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INTEREST RATE WATCH
Prepared by
R. J. O'Brien & Associates, Inc.
Fundamental
No longer can there be any doubt, the U.S. economy is extremely strong. Non-farm payroll employment rose by 284,000 in October to 123.0 million, and the numbers for the prior two months were revised higher. Job gains were widespread, and were especially large in the manufacturing sector, which increased by 54,000. Average hourly earnings were up six cents in October to $12.41. This follows increases totaling 11 cents in the prior two months. Average weekly earnings rose by 0.5 percent over the month to $428.15. Over the past year, average hourly earnings have risen by 4.2 percent and average weekly earnings by 4.5 percent. This is the strongest increase since July, 1989.
In the household survey, total employment rose by 179,00. Both the unemployment rate and the number of unemployed persons fell in October. The number of persons who were unemployed, at 6.5 million, was 285,000 below September's level, and the nation's unemployment rate declined by 0.2 percentage point to 4.7 percent–the lowest level since October 1973.
A close examination of the real, unadjusted numbers reveals the economy is even stronger than it first appears. Our customers should be aware of the following:
The real unemployment rate is 4.4%, not 4.7%. As it happens so often, the seasonal adjusters get it wrong, and distort the real picture. That's why we regularly get revisions, such as the “mere” 475,000 increase to the March payroll number.
The labor situation is getting tighter. The year-over- year increase in the labor force was 1.22% in October, but the growth rate for employment is much higher, with the non-farm payroll increase at 2.62% and the household increase at 1.74%. It's obvious that the supply of labor is shrinking, while at the same time demand for labor is firm. That's why wages are accelerating.
The duration of unemployment is decreasing. Compared to last year, the number of people unemployed less that 5 weeks was up by 3%. However, both the number of people unemployed for 5 to 14 weeks and the number of people unemployed more that 15 weeks were down approximately 6%
In a speech today, Federal Reserve Chairman, Alan Greenspan, reiterated his view that the U.S. is overstating consumer price inflation while greatly understating service sector productivity. That, along with continued weakness in world stock markets, make it unlikely that the Fed will raise short-term interest rates soon. However, as we mentioned last week, vigorous economic growth is placing Mr. Greenspan in a very difficult position, pushing him towards a tightening he cleanly does not wish to implement.
Over the years, we've often mentioned the strong correlation between the growth in manufacturing unemployment and the direction of short-term interest rates. This fact is more important these days, because manufacturing activity has been the laggard in this economic expansion. An upsurge is manufacturing activity is now putting a strain on an already short labor supply situation, and will be responsible for driving all wages substantially higher.
With this in mind, Chairman Greenspan has to be worried by this week's Factory Orders report and the latest survey of the National Association of Purchasing Managers. The most alarming development was the fourth consecutive increase in the NAPM's Price Index, which rose in October to 55.9%; twenty-four percent of respondents reported paying higher prices. Although Robert Ore, the chief of the NAPM survey, said that “it's too soon to sound the alarm that it's a major concern,” other aspects of the report are ominous. Chief among these is the NAPM's Backlog of Orders Index, which rose significantly to 56.5% from 50.0%. An increase in order backlogs fits in nicely with labor shortages and a higher capacity utilization rate, and it implies an increase in the nation's inflation rate. Finally, the NAPM's overall index increased to 56.0%. According to Mr. Ore, that corresponds to 4.2% GDP growth. That's too fast, and we don't believe the Fed will tolerate that kind of growth too much longer.
Global
We've been talking about the weaker dollar for some time, so it was nice to see some support for our position in the Wall Street Journal. In an article entitle Dollar Outlook Has Come and Gone, Some Say, it pointed out that the dollar “remains more that 8% below it August eight- year peak against the mark,” and it offered the theory that due to “America's dependence on foreign capital to finance its enormous current-account deficit,...we need the combination of a cheap dollar and relatively high interest rates to suck in overseas capital.”
This week the Fed's FOMC will face a real quandary. The U.S. economy is undeniably strong, and it appears to be accelerating. Federal Reserve governors will be aware that they can no longer count on the effects of a strong U.S. Dollar to quench inflation. If they do not act to raise short-term interest rates, it will only be because they hope the turmoil in Asia, and a weaker U.S. stock market, will serve as a drag on our economy.
It's our opinion that the longer the Fed waits and hopes for the unquantifiable effect of the Asian mess to occur, the weaker the U.S. Dollar will be. That is ordinarily bearish for bonds, and it should be a warning to U.S. investors who have been flocking to that investment sector. From a historical perspective, bond yields are quite low when compared to shorter maturities; so, if we are correct in our contention that the vigorous U.S. economy precludes an easing any time soon, we must conclude the bonds are overpriced.
November 7, 1997 R.J. O'Brien & Associates, Inc.
555 West Jackson Blvd., Ste. 700, chicago, Illinois
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