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NAIRU, And Other Will-O’-The-Wisps

NAIRU, And Other Will-O’-The-Wisps

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The discussion of the role in unemployment is a key theoretical divide between Modern Monetary Theory and mainstream approaches. Theoretical conclusions determine the suggested policy response of governments to unemployment. The structural changes to the labour market made by policymakers in the 1990s were based on following a theory.

(This is a rather lengthy unedited excerpt from the manuscript of my MMT primer. It has references to other sections of the manuscript.)

The modern version of the theory relied up the concept of the Non-Accelerating Inflation Rate of Unemployment – NAIRU – although if one digs into academic history, there are a few related measures with slightly different definitions. Since I want to focus on MMT – and avoid going too far into the swamp of critiques of neoclassical macro – I want to underline this section is offering a simplified version of the evolution of the concept. Interested readers are pointed to the text Full Employment Abandoned: Shifting Sands and Policy Failures by William Mitchell and Joan Muysken. From my perspective, the historical development of these concepts might be of interest of historians of economic thought, but from an empirical perspective, any measure like NAIRU is found to be of no use in understanding the economy. Within the physical sciences and engineering (which I briefly taught), we do not waste students’ time going through the history of failed concepts.

Really Short History of NAIRU

The history behind NAIRU is long, and to do it properly, one would need to watch the full evolution of economic theory. Rather than attempt to do that, I am going to focus on the political economy aspects. I will caution the reader that it is simplistic, but my argument is that you need to get the big picture view before being bogged down in who said what.

If we look back to the pre-Keynesian era – normally called classical economics – the working assumption was that all markets moved to equilibrium courtesy of the laws of supply and demand. The story was that unemployment was essentially a natural outcome of market processes, and there was little to be done about it. If the economy is perturbed by some disturbance (a depression or recession), it will move on its own back to the level where all workers who want to work at the prevailing wage are employed. (Note that business cycle analysis as well developed as it is now, and it is not clear how seriously held this view was. This may have just been pro-market propaganda produced for the masses.)

John Maynard Keynes created the field of macroeconomics when he launched his theoretical research programme into the business cycle. The politically-charged insight of this programme was that unemployment rates can stagnate at a level above what would be seen as “efficient.” A such, governments had an imperative to drive down the unemployment rate – the Full Employment framework described in Section 2.2.

Free market-oriented politicians and economists were not happy with the social programmes aimed to reduce unemployment, and eventually launched a counterattack. The main theoretical concept advanced was the natural rate of unemployment, proposed by Milton Friedman. The idea is straightforward: if the unemployment rate falls below the natural rate, the economy will experience accelerating inflation. Although Friedman cautioned that the word “natural” was derived from usage elsewhere in economics, it was effectively mis-interpreted as being a “law of nature” and immutable. (Friedman did argue that the rate depended on other factors.)

(From the perspective of MMT, this episode is a useful example of the concept of framing in economics. Why call it the “natural rate” if it is not a law of nature? One could easily assume that this was a deliberate attempt to mislead the broad public.)

The original formulation of the natural rate of unemployment failed miserably as an empirical concept. Nevertheless, new variants of the concept appeared. In North America, the concept of NAIRU was the most popular replacement. (European theory diverged slightly, following the path set in the text Unemployment: Macroeconomic Performance and the Labour Market, by Layard, Nickell, and Jackman. I will stick to the consensus North American version of the theory for simplicity.)

NAIRU: the U.S. Experience

If one looks at the historical debates about NAIRU (and its relations), it is easy to drown in details. However, if we focus on the post-1990 period, it becomes much easier to discuss. The issue is straightforward: the concept failed empirically, and it is fairly clear that there is no easy way to save it. This was not the case in earlier decades: new models were proposed that at least fit recent historical data.

For reasons of simplicity, I will look at a single measure of NAIRU: the long-term NAIRU produced by the Congressional Budget Office (CBO). It is extremely likely that one could find a different measure that performs slightly better, but that is clearing an extremely low bar.
Chart: NAIRU and U3 Unemployment Rate

The figure above shows the movements of NAIRU and the U-3 (headline) unemployment rate. The top panel shows the levels since 1990, while the bottom shows the difference – NAIRU minus the unemployment rate. (It seems preferable to subtract NAIRU from the unemployment rate, but I am reversing it for reasons to be discussed below.) I am labelling this difference the “employment gap” – as an analogy to the output gap – but I warn that this may not be standard terminology. I cut off the charts in January 2020 to avoid the jump in 2020, which obscures movements in earlier decades.

As can be seen, the unemployment rate spikes higher during recessions, and then grinds steadily lower during the following expansion. (The 2020 experience is likely to be erratic due to the nature of the slowdown. At the time of writing, only a few post-pandemic datapoints are available.) The unemployment rate slices through the relatively slow-moving NAIRU.

