.1% or 2.0% over the past 12 months.

An even better measure of inflation, is the so-called chained, or Boskin CPI, whose core reading was only 1.8% over the past 12 months.

This is exactly the reverse of what Richard Fisher and other yapping Fed presidents, with their irresponsible and misleading, alarmist, inflation rhetoric that has so upset the recent stock market.

These officials are actually missing a clear trend. Namely: that after the core CPI rose modestly in 2003 and the first half of 2004, over the past 11 months, that core inflation measure is actually declining, modestly, not rising to new highs.

First, Larry is right.  Core inflation is low and has been for awhile.  Congratulations Larry – you can read.  

The problem is there are several inflation measures.  Larry decides to find a number that makes the administration look good, ignoring other numbers issued in the same report that tell a more problematic reality.

Inflation reports have two figures: the core rate and inflation including food and energy.  Food and energy prices are far more volatile than other prices.  For example, food prices are related to harvests and weather patterns etc…  As a result, they are reported separately.  If there is a 1-month spike in these prices, the chances are they will go down the next month.  

However — for anyone that has been paying attention to the markets, Larry (don’t you always say you trust the market to do the right thing?  Then why the hell aren’t you looking at any of the energy charts?) you will notice a pattern in energy prices: they are increasing really fast.  Prices are in what is referred to as an uptrend.  These aren’t 4-5% increases, Larry.  These are really big price moves.  

Now, I have an idea, Larry.  Why don’t we find a substitute for oil that we can use instead – something cheaper.  I’m waiting Larry.  I’m still waiting Larry.  Can’t find something to use instead, Larry?  THAT’S BECAUSE THERE ARE NO SUBSTITUTES FOR OIL, LARRY.  DUH!!!!!!! – YOU JACKASS.  

Just to review basic business structure, Larry: it takes energy to – extract the raw materials, transport those materials to the manufacturing plant, convert the raw material into a product, ship the product to a wholesaler, store the product at the wholesaler, transport the product to a retailer, warehouse the product at the retailer, and transport the product from the retailer to the consumer’s home.  Do you notice a trend here, Larry?  Energy prices – much like Elvis – are everywhere.  There is no way to get around them.  

So, when energy prices increase to the tune of 40%+ in a year, the economy as a whole has a problem.  

This is the inflationary problem the Federal Reserve Presidents are talking about.  And it is a big problem, Larry.  Here is one example of the problem:  home hearing prices are increasing 40-90% this winter.  That’s just 1 story, Larry.  I have another idea: go the New York and Richmond Federal Reserve websites and look at their latest manufacturing survey.  Notice how the cost segment of those surveys is moving higher – really high, really quickly?  Can you say inflation?  I knew you could.  

Larry – you’re an idiot.  Please stop.  You have more than enough money to retire.  Retire.  Go into hiding and seclusion.  Play tennis.  Relax.  And fade from our memories.  

Within the next three months, Alan Greenspan will retire.  Personally, I don’t put him in the complete “political hack” category, although I will admit he has made some questionable calls for what appear to be purely partisan reasons.  My main complaint with Greenspan is his failure to raise interest rates in the 1990s and 2000’s to prevent asset bubbles from bursting.  But, that is not the reason for this essay.  

The reality is the US economy is entering a very difficult period.  We are facing a second asset bubble bursting, energy inflation, a federal deficit out of control, another year with a record trade imbalance, global competition driving down US wages, extreme income stratification and a lack of any meaningful economic development to create 21st century jobs.  One of these tasks alone would be difficult; together they almost seem insurmountable.  To deal with them, we need leadership – strong-willed leadership.  We need someone like Paul Volcker.

For those of you unfamiliar with Volcker, he is my favorite Fed chairman (yes I actually have a favorite Fed Chairman – I am a real econ geek).  In the early 1980s, the US was in the midst of stagflation – high unemployment and inflation.  Volcker had the unenviable task of dealing with this situation.  His answer was to jack-up interest rates until inflation dropped to a manageable level.  It was a painful period as the US went through 2 recessions.  However, there was no other way to wring inflation out of the system without this policy measure.  

Volcker knew he was creating pain for the economy as a whole.  He was criticized and burned in effigy.  However, he stick to his guns and 25 years later, we are better for it.  While he didn’t completely beat inflation, he certainly put it in its place.

