Trader Tip: Phillips Curve and Misery Index Revisited Often we discuss the technicals of the markets we trade, but underlying these technicals do lie the fundamentals that drive the markets in the end. Two such fundamental analysis indicators are the Phillips Curve and Misery Index. Today, these indicators are scoffed at and not really looked at much. Perhaps this may be true, but to understand the “why” they are less important (or not) is good to understand.
First off what is the Phillips Curve? The Phillips Curve (see thumbnail) is a single-equation empirical model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of inflation. This is why the Fed has been so focused on raising inflation (one aspect of their two fold mandate – click here), as they are under the belief that raising inflation will boost employment, the main political issue since the 2008 great economic recession.
So how has the Fed done? Well looking at the adjacent chart (click to view better), not very well. We see the Phillips curve collapsing since the 2008 great recession. They have managed (via lower interest rates and Quantitative Easing) to merely raise asset prices. This has been a boom for the markets, but makes the average worker less and less part of the economy. Yes, the rich have gotten richer (the fraud of fractional reserve lending, the main source of wealth inequality). Of course with the concentration of wealth into a few hands, it also means political control goes to these few people as well (they use their wealth to manipulate the people).
In the adjacent chart (click to view better) we can see this effect of workers being less of the economy each passing year – not a good picture for the workers. This is why the Fed has been so puzzled to understand why employment and rising wages has been such a problematic mystery (for the conspiracy theorists perhaps it was the plan). The other part of this is to understand why people are so angry when inflation is low and unemployment is low. Isn’t this a good economy and the Fed has done well? This “feel good” also has an indicator called the Misery Index. Let’s see what this tells us.
The Misery Index was initiated by economist Arthur Okun, an adviser to President Lyndon Johnson in the 1960’s. It is simply the unemployment rate added to the inflation rate (the main parts of the Phillips Curve). It is assumed that both a higher rate of unemployment and a worsening of inflation both create economic and social costs for a country. However, here there is a problem as well. Are in fact both inflation and unemployment being understated? Looking at the current political divide one could conclude, yes. I am not implying that the existing data is wrong, or anything necessarily nefarious, rather simply like the Phillips Curve, the formulas and basic economic thinking to compute this data are challenged and outdated.
Looking at inflation, the Fed often uses the core CPI rate. For the people that have assets this maybe more true, but for the bottom 50% they pay the “Big Mac” CPI rate, as they have no asset hedges. So inflation for them is far higher (see this article on the Big Mac Index). On the employment side as well there are issues, as the currently stated official unemployment rates maybe skewed as well. The government data merely tracks those looking for work, not actual unemployment (click here for alternative employment statistics). So just what is the real Misery Index?
In the adjacent chart (click for better viewing), what we have done is to plot the existing Misery Index with our own Adjusted Misery Index, and line them up side by side for comparison. The way we computed ours was to add in a scaling factor for an inflation rate twice the core CPI rate and similar to the employment rates. It may also not be the best formula, however, if all data items are computed the same, the actual data items values are not important, rather the delta between them. It should be noted, our model assumed a linear progression. If it would be more exponential (and most likely is), the future looks even more challenging if we would extrapolate into the future. This paints a more clear picture and explains the social anger we see today. This also says, similar to the 1970s, we are living in a pivotal moment. Oh dear …
So why is this all important? As I have said before, culture (social cohesion) is upstream from politics. People vote on feelings, few vote on actual data like is presented here. The economy and financial markets are downstream from politics, as now that the government controls more and more of the economy (good or bad), they do have a significant impact on this when they pass laws that will determine its future. I can not predict when major political events will occur, just that I know someday they will. It should also be understood that this is just not a US phenomenon, it is global, as most central banks of the world are doing the “group think” similar thing (another point for the conspiracy theorists). Along with many other “Black Swans“, this Adjusted Misery Index will bleed even further into the culture and cause subsequent major negative effects for the markets in a very divided political world. Oh dear …
Perhaps on a day to day trading basis these longer-term fundamental issues may not affect the markets we trade. However, we need to understand these fundamentals, so that when daily scheduled reports do come out, we understand what specific reports may be important, as these “hot red” issuse are used in many of our trader’s Trade Plans as trade Filters (i.e. when to be wary and avoid certain trades, due to important market events.) Click here, or watch below a video presentation of this Trader Tip.
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