Keep in mind that there are many ways in which one could calculate a NAIRU estimate. However, the premise is that it is a slow-moving variable, similar to the CBO measure shown. If we replaced the CBO NAIRU estimate with any variable that meets that criterion, all that would happen is that the unemployment gap measure just shift up or down by a certain amount, but the qualitative picture would be the same. That is, the unemployment rate drives below the new series during the expansion, and then shoots above it during the recession. (If the measure was always above or always below the observed unemployment rate, something is obviously wrong.)

Just a simple visual analysis of this chart largely puts to rest an ancient theoretical debate: does the unemployment rate “naturally” converge to NAIRU? Given that it typically took around half a decade to close the negative employment gap after recessions, the reversion speed is too slow to be of any interest.

NAIRU and Inflation

Instead, modern theories of the NAIRU (and its relations) suggest that the employment gap ought to be a determining factor for inflation. The initial problem is that “inflation” is somewhat vague: in this context, one could either look at wage inflation, or the rise of consumer prices (e.g., the CPI). (Yet another alternative is the GDP deflator, but the GDP deflator has some unusual properties that I do not want to deal with.)

If one delves into the economic literature (including Full Employment Abandoned), whether one uses consumer price inflation or wage inflation matters if one looks at the historical development of models (who gets credit for what). Since these models have obvious weaknesses, I am not too concerned about these distinctions. For completeness, I will show both variants.

The chart above shows the experience of the employment gap and the changes in average hourly earnings in the United States since 1990. The top panel shows the employment gap (NAIRU minus the unemployment rate), and the bottom panel shows the annual change in average hourly earnings.

One initial reaction is that the two series are correlated (the two series move up and down together). This is exactly what one would expect if wage inflation is correlated with the business cycle – which is a prediction of most plausible economic models.

However, this is not enough – we need to see whether inflation is accelerating (since accelerating is the “A” in NAIRU). As we can see, this is not happening. Wage inflation bottoms after a recession, but it does not keep falling. If we look at the three circled episodes after recessions, wage inflation stopped falling when the employment gap was negative – which means that it did not keep falling, even though the employment gap was still negative for a few years. As for a positive acceleration, the one clean episode where the employment gap was clearly positive (in the 1990s), we see that wage inflation stopped accelerating years before the recession (and the employment gap was positive). (The employment gap did not get very positive in the latter two expansions, so the picture is not particularly clear.)
Chart: Employment Gap And Core CPI

The figure above repeats the analysis with core consumer price inflation – excluding food and energy. (Although the use of core inflation distresses some people, the difference between headline and core is largely the result of gasoline prices. Energy prices are important, but oil price spikes cannot be exclusively pinned on U.S. domestic policy settings in the post-1990s period.

If we put aside the period of relatively high inflation in the early 1990s, we see that core CPI inflation stuck near its period average of 2.4% - with dips that occurred after the recessions that started in 2001 and 2008. Core CPI inflation was correlated with the employment gap – an unsurprising outcome given they are both pro-cyclical – but given the scale on the graph, we see that “acceleration” in inflation is negligible.

With some ingenuity, one could attempt to explain away the lack of acceleration by appealing to other factors that coincidentally always managed to cancel out the acceleration predicted by the NAIRU concept. I will return to that argument in the technical appendix.

The Policy Debates

The three expansions after 1990 featured the same debate: the unemployment rate is about to drop below NAIRU, so should the Federal Reserve hike rates to counter-act the risks of rising inflation? The lack of accelerating inflation was typically seen as the result of flawed estimates of NAIRU; if we improved the methodology, NAIRU was lower than expected. Pavlina R. Tcherneva discusses the “search for NAIRU” in Chapter 2 of The Case for a Job Guarantee.

This argument that any particular NAIRU estimate (like the one produced by the CBO) is flawed and could be replaced by a better one is entirely reasonable. If we assume that economics is a science, we need to adapt our theories to observed data. However, I have some deep reservations with this view. Given the complexity of the topic, I have deferred this discussion to a technical appendix at the end of this section.

Rather than debate estimation methodologies, there is a much simpler alternative: NAIRU does not exist. The title of Chapter 4 of Full Employment Abandoned is “The troublesome NAIRU: the hoax that undermined full employment” offers a hint as to what the authors’ views on the matter are.

From my experience, when one argues that NAIRU does not exist, one is hit with a wall of objections. The objections that I have seen were not particularly strong, as my feeling is that the people raising the objection are conflating “NAIRU does not exist” with “there is no relationship between unemployment and inflation.”

I will start off stating what I see as a minimal version of the statement “NAIRU does not exist.” The statements are theoretically weak (assume very little) but are easily understood. However, this is how I interpret MMT, and thus need to be taken as a grain of salt. I will then discuss some of the comments from Full Employment Abandoned, which is an authoritative source.