And here is where the problem comes.  We need another Volcker in the US economic policy arena.  We need someone who will stand-up and call a spade a spade.  We need someone who will be willing to disagree with the administration when their policies are wrong.  We need someone who will say for the deficit  to go, you either have to lower spending or increase taxes.  We need someone who will say a trade imbalance like the US’ is unsustainable.  We need someone who will talk about needing to create good-paying jobs.  We need an economic leader.

Bush’s track record on appointments is to seek out the most loyal person – not the most qualified or able.  Bush doesn’t have enough confidence in his own opinions to deal with disagreement nor the self-confidence to admit policy mistakes.  As a result, we face a strong possibility of an economic sycophant like Treasury Secretary Snow.  

Should Bush appoint someone like Snow – a glorified yes man – we will be in very deep trouble.  We will lack someone with a vision for dealing with these Bush created problems.  In short, we will be in for a rougher economic road.

The U.S. trade deficit widened to $59 billion in August as record crude oil prices caused imports to rise, keeping the nation dependent on foreign investors to fund the shortfall.

The gap in goods and services trade was the third-largest on record and followed a $58 billion deficit in July, the Commerce Department said today in Washington. Both imports and exports were at all-time highs during the month, and the gap with China widened to a record on more shipments of textiles.

“The risks are to the upside for this number,” said John Shin, an economist at Lehman Brothers Inc. in New York. “No one thinks the appetite for imports will genuinely diminish in the U.S.”

Isn’t that comforting?  The risk for the trade deficit is to the upside.  No one seems to be doing a damn thing to change the course of this number.  The US continues to consume more assets than it produces – and no one gives a damn.  Hell, Treasury Secretary John Snow and President Bush think a trade deficit of this magnitude is good because it means the US is growing faster than other countries.  Technically, this is correct.  However, it is a convenient argument to paper over the real problem:  The US must still borrow about 2 billion dollars a day to finance its standard of living.  

But wait!  Today’s news is a two, two, two for the price of 1 deal!

Import prices rose 2.3 percent after a 1.2 percent gain in August, the Labor Department said today in Washington. The increase excluding oil was the largest since record-keeping started in January 1989 because of increases in natural gas prices.

Prices for imported oil, natural gas and other raw materials surged after Hurricanes Katrina and Rita slammed into the Gulf Coast, snarling port traffic and shutting down production and refining facilities. The Federal Reserve is warning of quickening inflation, and some companies such as consumer-goods producer Georgia-Pacific Corp. are passing on the additional costs to customers.

I have a great idea!  Let’s import inflation.  We don’t have enough here in the US; we need more.  Send us your poor, your tired, your inflationary pressures.

This is what an oil dependent economy means.  When the price of that commodity increases, we stand a good chance of importing inflation.  Which means the Federal Reserve will keep increasing interest rates, placing more stress on the housing market which has driven the US economy for the last 5 years…..you get the idea.

Here’s the bottom line with the trade deficit, in the words of Paul Volcker:

As a nation we are consuming and investing about 6 percent more than we are producing.

What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.

No one on the right will listen to him how that he didn’t give them Kofi Anan’s head on a platter in the oil for food scandal.  He’s no longer a good Republican.  But we could use a strong-willed economist who speaks his mind right now more than anything.  Although painful, he saved this country once in the early 1980s.  We could use that kind of leadership again.

Volcker
Import News
Trade Gap

Over the last few weeks, several economic commentators have written about an upcoming recession – its causes and its overall effect.  These writers highlight the systemic problems of the US economy, namely, that we are not creating anything.  Instead, the US economy is based on asset prices that will eventually come down in price, causing a drop in consumer confidence leading to a recession.
Marshall Loeb at CBS.Marketmatch writes from the perspective of 2007, analyzing what happens in 2006:

The prime cause of the recession that began in 2006 was that, as often happens, the President tried to do too much at once.

Historians know that, for example, Lyndon Johnson brought the economy to perdition in the 1960s and 1970s by not leveling with the American people about the true total cost of the Vietnam war (about $121 billion). Reason: LBJ wanted to pursue both his war and his costly Great Society domestic programs at the same time.

