Investing

Making Sense of Noisy Economic Data

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23/04/2019

by Scott J. Brown, Ph.D., Chief Economist

Economic data is critical to the financial markets. It helps to drive earnings expectations and is a key factor in Federal Reserve (Fed) policy decisions. However, economic figures are noisy and reports often conflict with one another. How do we make sense of it all?

Many sources of U.S Data

Unlike in other countries, the responsibility for collecting and publishing U.S. economic data is spread across several agencies. The Bureau of Economic Analysis reports on Gross Domestic Product (GDP), household income, and consumer spending, while the Bureau of Census covers things like retail sales, residential construction, new home sales, and durable goods orders. The Bureau of Labor Statistics reports on the job market, but it also publishes the Consumer Price Index (CPI) and other inflation gauges. The Fed produces the index of industrial production. In addition to the government figures, there are a variety of private-sector data sources, including the Institute for Supply Management (monthly purchasing managers’ surveys) and the Conference Board (consumer confidence and the index of Leading Economic Indicators).

Sources of uncertainty: Statistic sampling and seasonal adjustment

There are two major sources of uncertainty in the economic data. The first is statistical error. The government can’t observe all of the particular activity it is interested in, so it measures a sample. Choosing that sample is a science and the various agencies generally do an excellent job, but that still means there will be some uncertainty in the data.

For example, the monthly change in nonfarm payrolls is reported accurate to ±115,000. That means if the monthly change is reported as +160,000, there is a 90% chance the true monthly change is between +45,000 and +275,000.

The other major source of uncertainty is due to seasonal adjustment. There is a significant seasonal pattern in most unadjusted data. For example, we normally lose about three million jobs each January following the end of the holiday shopping season. The government does a good job with seasonal adjustment, but it’s difficult to get it exactly right.

Economic data are subject to two kinds of revisions. Figures are often revised in the following month, reflecting more complete information. Annual benchmark revisions seek to tie the data back to more comprehensive sources, such as nonfarm payrolls to actual payroll tax receipts.

For those using the economic data, uncertainty means one should take any reported number with a grain of salt. It’s best to look at a three-month average, which reduces much of the noise (but does not eliminate it) and is a better gauge of the underlying trend.

Monetary policy: Minor shifts are a major deal for the markets

The partial government shutdown delayed a number of important economic data releases in early 2019, but the shift in the Fed policy outlook from mid-December to late-January was driven by other factors. Fed Chairman Jerome Powell noted the economic outlook hadn’t changed much since the 18-19 December policy meeting. However, the downside risks and uncertainties had increased substantially. These “cross-currents,” noted Powell, included the partial government shutdown, trade policy uncertainty, Brexit, and evidence of slower economic growth outside the United States, “especially in China and Europe.”

The Federal Open Market Committee had a mild tightening bias in December, with market participants generally anticipating a rate increase in June 2019 and perhaps another in December. In January, the Fed moved to a more neutral stance, indicating it could be “patient” in deciding its next move. For seasoned Fed watchers, this was a relatively modest shift, but it proved to be a much more important development for the financial markets.

During the financial crisis, the Fed conducted three large-scale asset purchase programs (quantitative easing or QE), adding more than $3.5 trillion to its balance sheet. As part of monetary policy normalisation, the Fed has been allowing some of these securities to roll off the balance sheet as they matured. The Fed now expects to end the unwinding of the balance sheet later this year, sooner and with the balance sheet at a higher level than previously expected. The unwinding of the balance sheet was meant to be background, not active, monetary policy. Fed officials do not believe it was the catalyst for the stock market weakness last year. However, many market participants believe otherwise. The Fed based its decision to end its balance sheet unwinding on considerations of bank reserves.

The job market is a focus

Which data releases does the Fed consider in setting monetary policy? Basically, all of them. The Fed also pays a lot of attention to the anecdotal evidence. However, its main focus is on the job market and inflation. Based on the demographics, job growth in recent years has been well beyond a long-term sustainable pace. That’s not a problem in the short term. In his monetary policy testimony to Congress in February, Chairman Powell said there is likely more slack in the labour market than what is suggested by the unemployment rate. Firms continue to report difficulty in finding qualified workers, but they remain reluctant to raise wages enough to attract those workers. In addition, firms generally appear to have a limited ability to pass higher costs along.

A debate on the monetary policy framework

Powell also said the Fed is considering whether to move to a price-level targeting framework when analysing inflation. The Fed has consistently undershot its 2% target in recent years and market participants may view that as a ceiling rather than a goal, pushing inflation expectations below 2%. In a price-level targeting system, the Fed would seek to hit an inflation target on average. Hence, a period of sub-2% inflation would be followed by a period of above-2% inflation. All else equal, that implies the Fed would be less inclined to raise short-term interest rates in the short run.

Putting it in perspective: The trend trumps the noise

Many of the uncertainties we faced at the start of the year have abated. The government shutdown is behind us. The U.S. may get a trade deal with China. The Fed seems in no hurry to raise short-term interest rates and has plans to finish the unwinding of its balance sheet. The question then is what to look for next. Partisan politics and congressional inquiries could rattle investors’ nerves. However, the market focus should eventually get back to the economic data. Yet, the markets often use the economic data as an excuse. What’s more important is how the data fits into the overall narrative.

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