I argue that the following terms are safe observations to make about the business cycle.
  1. Inflation (however defined) is positively correlated with the business cycle: it tends to rise during an expansion.
  2. The unemployment rate is negatively correlated with the business cycle. (This seems almost to hold by definition, but people enter/leave the workforce.)
  3. The two previous statements imply that should expect to see a local relationship between unemployment rate changes and the inflation rate. This implies that we can typically fit a NAIRU-style relationship to a small segment of historical data.
  4. The unemployment rate and annual (core) inflation both feature trending behaviour: the level in the current period is relatively close to historical values. (There is considerable noise in annualised inflation rates on a month-to-month basis, but that noise tends to cancel out, so that the annual average follows a trend.)
  5. This trending behaviour means that the local models in (3) can be spliced together in back history, but one would expect that predictions based on such splices will tend to break down.

The implication of this logic is straightforward. It is a mistake to look at historical data and argue that if the unemployment rate drops below some arbitrary level in future years, inflation will accelerate. That was the mistake that policymakers and market participants kept making over the 1990-2020 period. (Will they do it after 2020? That may depend upon the theoretical success of MMT.)

Mitchell and Muysken phrase the idea differently.
We have demonstrated (in Section 4.2) that contrary to theoretical claims of the natural rate theorists, non-structural variables have an impact on the NAIRU, which means that aggregate demand variations can alter the steady-state unemployment rate. This insight, alone, undermines the concept of natural unemployment, or NAIRU, which is driven by the notion that only structural measures can be taken if the government wants to reduce the current steady-state unemployment rate. As a consequence it is little wonder that the concept of equilibrium unemployment lost its original structural meaning and becomes indistinguishable in dynamics from the actual unemployment rate. [Section 4.2, page 116]
These statements are somewhat more complex than saying NAIRU does not exist, rather it is saying that if it existed, it does not behave the way that “natural rate theorists” suppose. Fans of arcane theoretical disputes will probably prefer this phrasing, but my argument is that the plain English interpretation of the phrase “NAIRU does not exist” covers this more complex theoretical position.

The jargon about “structural” and “non-structural” might be unfamiliar. To interpret, “structural” factors are institutional barriers that allegedly cause people to remain unemployed. From the neoliberal perspective, these are mainly the result of social programmes that give incomes to the unemployed. Non-structural factors are those related to the business cycle. I now will turn to one such factor that is highlighted by Mitchell and Muysken: hysteresis.

Hysteresis

Bill Mitchell’s work in the 1980s emphasised the concept of hysteresis, although the idea has a longer history. (Full Employment Abandoned provides a 1972 quotation from Edmund Phelps that used the term in this context. Hysteresis is a term used in physics and is typically described as “path dependence.”

In the case of unemployment, the definition is as follows. Firstly, we need to assume that there we can define something resembling NAIRU so that the employment gap offers useful predictions about inflation. If hysteresis is present, this measure is affected by the historical trajectory of unemployment. More specifically, if the rate of unemployment was high, the estimated “NAIRU” will rise.

Although this might sound like the case without hysteresis, this has radically different policy implications. By driving the unemployment rate lower, the value of “NAIRU” is lower. It implies that there can be a trade-off between unemployment and inflation, and that policies that create employment are optimal – since they are associated with lower steady state unemployment. Meanwhile, this help explain the lack of inflation acceleration discussed earlier. If “NAIRU” is just tracking the unemployment rate (similar to taking a moving average), inflation will not move very much.

There are several ways in which hysteresis can arise – the literature surveyed in Full Employment Abandoned gives a number of mechanisms. Although this of interest to academics, from a practical perspective, it means that “NAIRU with hysteresis” does not behave the way the consensus assumes (e.g., the only way to lower it is through “structural reforms”). From a forecasting perspective, the concept is largely useless. Since the reality is so far away from beliefs about NAIRU, I would argue that the simplest description is that “NAIRU does not exist.”

From the perspective of MMT, the key conclusion to draw from this line of argument is that it makes little sense to keep people unemployed in order to stabilise the price level. This will be expanded upon in the discussion of the Job Guarantee in Chapter 3.

Technical Appendix: Falsifiability?

Given that the neoclassical consensus decided that inflation control is the mot important task for policy, it is no surprise that a great deal of effort has been expended upon the analysis of inflation. As such, just showing a couple time series plots is not the final word on this topic. Nevertheless, the outlook for NAIRU is not much better even if we dig deeper.

The first thing to realise is that we can very easily reject the belief that NAIRU is a constant, or that inflation depends solely upon the employment gap. We need a more complex model, where other factors influence inflation, and the estimate of NAIRU changes over time (as does the CBO series).
The addition of the extra factors gives the defenders of the concept of NAIRU (and its close cousins). Those other factors always managed to shift in such a fashion so that inflation did not accelerate, even with a non-zero employment gap. So, we can find a model that has a good fit to the back history.