So, too, George Bush tried to pursue his war in Iraq (total cost: more than $200 billion by the end of 2005) and simultaneously to spend $150 billion or more to rebuild the Gulf Coast after the catastrophes of Hurricanes Katrina and Rita.

The consequence was that the federal debt surged from $7.3 trillion in fiscal 2004 to $8.2 trillion in 2006. You don’t have to be a card-carrying economist to know that such excessive demand strained the supply of goods and services. That strain, combined with increases in the price of energy, inevitably lifted prices throughout the economy. Inflation reared its ugly head.

To combat it, the Federal Reserve Board raised its discount interest rate in 2006 from 5 percent to 5.5%. As a result, mortgage rates surged, turning the housing boom into the housing bubble, and bringing back memories of the high-tech stock crash of 2000 and 2001.

When housing started down, it took away what UCLA economist Christopher Thornberg had called “this fabulous sense of wealth that homeowners are feeling.” No longer feeling house rich, consumers cut back their spending. This hit the economy particularly hard since consumer spending had been one of the main forces driving it.

James Cramer of theStreet.com has a slightly different take:

It’s dawning on wall street that George W. Bush may be the first president since Lyndon B. Johnson who believes that we can have a guns-and-butter federal spending policy without creating a serious inflation spiral, if not outright government bankruptcy. At least LBJ, to his credit, believed that there were limits to profligacy and that taxes had to be raised. Not President Bush. He’s making Johnson look like a fiscal conservative, what with his insistence on waging a war in Iraq that’s costing $177 million a day and rebuilding New Orleans by taking on a monstrous load of federal debt.

For the longest time, because Bush is a Republican, we on Wall Street simply didn’t believe that he could be a reckless spender. We knew only two paradigms: You either spent less and cut taxes or you spent more and raised taxes. Both courses at least presumed some sacrifice at some time. Not Bush’s plan. He’s gone on both the biggest spending binge and the lowest taxation course in U.S. history, which, alas, will produce gigantic liabilities down the road. Of course, he’ll be back on the ranch by the time his successor will have to deal with his inflation and currency debasement. Our only hope that financial disaster won’t strike sooner lies with the Chinese, who actually fund our deficit by buying our Treasuries–$242 billion worth, or 12 percent of all foreign holdings. If the Chinese decide to be good communists and stop buying our bonds, the Feds will have to raise rates to attract new investors and the reaper will be at our doorstep with interest rates more akin to those of South than North America. Right now, it’s not a problem. But in a year or two or maybe less, I perceive that the government will throw a bond auction and nobody will show, including the Chinese, until rates shoot up dramatically.

Central to Loeb’s and Cramer’s theory is some event (here excessive demand from a massive increase in federal spending) causing the Federal Reserve to boost interest rates.  Both note the size of combined spending associated with Iraq and Katrina rebuilding as cause.  Loeb’s theory states the Massive increase in government spending simply increases macro-level demand to the point where it pulls prices up – the classic example of demand pull inflation.  Cramer ties the US’ complete dependence on foreign capital, arguing Bush’s profligate spending finally causes creditors to demand increased compensation for their purchases of US debt.  Either way, interest rate levels reached a tipping point where they negatively affected the housing market.  This will eventually hurt the US consumer, who has financed the latest economic expansion by taking on record levels of consumer debt.

Central to both theories is an understanding that housing – and the extraction of excess value from home price appreciation – has fueled the latest expansion.  A recent paper by Alan Greenspan explains the process:

Greenspan disclosed the results of a study he had done with Fed staff economist James Kennedy. The study estimated the amount of cash that homeowners have extracted from rising housing prices (those prices are up 53 percent over five years, according to government figures).

Homeowners could convert higher real-estate values into cash in three ways, reasoned Greenspan and Kennedy: (1) sell their homes and grab the surplus, deducting any amounts paid for other homes; (2) refinance their existing mortgage for a higher amount and pocket the extra money (a “cash out” refinancing), and (3) take out a home-equity loan against the higher house value.

By estimating all three sources, Greenspan and Kennedy reached annual grand totals, shown on the table below. It provides the figures both in billions of dollars and as a percentage of people’s ordinary disposable (after-tax) personal income. The housing money is extra, on top of personal income.

