NEWS ALERT: Nonfarm Payrolls Sank 17,000 in January, First Drop in Four Years

Actually, August was originally reported as a 4,000 drop but has since been revised to show a 74,000 gain.

Similarly, private payrolls were originally reported to have declined by 13,000 in December but are now estimated to have risen by 54,000.

So is the fall for real this time? Perhaps but another upward revision should not be ruled out. Weak withholding tax receipts and a surge in jobless claims in the latest week are concerning but both the household and ADP survey employment measures registered solid gains in January. The household measure has diverged significantly from non-farm payrolls recently – see chart.

On balance, I still think recent data are consistent with a flat rather than contracting economy.

My concerns about manufacturing weakness were borne out by today’s purchasing managers’ survey, showing a fall in the key new orders index below the 50 level separating expansion and contraction. However, the output prices index simultaneously reached a new record high in its nine-year history.

There was a similar divergence in yesterday’s EU Commission consumer confidence survey. Respondents were more bearish on the economy and their own financial prospects, while the buying climate for major items fell to a 17-year low. My retail sales leading indicator now suggests a fall in spending in early 2008 – see first chart below.

All aboard for a 50 bp rate cut next week? Not so fast. Consumer perceptions of past and future inflation surged further, to record levels since the MPC’s inception. In isolation, this suggests rates should be rising not falling – see second chart.

It doesn’t get easier for the MPC. I shall post the MPC-ometer’s forecast on Monday.

The chart below shows the real level of the US Fed funds rate, defined with respect to the annual change in the consumption price index excluding food and energy – the Fed’s favoured inflation measure. After yesterday’s cut the real Fed funds rate stands at just 0.8%.

Real Fed funds peaked at a lower level in the current cycle than before the last six recessions. This has been one factor preventing my recession probability indicator from breaching the 50% “trigger” level.

As the chart shows, a real Fed funds rate of 0.8% was reached only near or even after the end of prior recessions. (In one case – the 1981-82 recession – it bottomed well above this level.) The shortest interval between the onset of a recession and real Fed funds reaching 0.8% was five months (in 1980). 

Pessimists argue that the economy entered a recession in November or December. Employment trends will be a key influence on the determination of the official arbiter, the National Bureau of Economic Research. Tomorrow's offical numbers will provide more information but the solid ADP payrolls report for January suggests employment has yet to turn down, implying the pessimists’ case is weak.

The Fed has embarked on an extraordinary monetary policy experiment, cutting official rates to post-recessionary levels when there is still little compelling evidence that a contraction has actually started.

One risk with this strategy is that the Fed is squandering ammunition that would be better reserved until significant economic weakness is confirmed. Premature easing may have boosted inflationary pressures with little positive impact on the real economy – see here.

The alternative risk is that the Fed is too pessimistic about economic prospects and combined monetary and fiscal stimulus will produce a strong rebound later in 2008, pushing inflation further above target. Anyone under any illusions about the Fed’s superior forecasting ability should read Chairman Bernanke’s monetary policy testimony to Congress in February 2006, containing the memorable phrase “a modest softening of housing activity seems more likely than a sharp contraction”.

Political and Wall Street pressure on the Fed is enormous but I think these risks warranted more measured cuts.

The headline balances from January’s CBI distributive trades survey are unremarkable, suggesting a slowdown but not collapse in retail spending. However, some worrying developments are buried in the detail of the report.

Specifically, wholesale traders have reported a sharp rise in stock levels in December and January and have cut back their orders with suppliers accordingly. Few economists bother to look at these series but weakness in wholesale orders usually signals deteriorating manufacturing prospects – see chart below.

I still favour a moderate growth slowdown this year rather than serious economic weakness but this is troubling news. Let’s see if there is any confirmation in the January purchasing managers’ manufacturing survey due on Friday.

Recent falls in share prices of US financial companies can be compared with the bear market associated with the savings and loan crisis of the late 1980s.

According to a General Accounting Office study, the S&L crisis cost $160 billion to resolve, equivalent to 2.9% of US GDP in 1989, when the bear market in financial stocks began. The equivalent percentage of GDP in 2007 would be $400 billion.

Will the subprime crisis inflict damage on this scale? Some estimates of the eventual losses are even higher but care is needed in the comparison, for two reasons. First, S&L damage was largely confined to the US, whereas foreign institutions have borne a significant portion of subprime losses. Secondly, the GAO estimate refers only to the cost of the rescue operation and excludes losses suffered by creditors and equity-holders of insolvent S&Ls.

It seems reasonable to assume that losses suffered by US financial institutions as a result of the subprime debacle may approach but will not exceed those of the S&L crisis. On this basis, the late 1980s bear market in US financial stocks may represent a “worst case” scenario for current events.

The chart below overlays the 1989-90 fall in US financial share prices on the current decline. (It is based on weekly closes and the peaks in February 2007 and October 1989 have been aligned and rebased to equal 100.) Four observations are:

1. Financial share prices would have to fall a further 15-20% from current levels to match the 1989-90 decline.

2. The comparison suggests a bottom may be in place by March.

3. Share prices recovered strongly in late 1990 and 1991, regaining their prior peak within nine months of the trough.

4. The 1990 recovery began following five cuts totalling 125 bp in the Fed funds rate; the funds rate has already declined by 175 bp in the current easing cycle and markets expect a fifth reduction this week.

Risks remain high but the 1989-91 experience suggests a significant buying opportunity is brewing.