The Labor Market Conditions Index

The New PCE
June 27, 2016
Steak House Index UPDATE 6/29/16
June 29, 2016

When formulating monetary policy, the “data dependent” FED needs good data.

The “Labor Market Conditions Index” fits the bill.   The LMCI is a type of predictive model created by the FED to gain a deeper, broader grasp of true US employment conditions.  In the FEDs words, “The LMCI is derived from a dynamic factor model that extracts the primary common variation from 19 labor market indicators.

As this index incorporates far more data than the unemployment rate alone, I believe the FED places a lot of weight on the index when making FOMC rate decisions.  Let’s take a closer look.


Why you should care:  The FED decided to ‘hold‘ in their last meeting.   Rates remained unchanged.   This in spite of the 4.7% unemployment rate – a rate below the ‘natural rate‘ of unemployment.   While many were surprised by the FEDs decision to hold, I was not.  I discussed much of this in my ‘Voodoo Math’ BLOG:

Voodoo Math

Clearly, the LMCI is a much better indicator of US employment situation and the FED appears to use this index when making rate decisions.    Understanding and using this data will help us predict future FED rate decisions.

Finally, we will be incorporating the LMCI into the new SHCI – the “Steak House Composite Index,” which will make its debut later this week.


Taking Action:  Read on!  🙂


The BLOG: 

As discussed above, the LMCI is derived from a ‘dynamic factor‘ model.   This simply means that the model tracks a number of variables, over time, using a consistent methodology, to generate an index that reflects improvement (positive) or decay (negative) in the condition of the US labor market.   In a 2014 paper prepared by the FED on this topic, entitled “Assessing the Change in Labor Market Conditions,” the authors described the index this way:

“This paper describes a dynamic factor model of 19 U.S. labor market indicators, covering the broad categories of unemployment and underemployment, employment, work-weeks,wages, vacancies, hiring, layoffs, quits, and surveys of consumers’ and businesses’ perceptions.  

The resulting labor market conditions index (LMCI) is a useful tool for gauging the change in labor market conditions.   In addition, the model provides a way to organize discussions of the signal value of different labor market indicators in situations when they might be sending diverse signals. 

The model takes the greatest signal from private payroll employment and the unemployment rate.  Other influential indicators include the insured unemployment rate, consumers’ perceptions of job availability, and help-wanted advertising.”

(For the full report, click on this URL: 

https://www.federalreserve.gov/econresdata/feds/2014/files/2014109pap.pdf)

What are the 19 variables?   Take a look at this chart:

LMCI 2

Clearly there’s a lot more data here than simply the unemployment rate.   Quite a bit more.  How valuable has the index been?   How accurately has this index proven to be at predicting GDP movement?

Great questions.  Here’s a chart from our friends at FRED:

LMCI

I suggest you ‘click’ on this image to see the larger version.  Notice the red lines, the green lines, and the “?” that I added above?   Each line – sloping down from left to right – indicate an index reading that has gone severely negative.  In 5 cases since the late 1970s, the LMCI has preceeded a recession; in 3 cases, the economy recovered without slipping into a recession.

And there there’s the “?” at the very right.   Notice the index has gone negative.   When was this?   Every month this year.   Hmmm…..

Here are the actual index readings since January of 2015:

LMCI

It’s easy to see that every 2016 LMCI index value has been negative.  And the ‘red ink’ is growing in size.  This must weigh heavily with the FED.

How does this compare to the end of 2008?  In December of that year, the index reached a negative (39.00).   Far worse than today.  Which simply suggests we’d better keep our eye on further direction/movement of this index.

In the words of the FED:

“…the LMCI is one way to organize discussions of the signal value of a number of different labor market indicators in situations when they might be sending diverse signals.  Examples of such situations are not hard to find, such as recent discussions about whether the unemployment rate has been overstating the degree of improvement in the labor market.   

Answering this question requires one to compare the unemployment rate with other labor market indicators. The LMCI, and multivariate methods like it, are well-suited for that task. Indeed, from the perspective of the LMCI, the unemployment rate has improved slightly faster than is consistent with the signal from the other indicators over the past two years.”

OK…enough FED-SPEAK for one day.   In a nutshell, the FED is telling us that while the unemployment rate has improved meaningfully, some of the other components in the LMCI have not; in fact, they may have moved in an opposite direction.

Hence the negative readings this year.

I believe this index is one of the primary contributors to the ‘hold’ decision in June.   Tomorrow we’ll incorporate the LMCI into the Steak House Composite Index!

Tune in tomorrow!

  • Terry Liebman