YEAR | MONEY | SHARE OF DISPOSABLE PERSONAL INCOME
2000 | $204 bil. | 2.8%
2001 | 262 bil. | 3.5%
2002 | 398 bil. | 5.1%
2003 | 439 bil. | 5.4%
2004 | 599 bil. | 6.9%

Whoa! Consumers had a lot more to spend than ordinary income, almost $600 billion more in 2004. How much of that was actually spent (as opposed to being put into bank deposits, stocks or mutual funds) is unclear. Consumer surveys cited by Greenspan suggest perhaps two thirds, a big chunk of it on remodeling. The economy has depended heavily on all this extra cash.

Let me offer a third scenario that is perhaps just as likely: energy prices forcing the Fed to increase interest rates.  Energy prices are like water; they seep into every single nook and cranny of the US economy.  If you want to produce a good, you have to buy raw materials whose extraction consumes energy.  To build a good you need energy to operate the plant.  Then you have to ship the good with a mode of transportation that uses energy.  The wholesaler who stocks the good for distribution to retailers uses energy to light his warehouse and operate his computers.  The wholesaler has to ship the good to retailers – again using energy to get the goods to market.  Finally, the retailer has to use energy to light his store, cool his store in the summer and heat it in the winter etc….

Over the last few years, energy prices have increased sharply.  Oil has increased 50% since January starting 2005 at roughly $40/bbl, and now standing near $60/bbl.  Unleaded gas has increased about 75% since January, starting near $1.00 and currently standing near $1.75.  Heating oil has increased about 60% since the beginning of the year, starting at about $1.25 in January and standing near $2 in October.  Natural gas has increased about over 100%, starting January at $6 and standing near $13 in October.

All three scenarios are a possibility.  Or perhaps more exist that haven’t been discussed yet.  Regardless:

1.) Our dependence on foreign capital to finance our standard of living,

2.) Our complete dependence on oil for energy, and

3.) The consumer’s near complete dependence on asset prices to fuel his purchasing,

are all three serious problems that may lead to more serious macro-level issues that will cause a great deal of pain.

[From the diaries by susanhu.]

There is an excellent essay on the difference between the US and European unemployment numbers on the front page.  I want to say that again: IT IS AN EXCELLENT ESSAY.  

I wrote this when the Federal Reserve of Boston released this study.  Given unemployment figures and their computation seem to be a topic of the day, I though reposting it was in order.

Again: many cudos and much mojo to Coleman for his work.

“There are lies, damn lies and statistics.”   From an analysis perspective, the recent unemployment numbers have been difficult to explain because they do not jibe with the results of the labor participation rate.  With help from an analyst at the Boston Federal Reserve, I will explain below why the current unemployment number is too low, why the labor participation rate is right and why the employment situation is not as good as President Bush and his band of yapping right-wing idiots say it is. … Continued BELOW:
First, let me provide some basic definitions, courtesy of the Bureau of Labor Statistics.

The BLS derives the unemployment rate from a sample of payroll records from all 50 state employment agencies.  People are classified as unemployed if they meet all of the following criteria:  “They had no employment during the reference week; they were available for work at that time; and they made specific efforts to find employment sometime during the 4-week period ending with the reference week.”

The bold-face type makes an important distinction: if someone did not search for work in the last month, the unemployment rate does not count them at all.  

The labor force participation rate is the labor force as a percent of the population.  The BLS takes the total population of the US and figures out what percentage of the total population is the “work” force.  Then, they compute the “labor participation rate” which tells us what percentage of the US workforce is in fact actually working.

The Boston Fed Study uses the labor participation rate as the basis for analysis of the current employment situation.

The Study breaks the workforce down into sex and age group categories – for example, men age 16-17, men age 18 – 19 and so on.  In total they have 14 different groups.  There are 7 for each sex.  In addition, the study breaks down each sex into the following age groups: 16-17, 18-19, 20-24, 25-34, 35-44, 45-55 and 55+.  It might help at this point to either go to the study at the link below or draw out columns of a sheet of paper.

The study looks at each group’s labor participation rate in March 2001 and compares it to each group’s participation rate from November 2004 – February 2005.  March 2001 was the final month before the last recession began.  The percentage from November 2004–February 2005 provides as example of how each group is doing in the current cycle.

