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Economy in Brief

EMU PMIs Take Grim Turn for the Worse
by Robert Brusca  March 22, 2019

If there is a silver lining to the severe weakness in EMU and German manufacturing as exhibited by the Markit flash PMI readings for March, it is that the transmission of weakness to services has been blunted. The chart shows that there has been some separation between the path of the manufacturing PMI and the services PMI in the EMU. Manufacturing has continued to plunge while the services metric has stabilized in the past several months by drifting mostly sideways after a rebound. Nonetheless, the EMU services gauge does decay slightly in March compared to February.

The March EMU PMI reading is the third lowest since November 2014. Factory orders have fallen for six straight months. The drop in factory output is the most severe in six years, but new orders show the sharpest drop since 2012. The factory sector portion of this survey is chilling.

The data in the table above cover all observations since January 2015 and on that basis weakness is profound and widespread. There are isolated pockets of ‘growth' but none of strength.

Japan's manufacturing sector joins the EMU and Germany in a show of weakness. Since early 2015, Japan's manufacturing has been weaker only 7.8% of the time.

The Markit PMI data for the U.S. precede the availability of ISM reports. The ISM readings have been firmer than the Markit data. The Markit data are used in this report; they show U.S. readings below their median for manufacturing and for the composite but with a services reading that has a 60th percentile standing.

The best recession indicator in the world lights up on March 22
What this collection of data shows us is that the manufacturing slowdown is not running out of momentum. The Fed's shift to a neutral stance and then to removing its bias to rate hikes altogether in 2019 has come too late to prevent a technical inversion of the U.S. yield curve from 3-month bills to the 10-year note. On this metric, the U.S. Treasury yield curve has inverted today. And this is the preferred reference gauge to use as a recession indicator according to a study from 1996 by two former Federal Reserve economists Mishkin and Estrella (here). However, the inversion may have to stay in place for a while for its signal to be authenticated. For now the technical signal has been tripped. It is not clear if it is now too late to avoid recession or to know if recession is baked in the cake. Since the technical recession signal has been tripped, can the Fed still act to avoid recession if it is willing to act quickly to reduce the level of interest rates? We may not have a chance to find out because the Fed does not seem to care enough...

Second-guessing not allowed
It is not clear that the Fed is willing to reduce rates to attempt to mitigate this signal. It is not clear that despite economic studies conducted by well–respected Federal Reserve economists, that the Fed itself values this study enough to give it priority over and above decisions that already have been made.

ECB takes preemptive steps but only baby steps
The ECB has another round of lending ready to go but was so unconcerned about the economy that it scheduled its operation for a September start. While the move looks like a bold one to offset and reverse its own policy that had shifted to less accommodation, in fact the ECB seems to have announced a policy for out in the future to try to affect expectations today without doing anything right now. Right about now that does not look like a good choice. Based on this weakness in the PMI gauges, the bellwether German 10-year bund moved down to a negative yield and the euro fell sharply. Europe really is in the soup again and with virtually no interest rate ammo left at all and the ECB planning to move in September.

Policy needs to be about THE DATA, not THE MODEL
Central banks simply need to pay more attention to markets. It is a great shortcoming in economics that there has been such a shift to modeling and the use of econometrics. Many economists seem to think that their models offer a better view of reality than the data that the actual economy spews out in real time. The Federal Reserve has for a long time minimized the input of market signals especially when they contradict polices that (for some unknown reason) the Fed wants to pursue. Janet Yellen tried to minimize the inflation ‘forecasts' embedded in the treasury TIPS data calling those results inflation compensation rather than expectations raising the specter of contamination by liquidity premium. She wanted to raise the Fed funds rate and the TIPS curve was in her way. The Fed in this cycle under Yellen and Powell has done its level best to ignore the flattening of the yield curve and the potential for curve inversion. I have been haranguing the Fed about it since before the December meeting. The Fed has been warned and many observers have talked on the danger of inversion and of the high quality of the inversion signal as a recession ‘forecast.' Even so, the Fed has been unwilling to swerve to try to arrest the movement in the yield curve. The December rate hike was unnecessary. Even Larry Summers was warning the Fed to pay attention to the legacy of rate hikes and the fact that monetary policy works with a lag. Now the global economy may be paying the price for that step too-far. There is no inflation – and we all know that. In Japan, inflation is moving even farther below its objective. Oil prices are slipping in reaction to today's weak economic data. Where's the risk? What's the risk?

Preparedness or ham-handed mistake?
The Fed, in its desire to hike rates, to be prepared for a recession when one came, may have caused one. While you are going to read a lot about how the Fed made the U.S. better-prepared for recession by hiking rates and while the ECB did not, the Fed also may have taken it a step or two, too far because it failed to stop and take the measure of what it was doing and was misled about how resilient the economy really was. Inflation was never the issue in this rate hike cycle; assuming inflation would go back to 2% was simply a device to allow the Fed to hike the Fed funds rate.

Good forecasts make good neighbors
What will it take to get central bankers to give reality a fair shake and to downgrade reliance on models and on making policy forward-looking based on their own forecasts? Both the Fed and ECB show a lack of flexibility once they have embarked on a course of action. Central bankers will have to learn to be more nimble and more open-minded as well as open-eyed. If Robert Frost were writing poetry about it, he might write that ‘good forecasts make good neighbors' but bad forecasts do not. That's a real dilemma because it requires central banks to admit their limitations.

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