Monday, March 5, 2018

A simple model of interest rates and the jobs market

 - by New Deal democrat

Since we are still in an era of very low interest rates, and during the past such era of 1930-1955 several recessions including the very bad 1938 recession occurred without a yield curve inversion, I have been looking at alternative measures.

One such measure I described about a  month ago, which is simply that an increase in the Fed funds rate of at least 1.75%, but typically 2% or more, and particularly when that occurs within a single year, has usually been correlated with a subsequent recession.

Today I want to propose another model: a YoY increase in the Fed funds rate equal to the YoY% change in job growth has in the past almost infallibly been correlated with a recession within roughly 12 months.

So, to the graphs!  The first shows the relationship I describe in the above paragraph over the last 60+ years:

To give an even better view, the below graph subtracts the YoY change in the Fed funds rate from YoY payroll growth, and subtracts a further -0.5%, showing that even when the relationship gets that close, with the exception of 2002-03 (a near recession), a recession has always followed:

In other words, there is only one false positive with two false negatives in the 1950s.

Here is a close-up of what that relationship has looked like in the last several years:

Currently the spread is about +0.7%. Note that if the rate of YoY payrolls growth continues to decelerate at its pace from the last several years, and we get the three expected Fed funds hikes this year, we will probably cross the +0.5% threshold by year's end. 

We can coax even more from the model, because the YoY change in the Fed funds rate also does a very good job forecasting the *rate* of YoY change in payrolls 12 to 24 months out, as shown in the below graph (note that the Fed funds rate is inverted, so that a rise in that rate forecasts a deceleration in YoY jobs growth):

Now  here is a close-up of the last three years:

With rates at the "zero lower bound," the relationship did break down in that there was increasing YoY jobs growth while the Fed funds rate remained at zero, and jobs growth slowed down even as the Fed started to raise rates slowly. But if the longer term correlation holds, then the Fed rate hikes from last year should mean that jobs growth this year and into next year should decelerate at a faster rate than they have in 2015-17.  In other words, we could be under the +0.5% level in our model by midyear.