Unfortunately, there are two explanations for this.
  1. The more complex model is correct.
  2. The model is wrong, and the employment gap does not cause inflation to accelerate.
Since central bankers and academics are paid to produce models that predict economic outcomes, it is perhaps unsurprising that the first option was chosen, and the second brushed aside.
Neoclassical theory is highly dependent upon variables that are inferred from the data:
  • the natural rate of unemployment/NAIRU;
  • potential GDP (a replacement to the above);
  • the natural rate of interest (r*).
Economic outcomes are the result of observed variables (unemployment, GDP, interest rates) from these theoretical constructs. Since the variables cannot be directly measured, they are inferred from statistical procedures that assume that the underlying neoclassical theory is correct.

Neoclassical theorists have little difficulty believing that the underlying assumptions of their theories are correct. However, outsiders have a good cause to question the falsifiability of the methodology. Since the level of the hidden variables are backed out from observed data, there is no way that historical data can deviate from the model predictions.

However, we are not interested in predicting historical events, we need forward-looking behaviour. As one might suspect, the models do a decent job in fitting economic data following smooth trends, but have a hard time dealing with turning points (mainly recessions, which is a sub-theme of my text Recessions). Longer-term extrapolations – such as inflation rising when NAIRU is hit in future years – also fail, with the failure covered up by continuous cuts to the estimated value of NAIRU.

It is safe to say that neoclassical theorists can find counter-arguments to my line of argument here. Since the objective of this text is to explain MMT, I will not pursue the argument. But from the perspective of those who are interested in how MMT fits in with financial market analysis, this is a topic that is of importance.

References and Further Reading

  • Full Employment Abandoned: Shifting Sands and Policy Failures, William Mitchell and Joan Muysken, Edward Elgar Publishing, 2008. ISBN: 978-1-85898-507-7
  • The Case for a Job Guarantee, Pavlina R. Tcherneva, Polity Press, 2020. ISBN: 978-1-5095-4211-6

(c) Brian Romanchuk 2020

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Industrial Production Decreased 0.1% in January

From the Fed: Industrial Production and Capacity Utilization
Industrial production edged down 0.1 percent in January after recording no change in December. In January, manufacturing output declined 0.5 percent and mining output fell 2.3 percent; winter…

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From the Fed: Industrial Production and Capacity Utilization
Industrial production edged down 0.1 percent in January after recording no change in December. In January, manufacturing output declined 0.5 percent and mining output fell 2.3 percent; winter weather contributed to the declines in both sectors. The index for utilities jumped 6.0 percent, as demand for heating surged following a move from unusually mild temperatures in December to unusually cold temperatures in January. At 102.6 percent of its 2017 average, total industrial production in January was identical to its year-earlier level. Capacity utilization for the industrial sector moved down 0.2 percentage point in January to 78.5 percent, a rate that is 1.1 percentage points below its long-run (1972–2023) average.
emphasis added
Click on graph for larger image.

This graph shows Capacity Utilization. This series is up from the record low set in April 2020, and above the level in February 2020 (pre-pandemic).

Capacity utilization at 78.5% is 1.1% below the average from 1972 to 2022.  This was below consensus expectations.

Note: y-axis doesn't start at zero to better show the change.


Industrial Production The second graph shows industrial production since 1967.

Industrial production decreased to 102.6. This is above the pre-pandemic level.

Industrial production was below consensus expectations.

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The Greenback is in Narrow Ranges to Start the Week

Overview: The foreign exchange market is quiet. The
Lunar New Year holiday shut most Asian markets. That, coupled with the light
news in Europe, have…

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Overview: The foreign exchange market is quiet. The Lunar New Year holiday shut most Asian markets. That, coupled with the light news in Europe, have served to keep the dollar in narrow ranges against the G10 currencies. The Swedish krona, Norwegian krone, and Japanese yen are posting minor gains against the greenback. The New Zealand dollar, which was strongest major currency last week (1.4%) is off by almost 0.5% today, making it the weakest today. RBNZ Governor Orr underscored the recent message that inflation is still too high (~4.7%). Emerging market currencies are narrowly mixed (+/-0.2%). Of note, India reports December industrial production and January CPI shortly.

The few equity markets in the Asia Pacific region that were not on holiday today, including Australia, India, and New Zealand slipped. Political uncertainty in Pakistan saw its stock market tagged for 3%. On the other hand, Europe's Stoxx 600 is trying to snap a three-day fall (less than 0.4%). Of note, real estate is the strongest sector today, rising by more than 1%. US index futures are trading firmly after new record-highs before the weekend. Benchmark 10-year bond yields are 3-6 bp lower in Europe. The 10-year US Treasury yield is off a basis point to around 4.16%. Gold is trading with a softer bias near $2020. Last week's low was around $2015. April WTI set this month's high before the weekend near $77.15. It is approaching the pre-weekend lows slightly below $76. Support is seen closer to $75. 