Here are the basic results.   men and women over 55+ are the only group that is participating at a higher participation rate in November 2004 – February 2005 compared to March 2001.  All other age groups are participating at a lower rate, particularly women.  This drop in participation is most pronounced in both sexes teenage and early 20s categories.  The report states it thusly:

“What leaps out … is the below-average recovery of participation in the current business cycle to date.  The depth of the shortfall is most pronounced among teens and for women of all ages.”

Here is the report’s kicker.  If all of the groups returned to their usual labor participation rate, the labor force would increase by 1.6 million people. Because these people are not in the workforce, the 5.4% unemployment rate for November 2004 – February 2005 is too low and should be revised upwards by 1.1%.  This would make the unemployment rate at the beginning of the year 6.5%.

So, how do I prove all this statistical mumbo jumbo? Simple.  Economists consider 5% unemployment to be full employment.  This assumes that 5% of people are either looking for work, or quit a job to look for work, or were laid off etc…..  Therefore, at 5% unemployment, we should be getting wage increases because it is harder for businesses to find employees.  However, according to the BLS inflation adjusted wages actually decreased .31% in 2004. If there was a tight supply of labor, this number should have increased.

In short, game, set and match to the Boston Fed’s analysis.

Boston Fed Study

There have been several major bankruptcies over the last year.  Delta and Northwest declared bankruptcy within the last few months.  Yesterday Delphi declared bankruptcy.  Following United Airlines lead, I would expect all three to pass their underfunded pensions to the Pension Benefit Guaranty Corporation (PBGC)  which is already showing a large deficit.  If this happens, two parties will be hurt: US taxpayers and pension plan beneficiaries.
The pension crisis has been building for some time.  Here is an oversimplified timeline.  Until the early 1980s, most pensions were defined benefit plans.  In these plans, each person will usually receive x% of their annual pay for their retirement income.  For example, if a beneficiary’s annual income was $50,000/year, their retirement income would be 80% of $50,000, or $40,000 or something similar in structure.  The beneficiary would consistently pay into the pension fund during their employment.  Companies would have to contribute to these plans to enable the plans to pay their respective obligations.  This is where on of the current problems occurs.  Companies have routinely under-contributed or not contributed to their respective pension plans.  Hence many plans are underfunded, or not able to pay all their respective beneficiaries.  

In addition, when the PBGC takes over a plan, they do not pay all of the plans respective obligations.  According to this table, the maximum benefit the PBGC will pay for a plan terminating in 2004 is $44,386.32/year.  While this is not necessarily a bad thing, suppose the PBGC takes over an airline’s pension (like United’s) where some people (like pilots) were expecting a larger retirement payment – perhaps twice as large.  These people who have been planning a retirement with income of X must now adjust to an income half as much as expected:

Murray Specktor, a first officer who flew Boeing 747-400s on Northwest Airlines’ Asian routes, took early retirement this year at the age of 52, knowing he wouldn’t get a huge pension.

But now that the carrier has filed for bankruptcy protection, he fears his monthly payments will be cut as much as 70 percent.

When the government takes over a pension plan, the payouts usually don’t change. But with airlines, pilots and sometimes other employees can take enormous hits when a plan is turned over to the PBGC. Federal law limits annual pension payments for plans canceled in 2005 to $45,613 for people who retire at age 65.

That would be a big hit for Les McNamee, who retired from Northwest in 2001 and draws an annual pension of $94,000. But McNamee, who still works fulltime flying corporate jets, said he’s saved diligently and is more concerned for other pilots than for himself.

Some people may have trouble sympathizing with well-paid pilots, said Norman Stein, a pension expert at the University of Alabama School of Law. But he pointed out that for many pilots, it’s almost too late to make up the difference.

“I think there’s something wrong with a system that can change, with the stroke of a pen, a $150,000 pension to a $35,000 pension overnight,” Stein said.

According to the PBGC’s latest annual report, they have a 23 billion dollar deficit.  This is before they took over United’s pension plan, which was one of the largest pension defaults in US history.  Now we have three new large bankruptcies with huge underfunded pension liabilities.  According to the Heritage Foundation, Delta’s pension is underfunded by $10.6 billion, Northwest’s is $5.6 billion and Delphi’s is 4.7 billion.  With these three bankruptcies, the PBGC’s deficit could double by the end of the year.  The US taxpayer will be responsible for this.  

