Since 1980 the three most volatile cyclical components of GDP have been “change in private inventories”, “fixed investment in non residential structures”, and “fixed investment in residential structures”. While these three categories make up only 8% of GDP, they have historically accounted for almost 60% of any negative change in GDP during a recession.

Recent economic data indicate that the risk of recession in the U.S. has increased substantially over the last three months. However, one major difference as the chart shows, is that these components of GDP (“change in private inventories”, “fixed investment in non residential structures”, and “fixed investment in residential structures”), which typically are the key drivers of a cyclical downturn, are not anywhere close to the peak levels that are often seen leading up to a recession. In fact, “fixed investment in nonresidential structures” is almost one standard deviation below normal, “fixed investment in residential structures” is more than two standard deviations below normal, and “change in private inventories” is roughly in line with historic norms.

While this does not mean that the US cannot slide into recession in the coming months, it does mean that any recession is likely to look very different from the prior recessions the US has experienced since 1980. Since any recession is usually positive for net exports (as we saw in 2008), and given that the normal drivers of recession discussed above are already unusually low, a recession is likely to be driven by a drop in Government Consumption Expenditure or Personal Consumption Expenditure. These two components made up 91.4% of GDP in 2Q2011, but have historically been two of the most stable components of GDP.

As a result it seems likely that if a recession occurs over the next 12 months, it will be driven by lower consumer or government spending. However, since these components tend to be very stable, both a deep recession or a rapid recovery seem unlikely.

The chart above shows labor share on the left axis, and corporate profits as a percentage of GDP on the right axis. Labor share is calculated by the U.S. Bureau of Labor Statistics, and measures the percentage of output that employers pay in employee compensation. Corporate profits as a percentage of GDP is calculated based on the U.S. Bureau of Economic Analysis (BEA). It includes income earned abroad by corporations.

Since the 1980’s until the most recent recession, the U.S. maintained relatively stable GDP growth. However, this growth was not evenly apportioned. During this time, income inequality increased, and labor’s share of output declined. Over the past decade this loss in income was supplemented with an increase in leverage, including mortgage debt. The subsequent consumer deleveraging has led to weak aggregate demand and tepid GDP growth out of the recession. With lower wage costs and new sources of global demand, corporate profits soared.

In the near term, these imbalances still seem firmly in place. Aggregate demand, and thus economic growth, is weak. Earnings growth remains comparatively strong. In the long-term, what may be good for the economy may or may not be good for corporations and the stock market. Wage inflation would improve household balance sheets by both increasing income and decreasing nominal debt burdens. However, higher costs would lead to declining corporate profits.

This week’s Chart of the Week compares growth in nonfarm payrolls to real GDP growth. The year over year change in nonfarm payrolls (i.e. jobs created or lost) is plotted on the left axis, and year over year real GDP growth is plotted on the right axis. As the chart shows, job growth is highly correlated to GDP growth.

Currently, the civilian labor force in the United States (the measure the BLS uses when calculating the unemployment rate) is approximately 153 million people. The civilian labor force has grown at about 0.8% per year since 2000. This means that the U.S. economy needs to add approximately 1.2 million jobs per year in order to keep pace with the growth of the labor force (i.e. keep the unemployment rate at the current level). A 1.0% decrease in the unemployment rate would require an additional 1.5 million jobs on top of that. Given the recent GDP numbers (GDP grew at an annualized rate of 1.3% in the second quarter), the near-term outlook for employment is not very positive.

The Bureau of Labor Statistics (BLS) release of the U.S. unemployment rate each month generates a significant amount of attention; however, this headline number provides only a static view on the health of the labor market. Since reaching a high of 10.1% in October 2009, the unemployment rate is currently 9.2% through June 2011 and remains at elevated levels following the “Great Recession” of 2007-2009.

An alternate method to gauge the health of the labor market involves analyzing the total number of job openings, hires, and separations each month. The BLS refers to this as the Job Openings and Labor Turnover Survey (JOLTS). The JOLTS survey shows the level of activity taking place in the labor market, generally referred to as “churn”. Labor market churn, the movement of workers from one job to another, shows how fluid the job market is with higher levels generally corresponding to a healthier job market. Hires and separations have remained below pre-recession levels and have shown little improvement during the past two years.

It has been estimated that approximately 125K jobs need to be created every month just to keep up with the pace of population growth. In order to bring unemployment down, a significantly higher amount of job growth per month will be needed for a sustained period of time. In May 2011, the number of hires was roughly 12% higher than the low in experienced in October 2009, but remains well below pre-recession levels.