Asia Pacific

The top two BOJ officials played down speculation that the central bank’s from negative interest rates will signal the start of a tightening cycle, and for good reason. First, inflation is already well off its peak and could easily fall below the 2% target before the April BOJ meeting that is widely expected to adjust policy. Second, despite a shortage of workers, (Japan's working age population peaked nearly 30 years ago) and the gradual opening to foreign workers, wage growth continues to lag inflation. Third, and related, domestic demand is soft. Toward the end of the week, Japan will publish its initial estimate of Q4 GDP. Consumption is likely to have recovered weakly from the contraction in Q2 and Q3 23. In the five years (20 quarters) before the pandemic, Japan's private consumption component in its GDP contracted by an average of 0.2% a quarter. Also, note that although the BOJ set the overnight target rate at minus 0.10%, the effective rate at the end of last week was 0.005%. Governor Ueda is determined to exit the negative interest rate policy for technical and strategic reasons. Arguably, there was windows of opportunity previously, where the macroeconomic setting was conducive to exiting the negative policy rate. 

Most Asian markets were closed today, and China's mainland markets are closed all week for the Lunar New Year holiday. We expect that after the holiday, more efforts to support the economy and fight deflation will be forthcoming. Despite the stimulus in H2 23, the economy does not seem responsive. The assumption that the state-owned banks are just arms of the government is challenged by the same banks not fully passing on the PBOC's lower rates. The one- and five-year loan prime rates will be set on Feb 20. The same state-owned banks have also been reluctant to lend to the property market and enact the support measures Beijing unveiled in 2022. Lastly, consider the offshore yuan. It does not have to but with few exceptions respects the onshore band (2% for the dollar around the reference rate). Why? While the PBOC could intervene there, but when it does it is fairly clear. The last reference rate creates a band of ~CNH6.9640-CNH7.2485. Is it too much to suggest that the same mechanism that keeps the offshore yuan within the onshore band explains a great deal of how the PBOC manages the exchange rate? To paraphrase an old Chinese saying, "kill an occasional chicken to scare the monkeys."  

The dollar edged a little closer to the JPY150 level ahead of the weekend (~JPY149.60) before settling virtually unchanged near JPY149.30. There are around $1.4 bln in options at JPY150 that expire tomorrow. During the six-week decline in the yen, speculators in the futures market have grown their net short yen position by more than 50% to 84k contracts (~$7 bln). The greenback is a narrow range of about a third of a yen above JPY149. The price action looks like a bullish pennant or flag, The Australian dollar's range last week, roughly $0.6470-$0.6540, is the key to the near-term direction. We favor an upside break and watching the possible bullish divergence with some of the momentum indicators but recognize the $0.6555-75 area to be an important hurdle. The Aussie eked out a small gain last week (~0.20%), the first of the year. Speculators in the futures markets added to their net short Australian dollar position for the fourth week in a row. It now stands at about 71.8k contracts (~$7.2 bln), up from 32.3k before the streak began. The Aussie is trading in about a fifth of a cent range above $0.6510.

Europe

The European economic calendar is light this week, and what there is, may be a sad reminder of the Europe's sad state. Eurostat will publish the details of Q4 23 GDP. The initial estimate had the regional economy stagnating after a 0.1% contraction in Q3. The dramatic 1.6% drop in Germany December industrial output (-3.0% year-over-year) underscores the lack of growth impulses to start the new year, and the weakness of what had been the European engine. At the same time, leadership is weak. Among the large members, Italy's Meloni, right-government seems among the strongest, and incidentally, the economy is doing better (but still not well). In 2022, Germany grew by 1.8%. Italy grew twice as fast. Last year, the German economy contracted by 0.3%, while Italy expanded by 0.7%. On the other hand, Italy's budget deficit was about 5.4% of GDP last year, while Germany's was less than 2.5%. Italy's 10-year premium over German narrowed to about 140 bp at the end of January, almost a two-year low, after rising to a nine-month peak last October over 200 bp. It is snapping back this month is near 155 bp. Italy's two-year premium peaked near 95 bp in the middle of last October and fell to almost 45 bp late last month. Last year's low was below 30 bp. It has jumped to about 65 bp now, the most since last November.

The Swiss franc was the strongest G10 currency in Q4 23 as dollar fell across the board. It rose 8.8% and so far, this year, the franc has fallen by about 3.9%. The dollar approached the (50%) retracement objective (~CHF0.8790). Above there is the 200-day moving average (~CHF0.8845) and the (61.8%) retracement near CHF0.8900. The euro is recovering from multiyear lows set against the franc in Q4 23 (~CHF0.9255). It traded up to almost CHF0.9475 last month but pulled back to support near CHF0.9300 earlier this month. There may be potential toward CHF0.9500-CHF0.9550. Switzerland reports January CPI tomorrow. The EU harmonized measure is expected to slip to 2.0% from 2.1%. Its own measure is seen easing to 1.6% (from 1.7%) and the core rate to 1.4% (from 1.5%).

