Last week, the Federal Reserve agreed to continue purchasing mortgage backed securities, expanding its holdings of Treasury securities and keeping short-term interest rates near zero until the unemployment rate is below 6.5% and inflation remains under 2.5%.

The unemployment rate has declined from 8.5% at the end of 2011 to 7.7% as of November 2012. On average, the economy has added approximately 150,000 jobs per month in 2012. While 150,000 jobs is a positive figure, it has not been the only driver in reducing the unemployment rate. A drop in the labor participation rate has been the other factor in the declining unemployment rate.

The chart above illustrates the labor force participation rate from January 1948-November 2012. Note that the rate grew precipitously from the 1960’s through the late 1990’s based upon the secular trend of women entering the workforce. Cyclical changes such as recessions have traditionally led to declines as unemployed workers temporarily leave the workforce.

In December 2007, the participation rate was 66%; today it is 63.6%. Now that the Federal Reserve has tied its economic policies to specific unemployment figures, it is difficult to determine if the labor force participation rate declines are cyclical or secular changes. Are the declines due to the baby boomer generation retiring or the younger population staying in school longer? Conversely, are the declines due to a disproportionate amount of discouraged workers who have given up on the job search?

According to the Bureau of Labor Statistics, there are 12 million unemployed and 2.5 million marginally employed. Depending on if and when the marginally employed begin searching for jobs, there may be an uptick in unemployment if job growth cannot accommodate their reentrance and population growth. Given these facts, it may be difficult for the Federal Reserve to achieve its goal of 6.5% unemployment by 2015 without an uptick in the economy.

Among the many factors the Congressional Budget Office (“CBO”) must estimate in budget projections provided to Congress, GDP is often the most important, as it provides a foundation for most other forecasts. While near term GDP growth can often be estimated with some accuracy based on current trends, longer term forecasts rely upon potential GDP. Utilizing the economic factors of labor input and physical capital, potential GDP is a measure of the maximum sustainable output of the national economy. It is the level that national output should be when the economy is at full employment and full resource utilization.

Going back to the 1950’s, real GDP has often plotted very near the CBO’s potential GDP forecast, often correcting any deviation quickly. Since the sharp economic downturn experienced in 2008, however, real GDP has remained below potential GDP, creating a sizeable output gap. In order to close that output gap, the national economy must grow at a faster rate than it has since 2008.

The various dotted lines on the graph contemplate constant forward growth rates in real GDP from the last recorded observation in the third quarter of 2012. Although it is unrealistic to assume the national economy will grow at a constant rate going forward, the analysis presents a hypothetical best/worst case scenario. If the national economy were to grow at a constant 5% annualized growth rate beginning in the fourth quarter of 2012, it would take the national economy until the third quarter of 2014 to realize its potential output. A 4% growth rate would reach potential GDP in the second quarter of 2015, and a 3% constant growth rate would reach potential GDP in the third quarter of 2020. If the national economy were to grow at a constant 2% rate – not far from the observed growth rates of the previous handful of quarters – the gap between real and potential output will continue to grow.

This week’s Chart of the Week compares the rate of change in business investment spending to GDP growth. Business investment spending (formally known as non-residential private fixed investment) measures spending by private businesses and nonprofit institutions on fixed assets in the U.S. economy. According to the Bureau of Economic Analysis, fixed assets consist of structures, equipment, and software that are used in the production of goods and services. Business investment spending includes the creation of new productive assets, the improvement of existing assets, and the replacement of worn out or obsolete assets. Business investment spending serves as an indicator of the willingness of private businesses and nonprofit institutions to expand their production capacity. Thus, movements in business investment spending serve as a barometer of confidence in, and support for, future economic growth.

Given that business investment spending accounts for approximately 11% of total GDP in the U.S., it is not surprising that there is a fairly high correlation between business investment spending and GDP growth. As the chart illustrates, since 2000 the correlation between the quarterly change in business investment spending and the quarterly change in GDP is 0.7.

In 3Q 2012, business investment spending shrunk at an annualized rate of 1.3% compared to the previous quarter, while GDP grew at an annualized rate of 2.0% compared to the previous quarter. Business investment spending has historically been much more volatile than GDP growth, so it is important to note that a contraction in business investment spending in the third quarter does not automatically translate to a future contraction in GDP. In addition, external factors such as uncertainty surrounding the recent elections and the pending fiscal cliff in the U.S. may have caused businesses to temporarily delay investment spending. However, if this contraction in business investment spending continues over the next few quarters, it is likely indicative of a larger negative trend in the economy as a whole. In terms of impact on the financial markets, it is likely dilutive for the equity market, but accretive to Treasuries.

In this week’s Chart of the Week we take a look at the velocity of the Money Zero Maturity (“MZM”) money supply over the last ten years. Velocity of money can be defined as the rate of turnover in the money supply; in other words, the number of times one dollar is used to purchase final goods and services included in GDP. The MZM money supply is one of the more popular measures of the liquid money available for immediate consumption in the economy. Assuming all other factors remain constant, an increase in the velocity of money coincides with an increase in GDP. In addition, higher velocity of money is often associated with rising inflation.

