Strategy & economics

If it quacks like a duck


Richard Jeffrey

Richard Jeffrey

Chief Economist

It’s a tough life being a professional economist. The man-hours we spend making up stories to fit the ‘facts’, only to find that the facts then change; it has been just so over the past three months. Two successive reports from the US Bureau of Labor Statistics, for August and September, suggested that employment growth had weakened. Then a few days ago we had the October report, which showed a much stronger gain than expected. The apparent weakening in the market was widely attributed to the impact of a slowdown in global manufacturing activity and, therefore, reduced demand for labour. This explanation always seemed dodgy, since job openings data indicated that demand had remained very strong. My explanation was that, as unemployment falls and full-employment approaches, it is more difficult to find people with the requisite skills to satisfy demand. Whatever: while I still think my reasoning fitted the facts more closely, it now seems the case that we were all misled by data readings that were probably understating the ‘true’ trend, most likely as a result of statistical quirks.

This might be incidental were it not for the fact that the Federal Reserve places significant emphasis on conditions in the labour market when determining the correct course for monetary policy. On this occasion, it would seem that the timing of the first rate increase since mid-2006 is heavily contingent on the prevailing pace of job creation. The rationale is that once the economy has reached full employment, then further reductions in the unemployment rate are likely to cause more appreciable wage inflation and, hence, a more general rise in inflationary pressure. The result is that financial markets, having begun to believe that the first rate increase would come in 2016, now assume this momentous moment will be December.

In my view, this will not be before time. As I suggested last month in this column, there is a significant risk that policy makers in both the US and the UK are already ‘behind the curve’. If so, they – and most others – will be judged to have ignored some very obvious signals. Bearing this in mind, I thought I would list some of the dos and don’ts of economic analysis and policy-making. These are in no particular order, but collectively they should work as a tick-list for whether we are applying the correct amount of intellectual rigour to our judgement of events.

• Maintain a healthy degree of scepticism with regard to the popular wisdom. The consensus view is not always wrong, but there is too much truth to the adage that many economists seek ‘safety in numbers’, rather than being willing to make an independently argued case.

• Do not fall for the reasoning that the authorities are behaving in a certain fashion because they have superior information or a better understanding of events. If only that were true. In reality, central banks, finance ministries and other public bodies are just as prone to errors of judgement as the rest of us. Unfortunately, however, they often act on those errors of judgement.

• Do not ignore the obvious and do not get bogged down with over-analysing minutiae. Prior to the recession and accompanying financial crisis, it should have been all-too-obvious that the inexorable rise in debt levels was like a big red double-decker bus trundling towards us (and that we were standing in the middle of the road) – we just failed to pay enough attention to it. Instead, we developed intricate arguments as to why growing global imbalances were sustainable. Right!

• Be wary of not paying sufficient attention to incremental changes (because they can end up being rather larger than the increment itself might imply), but also avoid extrapolating from the latest two or three potentially erratic data points. In other words, try to judge the underlying trend, both in terms of its direction and momentum.

• Do not over-interpret the latest data point, as it may well be wrong. My favourite example of this is from 1999, when the first estimate of the year-on-year increase in GDP in the UK for the three months to March was just 0.7%. The Office for National Statistics now tells us it was 2.9%. While it is not often the case that figures are revised so heavily, it is very often the case that data releases are in a range between heavily misleading and just plain wrong. In policy terms, the first estimate of growth in the first quarter of 1999 implied a cut in rates might have been sensible, whereas the current estimate suggests a modest tightening would have been appropriate.

• Always try to keep an open mind (the average economist, including your author, finds this very difficult), and do not become ensnared by arbitrary rules. In this context, we have to be careful of two easy-to-make observations: It will all be different this time round and the past is a good guide to the future. While it is important to learn from the past, it is equally important to note that no set of circumstances is precisely the same. Careful analysis is always appropriate. You might think this is blindingly obvious; if so, you might be surprised by the number of times I have been sent analysis based on seemingly similar trends in, for example, the US equity market over two different time periods, with the conclusion being that the coincidence will continue. If only it were that easy.

• (These are for policy makers.) Do not justify current policy decisions solely on the basis of what has already happened – it is the future that is more important. On the other hand, do not try to pre-judge the likely future course of policy without a reasonably good understanding of prevailing circumstances. In this context I would also note that transparency, rather than always being a good thing, can often interfere with the policy process, particularly when that transparency also includes a rules driven policy mechanism.

So, it’s a tough life, but the irony is that we economists often make it even tougher for ourselves (and I do not exclude myself).

This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

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