The euro reached a six-day high late in thin Asia Pacific turnover near $1.0805. It was quickly sold to almost $1.0765 before finding a bid in early European turnover. It is the fourth session of higher highs. The pre-weekend low was almost $1.0760, and a break of the $1.0755 area would weaken the fragile technical tone. There are options for about $755 mln euros at $1.08 that expire today. There are large (1.4-1.5 bln euros) at $1.07 that expire tomorrow and Wednesday. Stiff resistance is seen in the $1.0830-40 area. Sterling recovered after breaking down at the start of last week (~$1.2520) but settled back into the $1.26-$1.28 trading range in the past three sessions. The $1.2640 area had capped but, like the euro, set a new six-day high before Europe opened and took sterling down to almost $1.2615. Before the weekend, sterling briefly frayed the $1.26 level. It is an important week for UK data, including the labor market report tomorrow and the January CPI on Wednesday. Soft data may encourage bringing forward the first rate cut to June from August. 

America

Interest rates and expectations are a key force driving exchange rates. The market has gradually reduced the odds May rate cut to about 73% from 90% chance after the strong January jobs growth. It also scaled back the magnitude of Fed cuts by about 50 bp (to ~112 bp) in the past month. Tomorrow's CPI, more than last week's historic revisions, is a key input into the Fed's reaction function. Fed Chair Powell recently indicated the central bank was looking for more confirmation that inflation was on a sustained path back to its target. The January figures will give the Fed that. Ahead of it, the results of the NY Fed's inflation survey are of little consequence.

Canada reported a loss of full-time jobs in January for the second consecutive month. Wage growth slowed. The decline in the unemployment rate to 5.7% (from 5.8%) can be explained by the decline in the participation rate (65.3% vs. 65.4%). The takeaway is that the market boosted the chances of a June rate cut (to ~77% vs. ~67%). Despite the risk-on mood, which lifted the S&P 500 to a new record high, the Canadian dollar found no traction. It fell slightly for the first time in three sessions. The US dollar made session highs near midday in NY ahead of the weekend near CAD1.3480. The greenback is in a narrow 20-tick range above CAD1.3450 so fat today. Nearby resistance is seen in the CAD1.3500 area but the greenback has been turned back from the CAD1.3540 area three times. There are options for about $630 mln at CAD1.35 that expire tomorrow. The Mexican peso weakened after the central bank seemed to prepare the market for a rate cut as early as next month. However, it recovered and returned to pre-central bank levels near MXN17.08. It has edged low today to MXN17.0640. MXN17.00 was tested early last week. Around $580 mln of options expire there on Thursday. The US dollar reached BRL5.0175 at the start of last week. On the pullback, it found support near BRL4.95. It settled last week just above there. There is a band of technical support between BRL4.91 and BRL4.93.

 

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Week Ahead: Will Soft US CPI and Retail Sales Mark the End of the Interest Rate Adjustment and Help Cap the Greenback?

The
markets are still correcting from the overshoot on rates and the dollar that
took place in late 2023. The first Fed rate cut has been pushed out of…

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The markets are still correcting from the overshoot on rates and the dollar that took place in late 2023. The first Fed rate cut has been pushed out of March and odds of a May move have been pared to the lowest since last November. The extent of this year's cuts has been chopped to about 4.5 quarter-point move (~112 bp) from more than six a month ago. The market has reduced the extent of ECB cuts to about 114 bp (from 160 bp at the end of January and 190 in late 2023). The Bank of England is now expected to cut rates three times this year (75 bp), which is nearly 100 bp less than was discounted at the end of last year. The extent of Bank of Canada rate cuts this year has been halved to less than 80 bp from 160 bp in late December 2023. We suspect that the interest rate adjustment is nearly over. A soft US CPI and weak retail sales report next Tuesday and Wednesday could help cap US rates and signal the end of the dollar's New Year rally. 

The UK reports CPI on February 14, and given the base effect (-0.6% in January 2023), even a 0.3% decline in prices last month, the year-over-year rate is likely to rise (to 4.2%-4.3%). However, the bigger story for the UK, the eurozone, and Canada is that inflation rose sharply in the Feb-May period last year, and as these drop out of the 12-month comparisons, the year-over-year rates will fall dramatically. The UK and Japan will report Q4 23 GDP. The UK economy likely contracted slightly for the second consecutive quarter. Japan, the world's third-largest economy, likely returned to growth after contracting at an annual rate of almost 3% in Q3. Consumer spending and capex fell in Q2 and Q3 24. Both likely recovered. The UK and Australia report new labor market figures. In the UK wages are moderating and the economy likely lost full-time positions for the second consecutive month in January. It is difficult to image a worse employment data than Australia reported last month. It lost 106k full-time jobs, which, outside of the pandemic, looks like the worst on record. 