For those of you reading this who are saying to themselves “it’s those damn unions”, please answer this question: “Why is democracy OK for Iraqis but not US employees?”  A union is a group of people who use democratic principles to advance their objectives.  Isn’t that what America is about?  

Stagflation is a condition of high unemployment and high inflation.  This creates a policy dilemma for the Federal Reserve because they can only effectively tackle one of these problems at a time.  If the Fed raises interest rates to lower inflation, they will increase unemployment.  If the Fed lowers interest rates to decrease unemployment, they will increase inflation.  Either way, their policy actions in eliminating one problem will likely exacerbate the other problem.  In short, it’s a terrible place for a central banker to be.  The US last faced this problem in the late 1970s.  To cure the problem, Paul Volcker increased interest rates to very high levels to lower inflation.  This was a very painful process that caused a lot of pain for many people.  
Currently, there are some underlying trends in the US economy that are hinting at the possibility of stagflation.  I want to caution: these are the initial stages.  Nothing is set in stone.  However, over the last month the unified chorus of Federal Reserve members who have cautioned about inflation has jumped out of the headlines.  This combined with poor job growth over the last 5 years leads to the conclusion the initial stages exist.  

This diary is far longer than I normally write and prefer.  However, I think the need to present as much information on this topic is more important than brevity.  In addition, some of you have read part of the inflation information yesterday.  Yesterday the number of Fed inflation hawks increased by 3 and a further report on price spikes in another economic sector came out.  Once I put these Fed warnings, economic indicators and poor employment situation together, I grew very concerned.

Inflation

Atlanta President Jack Guynn on October 3:

“I consider inflation risks to be elevated at the moment, he said. “I think one has to give considerable weight to the fact that not only in some of the headline measures, but in some of these core measures, we may see the pass-through of at least some of the energy cost increases.”

Federal Reserve Bank of Kansas City President Thomas Hoenig on September 26:

Hoenig noted that the consumer price index has already pushed up significantly from a year ago, thanks to high energy prices, while unit labor costs were rising and economic capacity was being absorbed by the strong U.S. economy.

“When you see all three coming together you must be alert,” he said. “The mission of the Fed is to be sensitive to these pressures.

San Francisco Federal Reserve President Janet Yellen on September 27:

She said higher energy prices “put U.S. monetary policy on the horns of a dilemma” as policymakers balance possible passthrough of prices to core inflation against potential long-lasting cuts in consumer spending if high prices persist.

“Estimates of the extent of spending are escalating, and the recovery and bounce-back, fueled by massive fiscal stimulus, could propel the U.S. economy on an unsustainable upward trajectory,”

Chicago Feder Reserve President Michael Moskow on September 26:

Michael Moskow said there may still be excess capacity in the nation’s economy but that inflation is running at the upper end of the Fed’s comfort zone – a position he’s offered in other recent speeches.

Dallas Federal Reserve President Richard Fisher on October 4:

“Inflation has been on an upward tilt the past couple of years. Now, the inflation rate is near the upper end of the Fed’s tolerance zone, and shows little inclination to go in the other direction,” Fisher said in a speech Tuesday to the Dallas Chamber of Commerce.

Philadelphia Federal Reserve Bank president Anthony Santomero on October 4:

“To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one,”

St. Louis Federal Reserve President William Poole on October 4:

“I have no doubt that both the FOMC and the market would respond to surprises in core inflation that seemed likely to be persistent and to indicate a developing inflation problem,”

First, let me offer some explanations.  The Fed’s policy is accommodative when they was the economy to expand.  This means lowering interest rates to a low-enough point to stimulate borrowing.  The Fed’s policy is neutral when they feel rate levels are low enough to stimulate economic growth through borrowing and high enough to prevent inflation from increasing.  The Fed’s policy is restrictive when rates are high enough to prevent economic growth and inflation.  There is no empirical formula to derive these levels.  It is largely based on the personal perception of various members of the Federal Reserve.