The velocity of money has been dropping since 2005 and this trend accelerated during the financial crisis of 2008. Once the economy began growing again and exited recession in 2009, the velocity of money resumed growth as would be expected but soon began trending downward again. This continued downward trend in the velocity of money shows that as the Federal Reserve continues to increase the money supply through successive rounds of quantitative easing, each additional dollar injected into the economy has a decreasing effect on GDP. Conversely, if the Fed begins to reign in the supply of money and the velocity does not increase, GDP would likely decrease in response to any tightening policy enacted by the Fed. Going forward, the velocity of money will be another economic indicator to follow as we attempt to gauge the economy’s recovery.

Since March 2009, the S&P 500 has returned 130% through September. Unemployment rates in the United States have improved as well, though more sluggishly. With the unemployment rate in the headlines, it may be insightful to look under the hood and see how the numbers have changed on a more detailed level. Today’s chart of the week looks at the improvement in unemployment rates on a state by state basis since March of 2009. Changes are normalized by the unemployment rate ending in 2006 to show comparisons across states on a similar basis. The largest decreases in unemployment, or the “best” improvements, are shown in dark green. Mathematically, a state that falls into the dark green category of “less than -20%” means that unemployment since March of 2009 has fallen by at least 20% of the pre-crisis level in 2006. For example, unemployment in Alabama was 9.2% in March of 2009, and is 8.5% as of the most recent reading. This decline of 0.7% is about 20% of Alabama’s 2006 unemployment rate of 3.4%.

Looking at some of the individual states, a few stand out for assorted reasons. Utah, with one of the lowest unemployment rates in the country both pre- and post-crisis, has shown the greatest improvement since 2009 relative to pre-crisis levels. Michigan and Ohio, large rust belt states with some of the nation’s highest unemployment rates leading into the crisis, have also seen large improvements. Michigan currently has one of the higher unemployment rates in the country at 9.4%, but this is down from 12.6% in early 2009.

Housing bubble states Florida and Nevada both saw some of the largest increases in unemployment due to the crisis, with unemployment rates spiking north of 6% in both states. Since then however, Florida’s unemployment rate has experienced a strong improvement, while Nevada’s has continued to deteriorate. Nevada now has the worst unemployment rate in the nation at 12.1%, compared to 8.8% for Florida. States with a large amount of financial sector employees such as Connecticut, New York, and New Jersey are also among the states that have seen the largest declines in employment since 2009.

Other states of note include North Dakota, which with an unemployment rate of 3% is the only state with unemployment below 2006 levels, and Texas, which is in the same category as California on this chart but arrived there in a much different way. Though California had a large increase in unemployment during the crisis (5.6%) and relatively little improvement since then, Texas suffered a more modest deterioration in unemployment (2.3%) with a similarly weak rebound. On an absolute basis, California’s unemployment rate of 10.6% is one of the nation’s worst, while Texas’ rate of 7.1% is below the national average.

Since reaching 10% in October 2009, unemployment has been on a slow downward trajectory and fluctuated throughout 2012 within the range of 8.1% to 8.3%. At first glance, any reduction in this headline number appears to be good news. However, upon closer examination, the recent decline in unemployment rate is attributable to both workers dropping out of the labor force (and therefore not being counted as part of the labor force) as well as new job creation. Of the 12.5 million people currently counted as unemployed, 40% of those have been without a job for 27 weeks or more.

This week’s Chart of the Week examines the historical median duration of U.S. unemployment. During August, the median duration was 18 weeks, having fallen from an all time high of 25 weeks in June 2010. The above chart illustrates headline unemployment in recent years; note the drop from its high in June 2010. While the median duration has dropped, the overall impact of longer-term unemployment on labor market health and the economy is still significant. In this environment, the prospects for a rapid economic recovery are much lower than improvements in headline unemployment would suggest. Those unemployed for longer durations of time run the risk of increasing structural unemployment as well as reducing potential output within the economy.

On September 25, the Bureau of Labor Statistics released its final report on 2011 consumer expenditures. Although the information appears somewhat dated as we are practically entering the fourth quarter of 2012, the trends discovered in the analysis should have a material impact on GDP in the coming years, especially considering the importance of consumption to total GDP growth.

At the broadest level, consumer spending rose 3.3% in 2011 which was preceded by a 2.0% decrease in 2010. Given the importance of consumer spending to GDP, the increase does benefit the overall outlook for economic growth. However, the spending increase of 3.3% narrowly surpassed an increase in the prices of goods and services which grew by 3.2%. So although consumer spending has increased, an upswing in prices has blocked consumers being much better off on a net basis.

