Why The Economy Can Handle A Rate Hike

This article was originally published on Moneyball Economics.

Jobless Claims As a Macroeconomic Leading Indicator

A hallmark of every recession has been the surge in initial jobless claims. Specifically, more claims are filed than the previous year. The opposite is also true: recoveries are led by a drop in claims year over year.

Initial claims rise before recessions begin. Here’s a quick look at the performance of this metric:

Main Street understands this. When economic expansion slows, hiring slows as well. It shows up first in the initial jobless claims y/y metric since they are dominated by temporary and part-time workers: exactly those who are on the front-lines of hiring and firing decisions.

It becomes a macroeconomic benchmark because, as topline growth slows faster than bottom-line growth, businesses realign their inventory of people and things: operating and capital expenditure (OPEX and CAPEX) cutbacks begin. Along the way the markets respond to the drops in credit demand, the margin compression, and so on.

Main Street gets this. The Federal Reserve does not.

The Clueless Fed

Those who can invest, do. Those who can’t, work at the Fed.

Lots of people snickered back in February when the Fed’s Janet Yellen said that biotech stocks were overvalued. Those stocks have surged since then. iShares Dow Jones US Healthcare (ETF) IYH is up 9 percent since then, compared to a 2 percent rise in the S&P.
Unfortunately for the world, the Federal Reserve is just as credible with economic predictions.

The Fed always top-ticks the economic cycle. When it comes to economic downturns, the Fed has a perfect track record of getting things wrong. Or, rather, it is always right at raising rates exactly when the economy has begun to contract. Is the Fed causing the recession with its rate hikes? Not at all. Recessions emerge after several quarters of slowing growth. For the Fed to raise rates after several quarters of slowing growth and into a period of contraction means that it has completely missed the economic inflection point. Every… single… time.

With only two notable exceptions (the most recent two cycles), the Fed has raised rates immediately before the recession starts or a quarter or two into the recession – not at all what we expect from a central bank that has a mandate to keep the economy rolling along. However the Fed does it time and time again, almost religiously. Every cycle, the Fed has jacked up rates to a cyclical high just before a recession kicks in.

Worse, the Fed (again with the same two exceptions) has always been slow to cut rates.

But the Fed may be changing its ways. The last two cycles show that it may be learning.

No rate hikes immediately prior to a recession

Fast, deep rate cuts when the recession begins

In other words, the Fed seems to be better at seeing what Main Street does and faster at responding.

Anticipating the Fed’s Next Moves: This Time is Different

As history shows, Fed rate hikes have never corresponded with actual economic growth. They have been perpetually late to the party. What if they finally got it right, though? That is, if the economy shows growth, the Fed will raise rates. Then if economic benchmarks are flashing slowdown, it won’t.

In this case, the jobless claims y/y metric’s track record and accuracy position it as an incredibly useful tool for predicting the timing of the next Fed move.

Right now, the y/y gap in claims signals two trends:

Continued economic expansion: The tipping point comes when claims are only ~10K below last year (~95 percent of last year’s claims). At ~30K, the current level is far outside the range where we should prepare for a recession.

The y/y gap is closing: Claims are moving closer to last year’s levels. Today they are bouncing around 270K-280K. In September 2014, initial jobless claims (seasonally adjusted) were ~290K. Spitting distance, but still outside that danger zone.

From a Fed-Watch standpoint, the Fed is free to raise rates. Nothing in the jobless claims data indicates “downturn” either today or in the next few months. Slack or not, the labor market says that the economy is growing and can handle a rate hike.

Does inflation merit a hike? Not right now, but it will. Healthcare and wage inflation will boost CPI above 2 percent. Only continued global economic downturns will keep the Fed’s hands off the trigger.