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Weekly Economic Commentary

 
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The ECB’s rate cut signals concerns about deflation

November 8, 2013

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  • The ECB’s rate cut signals concerns about deflation
  • The U.S. job numbers provide an upside surprise
  • How reliable are the U.S. employment data?

I spent the early days of this week in Holland. There is excitement building in the Netherlands; St. Nicholas will be entering the country soon, continuing a voyage that culminates in a celebration (Sinterklaasfeest) on December 6. The tradition is for celebrants to give each other little surprises, which are accompanied by specially composed poems.

The European Central Bank (ECB) got into the Sinterklaas spirit a little early, giving the market a little surprise that was accompanied by specially composed prose. The question is whether the move is cause for lasting celebration. The ECB policy council lowered its main policy rate by 25 basis points to 0.25%. This move had been under loose discussion for some time, but few expected it so soon. It seems clear that recent European price level readings moved the timetable forward.



The three-month annualized change in the eurozone consumer price index turned negative in October for the second time this year. The ECB reduced rates the first time this occurred, in April, and did so again this time. Much of the downward pressure on the price level is coming from countries on the European periphery, where wages are falling as part of a “competitive devaluation” process.

On the other side of the equation, inflation in Germany and France is still positive. This complicates the establishment of monetary policy; the head of the Deutsche Bundesbank, in particular, was less than enthusiastic about this week’s rate cut.

But as prices have continued to soften, worry over a Japanese outcome for Europe have grown. With fiscal authorities leaning towards austerity, the ECB must feel as if it is the only agent able to lean against the prospect of a lost decade.

During his press conference, ECB President Mario Draghi touched on the monetary policy artillery at the central bank’s disposal. In addition to the availability of an additional 25 basis point reduction of the policy rate (the rate at which banks borrow from the ECB), a lowering of the deposit rate (at which bank earn interest for deposits at the ECB) may be on the table. Since the deposit rate is at zero currently, this means pushing terms into negative territory.

Draghi mentioned once again that the ECB is technically ready to implement negative deposit rates. The main objective of such an action is to provide banks with an incentive to lend rather than park funds at the central bank.

However, the eurozone has a banking problem with a large number of nonperforming loans and a shortage of capital, which has prevented credit extensions. A negative deposit rate may not be enough to overcome structural limitations on lending.

Further, the reaction of banks and depositors to negative interest rates is uncertain and potentially counterproductive. Money could flow out of the banking system and into hard assets, as investors seek to prevent an erosion of principal. It is true that there are negative rates in a couple of European countries, but they are of a small scale relative to the size of the eurozone. Their experience therefore does not provide a roadmap for what might occur.

The ECB’s announcement did get a favorable initial reception in the currency markets, where the euro ended the rally that started amid U.S. fiscal follies. The retreat should help European exports going forward.



Over the longer term, though, the lower policy rate will not have an impact unless it is reflected in loan rates among member countries. After the outbreak of the sovereign debt crisis, loan rates to nonfinancial corporations diverged to reflect the variation in underlying risk among members of the eurozone. If the ECB’s action is to succeed, this large disparity of interest rates has to be minimized. In this regard, remarks in the policy statement after the ECB’s meeting are noteworthy: “In order to ensure an adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further.”

Further, a turnaround in inflation will occur only if aggregate demand gathers steam. The jury is still out about whether the nascent recovery will be sustained and robust. The reluctance of Germany to stimulate demand, in particular, has held the continent back.

But it seems clear that the ECB is trying to make the most of a limited toolkit. Mario Draghi bears little resemblance to Sinterklaas, but he is certainly hoping to bring cheer to Europe. And for that, we should say dank u wel en veel success.

Employment Remains Resilient Despite Government Shutdown

Payroll employment advanced 204,000 in October, following net upward revisions of 60,000 to August and September estimates. Last month’s increase included a 212,000 jump in private sector payrolls and an 8,000 decline in government employment. The Bureau of Labor Statistics (BLS) noted in the report that “there were no discernible impacts of the partial federal government shutdown on the estimates of employment, hours, and earnings from the establishment survey.”

The unemployment rate moved up one notch to 7.3%, but was distorted by the federal government shutdown. There was a large increase in the number of federal government workers classified as employed but absent from work, and there was an increase in federal workers counted as employed but on temporary layoff.


 

In all, employment in the household survey fell 735,000 and the labor force dropped 720,000. The 0.4 percentage point drop in the participation rate to 62.8% adds another layer of complexity around the numbers. Therefore, it may be best to wait for the November employment report to sort this out.

The key question is whether October employment numbers are adequate for the Fed to commence tapering at the December Federal Open Market Committee (FOMC) meeting. At the September meeting, the Fed listed three reasons that prevented a tapering announcement – higher interest rates, lackluster labor market conditions and fiscal uncertainty.

Of the three, the fiscal uncertainty issue remains the most problematic. Congress needs to reach an understanding about spending and taxes by December 13, 2013, and the current Continuing Resolution expires on January 15, 2014. Another federal government shutdown is likely if Congress fails to compromise prior to these deadlines.

These unresolved matters could prompt the Fed to wait until the January 28-29 FOMC meeting to announce the reduction of asset purchases, barring a pleasant holiday gift from Congress or very strong economic data prior to the December 17-18 FOMC meeting.

The Potential for Error

The U.S. labor market report is arguably the most closely watched economic release of each month. Its status has only risen as the Federal Reserve has tied its policy more directly to measures of unemployment. Economists (including this one) follow the news very closely, and transactions worth trillions of dollars ride on the announcement.

The data, however, are subject to considerable measurement error. The outcomes are based on small samples that are extrapolated to a much larger population; while the samples are constructed to be representative, variance is certainly possible. For example, if the BLS estimates that 100,000 jobs were created in a given month, the 90% confidence band around that projection would be the range from 10,000 to 190,000. That is large enough to drive a truck full of workers through.

Each month’s release typically contains revisions to the prior two months. This occurs because sampling results may not be complete until well after the survey period ends. These revisions are sometimes sizeable enough to change perceptions of labor market health.

 

And each year the BLS performs a benchmark revision that serves to revise data for prior years. These sometimes can have a surprisingly large effect; in the last iteration, the count for 2012 was raised by 424,000. The improvement of 35,000 per month could certainly have made disappointing numbers acceptable and acceptable numbers strong.

Expanding samples and investing in new statistical techniques might certainly reduce the potential for error. The BLS has particular difficulty accounting for new firms, whose appearance and disappearance can sometimes mean big swings in payrolls. But Congress has been loath to make these kinds of investments, and the payoff is difficult to quantify.

So as we all scurry around reacting to this morning’s job news, we should keep in mind that the figures could look significantly different before all is said and done. Always best to avoid overreacting to a single number, and to understand its strengths and weaknesses.

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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