Friday, March 7, 2014

‘Animal spirits’ update

The approach taken to confidence determination here stipulates that, for the most part, confidence levels are determined by whether unemployment is above or below what people are used to, an adaptation level modeled as an exponential moving average over the past four years. When unemployment is below the adaptation level, we feel good; and conversely. Thus, in the 1980s, when unemployment came down from double digit levels to 9 percent, that level produced gains in confidence. Currently the adaptation level is at 7.8 percent and unemployment is at 6.7, so in theory we are “confident” (as I have mentioned, I don’t quite know why the median income household—really everyone below about the 90th percentile—has not lost confidence completely; we know the top 10 percent are confident, and for the most part completely out of touch with what is happening in the country.)

What is remarkable about this simple theory is that it is very sensitive to identifying the beginnings of the downward cascade of economic activity—and upward shooting of the unemployment rate—that occur at the outset of recessions.


The forecast in blue assumes the following judgmental forecast for unemployment:


Now it is possible that unemployment will bounce along a bottom at about current levels for longer than I have assumed, but in this theory of the business cycle confidence will always fail when the adaptation level comes down to the current unemployment rate. Note in the graph above that the crossover point is almost always exactly when the NBER defined recession begins, and when unemployment accelerates upward.

The negative skewedness of the first differences seen here is also seen in stock prices, which arguably follow a very similar type of adaptation-level theoretic dynamic, at least in part.

The current period is morphologically similar to the early 1970s, before the recession began, with the Michigan Consumer Sentiment series lagging (green in “animal spirits” chart). If we follow that pattern the collapse will be sudden.

My judgmental forecast puts the start of the collapse a year from now, in February 2015, but my forecast includes increases of 0.1 percentage points a month starting in about six months. I cannot comment on the calculation of the unemployment rate authoritatively, but many have found the sharp decreases in the labor force participation rate to be anomalous. (It was amusing and sickening to hear that Janet Yellen is worried that the labor force participation rate might increase from its generation low and cause the unemployment rate to go up. She and the Fed are apparently aware of the underlying model referenced here even if here book-writing husband’s book on “animal spirits” doesn’t reference it.)

If we are at something like “peak false consciousness” (again) it won’t take much to prick the bubble, especially as the unemployment rate and adaptation level converge.

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