Meet The LMCI - The Feds New Goal-Seeked, 19-Factor Labor Market Regression Rigmarole

By Tyler Durden
Created 08/26/2014 - 13:55
In the rush to make QEs taper and the follow-on forward guidance appear more
data-related than of due concerns [14] about the structural (and ultimately
philosophical) flaws in the economy, the regressionists of the Federal Reserve
have come up with more regressions. The problem was always Ben Bernankes
rather careless benchmarking to the unemployment rate. In fact, based on nothing more
than prior regressions the Fed never expected the rate to drop so quickly.
Given that the denominator was the driving force in that forecast error, the Fed had to
scramble to explain itself and its almost immediate violation of what looked like an
advertised return to a rules regime. When even first mentioning taper in May 2013,
Bernanke was careful to allude to the crude deconstruction of the official unemployment
as anything but definitive about the state of employment and recovery.
So at Jackson Hole last week, Bernankes successor introduced the unemployment
rates successor in the monetary policy framework. Janet Yellens speech directly
addressed the inconsistency:
As the recovery progresses, assessments of the degree of remaining slack in the labor
market need to become more nuanced because of considerable uncertainty about the
level of employment consistent with the Federal Reserves dual mandate. Indeed, in its
2012 statement on longer-run goals and monetary policy strategy, the FOMC explicitly
recognized that factors determining maximum employment may change over time and
may not be directly measurable, and that assessments of the level of maximum
employment are necessarily uncertain and subject to revision.
Economists inside the Fed (remember, these are statisticians far more than anything
resembling experts on the economy) have developed a factor model to determine what
Yellen noted above supposedly they will derive nuance solely from correlations [15].
A factor model is a statistical tool intended to extract a small number of unobserved
factors that summarize the comovement among a larger set of correlated time series.2
In our model, these factors are assumed to summarize overall labor market conditions.
What we call the LMCI is the primary source of common variation among 19 labor
market indicators. One essential feature of our factor model is that its inference about
labor market conditions places greater weight on indicators whose movements are
highly correlated with each other. And, when indicators provide disparate signals, the
models assessment of overall labor market conditions reflects primarily those indicators
that are in broad agreement.
Below is their list of the 19 factors included in that statistical conglomeration, the LMCI:
[16]
.
Of the nineteen, there are an inordinate number of surveys to go along with the more
traditional statistical figurings like the unemployment rate and private payroll
employment. What is conspicuously lacking is any measure of income. In fact, of those
nineteen only one refers to wages at all and that is the average hourly earnings rather
than a more comprehensive measure of earned income. And, as you will note from the
far right column, the calculated correlation of the wage figure is the third lowest of the
data set.
What does this mathematical reconstruction of the labor market tell us about the
labor market? If you believe the figures, this has been one of the best recoveries
on record. No, seriously:
[17]
From December 1982 until the official economic peak in July 1990, the Feds new tool
for nuance gained a total of 319 index points, or an average monthly change of 3. That
was during what was an unequivocal and inarguable recovery and robust expansion
(we can debate how much of it was artificial, particularly later in the decade [18], but
there was no debate, as now, that economic growth was there).
By comparison, the LMCI shows a total gain of 290 points from July 2009 through what
are apparently the latest estimates at the end of Q1. On an average monthly basis, the
index in this recovery gained 5 per month, besting by a wide margin the 1982-90
expansion.
The reason for that is the unemployment rate. The Fed helpfully breaks down the
contributions to changes in the index and, unsurprisingly, the three largest factors
driving this epic recovery in jobs nuance are the Establishment Survey, the estimate of
jobless claims and, somehow, the unemployment rate. Those statistical oddities [19],
more than any assurance of actual growth and recovery, actually offer up confirmation
bias directly within the index creation.
[20]
The idea, as Yellen more than suggested last week, was to try to get a handle on labor
market slack without rewarding the deterioration in labor participation that is inarguably
skewing labor perceptions as far, far too positive. So they come up with a new factor
model where the largest positive contribution still comes from the deterioration in labor
participation (the pink portions in the chart above).
If the overall impression of the factor models comparison to actual growth in the 1980s
wasnt enough to disqualify its use, then this surely should be. But rest assured, these
kinds of regressions are only going to grow in importance in setting monetary policy
under the Yellen regime. The amount of math, which behaved so poorly previously [21],
is set to rise exponentially as actual experience with the actual economy is totally
replaced via regression and multi-layered statistics.
This will be called a transition from discretionary monetary policy under
Bernanke/Greenspan to a rules based approach. The latter sounds far more appealing
given what has transpired, and even to what the Fed is now willing to admit as largely
ineffective. However, it still represents the same old problems as rules or not, when
setting those rules in the first place it simply re-arranges discretion from less clearly
defined to simply setting the variables. And if the discretion and subjectivity in setting
the variables is as poorly constructed as this LMCI, then what does it matter this change
in the first place? The answer may be simply PR and confidence (the full and various
meanings of that word).
Of the models in the Feds arsenal, however, this labor nuance has to be among the
least formidable. It almost seems like it was slapped together haphazardly just to fill the
void left by the participation problem cutting into the pre-programmed end to QE. But
more than that, it displays exactly the basic kind of ignorance you would expect of a
group that places mathematics before understanding (if it isnt a regression equation, it
simply doesnt exist to them [22]).
Even if the model represented a somewhat realistic assessment, it stills doesnt tell us
much about the actual economic trajectory. By focusing on the beancount raw numbers
of these various sub-parts, the FOMC and the orthodox economists using this
construction will over-emphasize the most cursory of the labor market aspects the
numerical number of jobs. That, as we well know today, is not much use where the
economy is being transformed by some structural shift. In other words, the model will
count as good the replacement of high-value productive jobs with low-value asset
inflation service jobs (ie, the bartender economy), seeing recovery where only
persistent drain exists.
The emphasis on the short run and the persistent appeal to generic activity leaves these
mathematicians blind to what a real economy consists of wealth and the valuable
trade of labor for work in productive action. Nowhere does income, the true measure of
economic strength, penetrate this moribund monstrosity. That is how this measure can
look at the labor market post-2000 and see it as equal or better than what came before.
Back to Yellen:
Second, wage developments reflect not only cyclical but also secular trends that have
likely affected the evolution of labors share of income in recent years. As I noted, real
wages have been rising less rapidly than productivity, implying that real unit labor costs
have been declining, a pattern suggesting that there is scope for nominal wages to
accelerate from their recent pace without creating meaningful inflationary pressure.
However, research suggests that the decline in real unit labor costs may partly reflect
secular factors that predate the recession, including changing patterns of production
and international trade, as well as measurement issues. If so, productivity growth could
continue to outpace real wage gains even when the economy is again operating at its
potential.
That is just nonsense the only way productivity growth could continue to outpace real
wage gains is under a system of financial repression that substitutes debt for wealth. In
other words, nominal redistribution via massive credit production is exchanged
for actual economic advance, but since the orthodox practitioner cant tell the
difference (monetary neutrality, after all, must be preserved no matter how much
incoherence and convolution is needed to maintain it) it leaves behind all these
mysteries in need of mathematical solutions, including so many poorly suited
to the ideals.