The chart above illustrates the debt ceiling and the amount of gross debt as a percentage of GDP. The debt ceiling ($14.3 trillion) is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The total debt outstanding is the sum of the debt held by the public and intergovernmental holdings. Total GDP through 1Q11 was approximately $15.0 trillion. The debt to GDP ratio is currently at 95%, a 46% increase from the pre-crisis ratio (65%); the significant increase is an indication of the amount of stimulus enacted to save the financial system from collapse.

There has been much discussion over the past several months regarding increasing the debt limit. Currently, the Treasury Department projects that the U.S. will exhaust its borrowing authority under the current debt ceiling on August 2, 2011. If politicians cannot come to an agreement in the coming weeks, the government could default on its legal obligations.

Much of the debate in recent months is based upon political posturing between democrats and republicans. There have been nearly 100 instances since 1940 that Congress has permanently raised, temporarily extended, or revised the definition of the debt ceiling; debt as a percentage of GDP has averaged approximately 59% over that timeframe. The U.S. debt ceiling reached $1 trillion in 1980 and has risen by a considerable amount since that point. It is worth noting that the last time debt to GDP was over 100% was WWII, but the years after the run up in debt featured a period of sustained economic growth. In theory, the temporary stimulus that has entered the system will allow for increased economic growth going forward so that growth will allow for the percentage of debt to GDP to fall. Growth alone will not solve the overarching problem of debt, though, so policy makers need to work together to ensure fiscal responsibility while fostering economic growth.

For all the bad press about the state of public pension plans, the chart above shows that not every state’s pension system is poorly funded. In aggregate, public pensions are approximately 75% funded (down from a high of 103% in 2000), but there is a great degree of dispersion of funding ratios on a state by state basis. Certainly, there are problem states, as shown by the bar on the left, with 11% (as a percentage of total public plan assets) funded at less than 60%. On the other hand, an almost equal percentage is fully funded, thus showing that not every state’s pension system is in need of massive contributions.

With the recent surge in commodity prices and inflationary pressures beginning to take hold in many emerging market countries, inflation has once again become a major topic of discussion in the United States. This week’s Chart of the Week shows the percentage changes in the Consumer Price Index and Unit Labor Costs since 1950. As the chart illustrates, over the past 60 years, there has been a very strong correlation of 0.825 between changes in labor costs and changes in inflation (a correlation of 0 indicates there is no correlation and a correlation of 1 indicates a perfect correlation).

Given the strong correlation between labor costs and inflation, it makes sense to look at current labor market conditions to get a more accurate picture of the inflationary pressures currently affecting the United States. The U.S. currently has an unemployment rate of 8.9% and an underemployment rate of 15.9% (the underemployment consists of the unemployment rate plus individuals working part time who would prefer full time employment and individuals who are not working or actively seeking a job but would want to have a job.) In addition, capacity utilization is currently 76.1%, which is well below its historic average of 80%, and worker productivity, which increased at a rate of 2.6% in the fourth quarter of 2010, has been steadily increasing over the past several years. The amount of slack currently built up in the labor market makes it very unlikely that the U.S. will see significant upward pressure on labor costs in the near term. This makes it unlikely that the U.S. will see significant upward pressure on inflation in the near term.

In the last four months of 2010, the price of oil rose from $72 as of August 31st to $91 as of December 31st, an increase of 26%. Over that same time period, the breakeven rate (the difference in yield between the ten year TIP and ten year nominal treasury) increased 34%, from 1.68% to 2.25%. Because the breakeven rate is commonly used as a proxy for inflation expectation, it is not a stretch to think that the run up in oil prices was driving inflation expectations (and inevitably, stories of “rising inflation” always seem to appear shortly after the price of oil shoots up). This week’s Chart of the Week compares inflation expectations (measured by the breakeven rate) with oil prices, to see if there really is a strong correlation between the two values. The blue bars represent the price of oil at the end of each month, and the red line chronicles the breakeven rate at each month end; data is used going back to 2003. Between 2003 and 2007, there seems to be a loose connection between the two, but it is not very tight, as the price of oil slowly creeps up but the breakeven rate is relatively static. From late 2008 through the end of 2010, the graphs seem to mirror each other more closely, most especially in late 2010. In total, however, the correlation is only .18, thus we conclude that the price of oil does not have a strong impact on expected inflation values, in spite of what we hear and read when oil prices rise dramatically.