So, what are they worried about?  First there is the increased cost of energy. That is concern enough.  However, there are indications at other levels of the economy that inflationary pressures are increasing.  Each month, various Federal Reserve regions issue a regional manufacturing report that is broken down into various sub-categories.  The price categories of these reports have all shown a recent sharp increase in prices.  The Empire State Index’s recent prices component increased by 20 points.  The most recent Richmond Federal Reserve Survey showed an increase in the projected prices paid for future manufacturing inputs.  The most recent Philadelphia Manufacturing Survey also showed a sharp increase in prices paid by manufacturers.

Several non-Federal Reserve Manufacturing reports have also showed a similar increase in prices.  The recent National Association of Purchasing Managers Index showed a 14 point increase in its most recent survey.  The latest ISM Manufacturing survey showed a sharp uptick in prices as well.  Finally, yesterday’s Service Sector report also showed a sharp uptick of prices.

Unemployment

According to the Bureau of Labor Services, the official unemployment rate is 4.9%.  However, is this an accurate rate?  Reports from the New York Federal Reserve, the Boston Federal Reserve and the Congressional Budget Office (links below) have analyzed the divergence between the low unemployment rate and the higher labor participation rate.  The evidence presented indicates unemployment is in fact higher that the unemployment rate would indicate.

The Boston Fed Study offers the most comprehensive analysis of the overall situation.  It uses the labor participation rate as the basis for analysis of the current employment situation.  The Boston Fed issued this report in mid-July.

The Study breaks the workforce down into sex and age group categories – for example, men age 16-17, men age 18 – 19 and so on.  In total they have 14 different groups.  There are 7 for each sex.  In addition, the study breaks down each sex into the following age groups: 16-17, 18-19, 20-24, 25-34, 35-44, 45-55 and 55+.  It might help at this point to either go to the study at the link below or draw out columns of a sheet of paper.

The study looks at each group’s labor participation rate in March 2001 and compares it to each group’s participation rate from November 2004 – February 2005.  March 2001 was the final month before the last recession began.  The percentage from November 2004–February 2005 provides as example of how each group is doing in the current cycle.

Here are the basic results.   men and women over 55+ are the only group that is participating at a higher participation rate in November 2004 – February 2005 compared to March 2001.  All other age groups are participating at a lower rate, particularly women.  This drop in participation is most pronounced in both sexes teenage and early 20s categories.  The report states it thusly:

“What leaps out … is the below-average recovery of participation in the current business cycle to date.  The depth of the shortfall is most pronounced among teens and for women of all ages.”

The other Federal Reserve reports come to similar conclusions albeit in different manners.  The bottom line is unemployment is probably between 1-3% points higher than the “official” unemployment rate.  Inflation adjusted wage growth for the past 5 years has been anemic at best, indicating these reports of higher labor market slack are more accurate in describing the overall labor market situation.  If the unemployment rate is indeed higher than reported, the stagflation scenario may be farther along.

Conclusion

First, I want to caution again: these are early signs.  This is not a foregone conclusion.  

Regarding the inflation outlook, the near unison inflation pronouncements from the Federal Reserve over the last month is an important warning regarding current Federal Reserve concerns.  Inflation is clearly number 1 on their list – and possible number 2 and 3 as well.  Higher prices are starting to have a wide impact on manufacturers and service providers prices paid.  It is only a matter of time before these economic intermediaries will start to pass these increases on to consumers.

Regarding the actual level of unemployment, the last 5 years of job growth have been at best anemic.   The US has lost nearly 3.4 million high-paying information technology and manufacturing jobs.  According to the establishment survey, the US economy created a little over 1.5 million jobs from January 2001 – August 2005.  While the household survey comes in at 4.6 million over the same period, that number is still too low to absorb the average monthly 150,000 displaced workers from attrition, seeking a new job, entering the workforce etc…   Joe Liscio noted in the August 15 Baron’s: “It looks like the U.S. economy is now dominated by housing, shopping, eating and drinking (with some help from very expensive health care). These don’t look like core productive sectors.”  In other words, the jobs created don’t pay as well.

The recent unanimous inflation pronouncements from Federal Reserve presidents sunk into the markets yesterday as the market sold-off breaching key technical levels.  Traders are nervous about the outlook, especially with 4th quarter earnings season coming up.  This nervousness combined with the weak employment situation is a proverbial double-whammy of concern.  And it should be.  Again, while nothing is definite, the initial occurrence of these combined economic warning signs should concern policy-makers.

Boston

CBO

NY