United States:  The data and official guidance have pushed out expectation of the first Fed cut and reduce the extent to this year's cut. The market's confidence (~73%, down from 90% after the employment data) of a May move still seems too high given the apparent momentum the economy enjoys in early 2024, even if we do put too much emphasis on the Atlanta Fed's GDP tracker (3.4%) this early in the quarter. The market has about 4.5 Fed cuts discounted this year, down from more than six cuts as recently as mid-January. The May decision is unlikely to be determined by January data. That counts even this week's highlights of CPI, retail sales, and industrial production.

At his post-FOMC press conference, Fed Chair Powell called attention to "six months of good inflation." This looks to have continued into this year. The headline CPI rate is seen rising by 0.2% (February 13), which, given the base effect (0.5% in January 2023), would see the year-over-year rate fall to 3.0%-3.1% from 3.4%  Yet, the median forecast from the nine economists that participated in Bloomberg's survey (by end of last week) see it falling to 2.9%. The core rate is expected to rise by 0.3% for the third consecutive month and the fifth time in six months. That may be more important that the softer year-over-year rate (~3.7% vs 3.9%). 

January retail sales (Feb 15) may have been dragged down by disappointing auto sales (15 mln SAAR, down from 15.83 mln in December). Consumption would appear be off to a slow start after retail sales rose by an average of 0.2% in Q4 23 after a blistering 0.7% average gain in Q3 23. The median forecast is for a 0.2% decline in headline retail sales (+0.6% in December). On the other hand, industrial production (Feb 15) appears to have accelerated and the 0.3% increase the median in Bloomberg's survey is looking for would be the strongest in six months. However, manufacturing itself may be flat. Other high frequency data points include producer prices (year-over-year rates are below 2%), housing starts and permits (small gains expected), and a number of early regional Fed surveys. Of note, the Empire State Manufacturing Survey crashed in January (-43.7 from -14.5) and a sharp snap back is expected in February. On balance, the data is likely to be consistent with the US economy expanding somewhat faster than what the Federal Reserve believes is the long-term non-inflation pace (1.8%). 

The big outside day for the Dollar Index after the US employment data on February 2 saw follow-through buying at the start of last week. It reached 104.60, the highest level since the middle of last November and spent the rest of the week consolidating above 103.95. A move above the 104.80 is needed to reignite the upward momentum. Despite the stretched momentum indicators and the proximity of the upper Bollinger Band (~104.50), there is little technical sign of a top. That said, given the nearly 4% rally off the late December lows, this is the area where we are beginning to look for a reversal pattern.

Eurozone:  Details for Q4 23 GDP (flat and 0.1% year-over-year) will be released with the revisions on February 14. It may be interesting for economists, but the general thrust is sufficiently known for businesses and market participants. The eurozone economy is stagnating or worse. In the last five quarters through Q4 23, in aggregate, there has been no growth. Still, the details of fourth quarter GDP saps much interest in high frequency data from the end of last year. More importantly is the momentum at the start of the new year and the data so far have been limited to some surveys and a preliminary estimate of January CPI (-0.4% month-over-month and minus 3.2% at an annualized rate in the last three months). There seems to be little reason to expect new growth impulses, leaving this quarter to be flat to +0.1%.

The euro's low for the year was set at the start of last week slightly below $1.0725. The subsequent recovery stalled in the $1.0790-95 area, meeting the (38.2%) retracement objective from the Feb 2 high set shortly before the US January jobs report. The momentum indicators remain stretched, as one would expect, given the five weeks of losses in the first six weeks of the year. And if there is a more of a recovery, the $1.0810-40 area may offer stiff resistance. The 20-day moving average, which the euro has not closed above since January 2 is found at the upper end of that band. Note that there are options for 2.5 bln euro at $1.0725 that expire Monday and options for 1.5 bln euros at $1.07 expire shortly after the US CPI report on February 13.  There is another 1.4 bln euro s at $1.07 that expire Wednesday. 

Japan:  In each of the past six years, the Japanese economy contracted in at least one quarter (in 2018 and 2022 there were two contracting quarters). Last year, it was the third quarter, when output fell by 0.7% (quarter-over-quarter). A stabilization in consumption and a recovery in private investment, both of which fell in Q2 23 and Q3 23, likely helped return the world's third largest economy to growth. Exports also increased. The GDP deflator appears to have peaked in Q3 23 at a 5.3% year-over-year pace. On the back of firmer US Treasury yields and comments by BOJ officials that downplayed the likelihood of a tightening cycle even after negative interest rate policy is jettisoned, the dollar rose to nearly three-month highs against the yen (~JPY149.60). Although Japanese officials have not expressed concern about the price action in the foreign exchange market, the yen's six-week drop is the kind of one-way market that is resisted. The November high was near JPY149.75, in front of the psychologically important JPY150 level. There are $1.4 bln in options at JPY150 that expire shortly after the US CPI report on February 13. A move above JPY150 brings last year's high near JPY152 into view.

