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February 10, 2022

EU inflation, volatile bond markets and US employment

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Julius Probst
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Stress in European financial markets

The ECB and other European central banks are currently changing their policy stance and communication as inflation rates across Europe continue to rise. The annual inflation rate in the eurozone is now at its highest since the inception of the single currency in 1999. As the chart below shows, more than 90% of European countries are experiencing inflation higher than 3% while about half of all economies have an inflation rate in excess of 5%.

With the ECB clearly becoming more hawkish, financial volatility is increasing across the board. Indicators of systemic stress are going up, albeit from a relatively low level. The large crisis interventions and asset purchase programmes throughout the pandemic clearly suppressed financial volatility even as the economy experienced one of the largest macroeconomic shocks since the Great Depression.

Bond markets, on the other hand, are experiencing a return to volatility as interest rates surge in southern European countries, widening spreads.

While the ECB’s enormous asset purchase programmes suppressed yields during the acute phase of the crisis and the pandemic, the shift towards a more hawkish policy stance is inviting speculators to bet against southern European bonds again as those countries have weaker macro fundamentals. 

Still, the current fluctuations are mild compared to the 2008 financial crisis and 2011/2012 eurozone debt crisis. Also bear in mind that the recent surge, while concerning, started from an extremely low base; southern European bonds yields remain comfortably below 2%.


A Fed tightening cycle unlike any other? 

The current spike in inflation is also worrying the Fed and financial market participants on the other side of the Atlantic.

The chart below compares the inflation rate at the start of the tightening cycle against the total increase in the policy rate throughout the first year of that cycle. Fed funds futures currently price in a rate hike cycle of almost 1.5% by December 2022.

However, this tightening cycle will be quite different from previous experiences because inflation is so much higher, unlike 2015, for example, when both inflation and interest rates were at record lows when the Fed started to raise rates.

US monetary policymakers find themselves in a tough spot; they must keep inflation in check without choking off financial markets by hiking rates too rapidly.


US labour market recovery

Turning to the US labour market, the next chart displays one popular high-frequency indicator for US employment: Indeed, an American worldwide employment website for job listing. 

A simple correlation analysis shows that online job postings have the highest correlation with the US unemployment rate five weeks later. 

We pushed forward by five weeks the Indeed job postings series to show that they are in fact a good leading indicator for labour market dynamics.

While the Fed starts to tighten, the labour market has yet to fully recover. Total employment is some 2.5 million lower than before the pandemic. Even if this shortfall is eliminated later this year, the pandemic will have inflicted three years of lost job growth despite this being one of the fastest labour market recoveries ever recorded.

The following chart displays the evolution of the unemployment rate for each recession since the 1970s. We have purposefully not rebased the chart to show how low the unemployment rate was at the end of 2019 – close to full employment for the first time in more than a decade. 

The Covid-19 shock triggered a short but severe economic contraction as unemployment surged to more than 14% before returning to normal levels within two years.

While the labour market has recovered in general, some groups are faring worse than others. In the chart below, you can see that employment for those without a secondary school degree – which was already falling somewhat before the pandemic – fell by another 25% and remains some 10% below its pre-pandemic level. Meanwhile, employment for persons with a bachelor’s degree or higher has risen above its pre-pandemic level.


A model for US consumer sentiment

Lastly, we performed a simple regression analysis of the University of Michigan consumer sentiment for the US on macroeconomic fundamentals using GDP growth, wage growth, unemployment rate and inflation rate – four key macroeconomic indicators that are expected to explain changes in consumer confidence.

Using our formula language, we also added a time trend to the regression as the unit root test shows that not all our variables are stationary.

The model seems to work relatively well: the predicted value from the regression tracks the actual value closely except for one large outlier in early 2020, when consumer confidence should have been much lower based on the GDP decline and unemployment surge, both of which turned out to be temporary. 

However, right now we see the largest divergence between the model and the actual value. US consumer confidence is extremely depressed and far lower than what the macroeconomic fundamentals seem to warrant – suggesting that the pandemic continues to weigh on long-term consumer confidence.  

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