More important – and the focus of this week’s chart – is how the increased spending dovetails with consumer incomes. If income increases do not move in at least lockstep with consumption increases, consumers will be squeezed at the margin and therefore spend a greater proportion of their incomes. As a way of investigating this, the chart above depicts the income before taxes and average annual expenditure per individual consumer over the last three years. The important relationship to note is the income level percentage change. Incomes increased only 1.93% year over year, while the expenditures rose 3.3%. When incomes are exceeded by expenses, it will be hard for the consumer to sustain this pattern without taking on debt of some kind.

The trend in the graph above – expenditures growing faster than incomes – is a cause for concern. Incomes are not increasing substantially, expenses are increasing, and consumer debt levels have increased year over year. Consumers will not be able to sustain this level of spending without greater incomes or increased debt. Unless this trend can be reversed, this is another reason to expect sub-par economic growth over the next few years.

Source: Bureau of Labor Statistics, Federal Reserve

This week’s Chart of the Week shows the impact of government transfer payments (Social Security, Medicare/Medicaid, unemployment insurance, veterans benefits, food stamps, training & education programs, etc.) on disposable income (defined as personal income minus personal income taxes) in the U.S. over the past several years.

As the chart illustrates, since the recession began in December of 2007, real disposable personal income in the U.S. has increased from $9,974.7 billion to $10,354.8 billion (an increase of 3.8%). However, when excluding government transfer payments, real disposable income has decreased from $8,203.4 billion to $7,979.3 billion (a decrease of 2.7%). There are several reasons for the discrepancy between discretionary income and discretionary income excluding transfer payments, but the two primary reasons are: the U.S. economy has approximately 3.5 million fewer jobs now than in December 2007, and the population of the U.S. is aging. The loss of 3.5 million jobs results in both a drag on income (fewer people working results in lower incomes) and a boost in government transfer payments (fewer people working results in increased payments for unemployment insurance, food stamps, Medicaid, and job training programs.). The aging population of the country drives a boost in spending on programs such as Social Security and Medicare.

Over the past 30 years, government transfer payments have represented 13.9% of total personal income in the U.S. From January 2008 to July 2012, government transfer payments have represented 17.4% of total personal income in the country. Given the persistently high unemployment rate, the current budget deficit, the looming fiscal cliff, and the potential for cuts to government transfer payments in the near term, it is important to understand where the growth in government transfers has come from. The table below shows the current breakdown of government transfers by category as well as the average from January 2008 to present and the 30 year average.

Breakdown of Government Transfers

	Social Security	Medicare/ Medicaid	Unemployment Insurance	Veterans’ Benefits	Other*
Current	32.7%	42.0%	3.4%	3.2%	18.8%
Jan 08-Present	31.8%	41.7%	4.9%	2.6%	19.0%
30 Year Avg.	36.2%	39.3%	3.6%	2.7%	18.2%

* Other includes programs such as welfare payments, food stamps, earned income tax credits, job training, and disaster relief.

As the table shows, part of the increase in government transfers are cyclical in nature and come from programs such as unemployment insurance, food stamps, and job training. These programs have begun to shrink and should continue to shrink as the economy improves. However, the aging population of the country will have a significant impact on the largest components of government transfers, Social Security and Medicare. These problems are structural in nature, and as the population continues to age, spending on these programs should continue to increase. This means that unless there are significant cuts to Social Security and Medicare, it is likely that government transfer payments will remain at this elevated level well into the future.

Our first Chart of the Week for 2012 covered the ISM Manufacturing Index, with December’s value of 53.9 indicating signs of economic expansion (above 50) and a positive outlook heading into 2012. We revisit the ISM index this week to gauge the current health of the manufacturing sector.

As indicated by the chart below, the ISM stayed above 50 through May, indicating further expansion in the manufacturing sector and therefore legitimate reason for optimism regarding economic growth. However, the past three months have seen manufacturing face some headwinds, with the index falling below the 50 mark with the release of the June data at 49.7. Given the latest August release, the ISM has been below 50 for the past three months, indicating an ongoing drag to economic growth from a slowing manufacturing sector. Unfortunately, the lack of sustained expansion in the manufacturing sector is likely to contribute to the currently high unemployment rate as factories are hesitant to hire large pools of new workers until they have more confidence in their long-term growth prospects.

This week’s Chart of the Week shows the contribution to GDP growth in the United States from spending at the state and local government level since 1990. As the chart shows, state and local government spending, which has contributed an average of 0.23% to GDP growth annually over the past 30 years, has declined to a level well below its 30 year average.

The sharp reduction is mainly due to a significant plunge in tax revenues for state and local governments, which is a direct result of the recession that began in December 2007. Since almost all state and local governments are subject to balanced budget requirements, they have had to slash spending in order balance their budgets. As a result of these budget cuts, government spending at the state and local level has detracted an average of 0.20% from GDP growth annually since the first quarter of 2008. Given the drag that state and local government spending has been on overall GDP growth in the United States for the past several years, it is not surprising that growth has been well below trend since the recovery began in the third quarter of 2009.