Tuesday, August 11, 2015

The Labor Market Conditions Index as a leading indicator

 - by New Deal democrat

Via Naked Capitalism, Bill Mitchell writes that the Fed's "Labor Market Conditions Index is Weakening."  As usual, I hate the present progressive tense, since there is nothing about the index that forecasts what it itself will do over the coming months. Further, since it is still positive, labor market conditions are still above trend - just much less so than last year.  But the Index itself turns out to be a useful addition to the forecasting toolbox.

The LMCI is based on 19 components.  Click on the link above if you want further information on its makeup.  What is important to me is that it has a 40 year history of signaling a turn in the economy.

Here is the entire history of the index:

Here's what the data behind the Index shows: (1) the index has with one exception (1981's double-dip) always failed to make a new high for at least 12 months before the next recession, sometimes much longer than that; and (2) the index has always dropped below 0 and stayed negative for 6 months or somewhat more before the onset of the next recession.

Here is the Index over the last 5 years:

The Index made its cycle high at the beginning of 2012.  It made a secondary high in early 2014. But it has not turned consistently negative.

The Index become more valuable when it is teamed with two other measures: the YoY% growth in nonfarm payrolls, and interest rates.

As shown in the graph below, the LMCI consistently leads the YoY% growth in jobs by 6 - 12 months, but YoY job growth (red) is a much smoother measure:

Thus job growth serves as an important confirmation for the long leading part of the Index.

But a downturn below 0 in the LCMI, even partnered with a downturn in the growth of YoY jobs, hasn't always meant recession, as in the 1980s and 1990s.  That's where interest rates come into play.  In the 1980s and 1990s, as shown in the graph below (green), a marked increase in interest rates led to the declines in both the LMCI and YoY job growth.  

When that upturn in interest rates abated, the LMCI, and jobs, came back.  It was only when both weakened to the point where the LMCI was consistently negative, before interest rates declined, that a recession ensured.

Here is the same information for the period 2000 - present:

While the "taper tantrum" in interest rates briefly put a dent in the LMCI and YoY job growth, interest rates have calmed down since. In other words, more confirmation that we are probably past mid-cycle, but no imminent threat of an actual downturn.

On the negative side, since the LMCI does lead the much smoother YoY growth in jobs, it strongly suggests that YoY payroll growth is going to decline over the next 6 months or so.  And that can only happen if those payroll numbers generally come in under 225,000, and probably even below 200,000 through next winter.

All in all, the LMCI is a useful addition to the forecasting toolbox.