United Kingdom: It is an important week for UK data and the jobs report and the CPI, in particular will likely impact expectations for interest rate policy. Average weekly earnings have slowed for four consecutive months through November and look poised to continue to slow as the labor market cools. The key message on UK CPI is that it will fall sharply starting the February report and running through May. In those four months in 2023, UK CPI rose by an average of 1.0% a month. In the last four months, through January, the UK's CPI rose by an average of 0.2% a month. Due to 0.6% decline in January 2023 UK CPI, the 0.3% decline expected for last month's CPI will translate into a small increase in the year-over-year rate. But that is not the signal. Even if UK's inflation averaged 0.4% in the Feb-May period this year, the headline year-over-year rate would still slip below 2% (from 4% in December). The core rate is firmer, but the direction is lower. It peaked at 7.1% last May and finished the year at 5.1%. The UK also reports Q4 23 GDP. Recall that the monthly print showed a 0.3% contraction in October followed by 0.3% growth in November. It is seen contracting by 0.2% in December. That would likely translate to a 0.1% contraction quarter-over-quarter for the second consecutive quarter. Surveys suggest manufacturing remains weak while the services are finding traction. The swaps market has about a 70% chance that the first cut is delivered by midyear. Three cuts and about a small chance of a fourth cut is discounted for this year. 

Sterling broke out of its $1.26-$1.28 trading range to the downside at the start of last week, largely on follow-through selling after the US jobs report on February 2. It bottomed near $1.2520 and recovered to settle above $1.26 for the past three sessions. Sterling's recovery stalled near $1.2645, the (50%) retracement of the losses from February 2 high (~$1.2770). The next retracement (61.8%) is around $1.2675, which is also where the 20-day moving average is found.

Australia: The January employment data will be reported early on February 15. It is difficult to imagine a worse report than December's, even though the unemployment rate held at 3.9% (up from 3.5% at midyear). Australia lost a stunning 106.6k full-time posts, which wiped out half of the increase reported in the Jan-November period (~211k). Part of the reason that the unemployment rate did not rise was that the participation rate fell by a sharp 0.5% to 66.8%. At the same time, other hard data have been poor. Remember December retail sales tumbled 2.7% in the face of expectations of a 0.5% gain. November gain itself was revised lower by nearly as much as economists had forecast a December gain (1.6% vs. 2.0%). Building approvals dropped 9.5%. Here, too, economists (median in Bloomberg's survey) forecast a 0.5% increase. November's 1.6% gain was revised to 0.3%. There may be scope for the market to bring forward the first rate cut by Reserve Bank of Australia to June from August. 

The Australian dollar recorded a new low for the year last Monday near $0.6470, its lowest level since mid-November as it extended the post-US jobs data drop. However, it stabilized and largely traded in a range mostly between $0.6480 and about $0.6540. The upper end of the range corresponds to the (50%) retracement of the decline from the pre-jobs data high a little above $0.6600. The next retracement (61.8%) is near $0.6555, and the 20-day moving average, which the Aussie has not closed above since January 3 is a little higher (~$0.6560).

Canada:  Canada has a light economic diary in the coming days. January existing home sales and housing starts, and Canada' portfolio investment account (December) rarely moves the market in the best of times. In terms of drivers, the 30- and 60-day correlations with the changes in the exchange rate seem to be the general direction of the dollar (DXY) and risk-appetites (S&P 500). The Canadian dollar seems less sensitive to oil and two-year rate differentials (less than 0.2 correlation for both period). The US dollar took out the January high marginally and rose to about CAD1.3545 early last week before consolidating at lower levels ahead of the Canadian employment data reported before the weekend. The Canadian dollar strengthened initially on the news, even though full-time jobs fell for the second consecutive month. The greenback found support ahead of CAD1.3400 and recovered back to set new session highs near CAD1.3480. The risk seems to be on the upside. 

Mexico:  After the January CPI figures and the central bank decision to hold policy steady, there may not be market-moving economic data February 22 with another look at Q4 23 GDP (0.1%), first half of February CPI, and minutes from the Banxico meeting. The central bank raised quarterly inflation forecasts through Q3 but left the Q4 24 projection at 3.5%. The target is 3%, +/- 1%. The dollar initially moved higher in response, but the upticks (to ~MXN17.17) were short-lived. The greenback settled last week below MXN17.10, to post its second consecutive weekly decline. The MXN17.00 area had been approached before Mexico's CPI and central bank meeting. It has not traded below there since January 16, but it could if the US CPI and retail sales data are soft and cap US rates. 

  

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