Unemployment declines, but don't sound the all clear just yet

FRBSF

The unemployment report released by the Labor Department on Friday shows nonfarm payroll employment increasing by 200,000 in December and unemployment falling to 8.5 percent. There is some question about the seasonal adjustment procedure used to adjust the numbers for holiday hiring, but even so this is a relatively strong report with job gains "in transportation and warehousing, retail trade, manufacturing, health care, and mining."

The good news in the latest unemployment report coupled with the decline in new claims for unemployment insurance over the last few weeks are both pointing to recovery. But how strong and robust will that recovery be?

We are recovering from a particularly troublesome type of economic problem known as a balance sheet recession. Balance sheet recessions are generally triggered by a crash of the financial sector. The result is big losses in investments in the stock market intended for retirement, education, and other uses; people who become unemployed are forced to dip into and deplete their life savings, and when housing markets are involved as well -- as they were in this recession -- home equity is also destroyed. It takes considerable time to rebuild all that is lost, and so long as this rebuilding is underway -- so long as people are saving rather than consuming -- economic growth will be slow and lost decades are not at all uncommon in this type of a recession.

It doesn't have to be this way. Effective monetary and fiscal policy can shorten the recovery time. However, fiscal policy makers are not going to increase spending on the scale needed. They are much more likely to do something that works against the recovery such as reducing the deficit before the economy is ready for it than to take further action to spur output and employment.

The Fed has, in general, been more effective and more aggressive than fiscal policymakers, and the economy is better off for it. There is some chance of further easing from the Fed if the economy takes a turn for the worst, but as it stands policy is likely to remain on hold for a considerable period of time (as the Fed's forward guidance makes clear).

Thus, while a long, drawn out recovery is not inevitable, we appear to be on such a path and there's little chance that policymakers will take the steps needed to change the trajectory.

As for robustness of the recovery, and by that I mean the chances the recovery will stall out or even reverse, there are two big worries on the horizon. The first is the situation in Europe. Things look better for the moment, thankfully, but Europe's troubles are far from over. If the Europeans run into further trouble, that would be bad news for the recovery in the U.S., so let's hope they hold it together. The second worry is the situation the the Gulf. If trouble erupts, e.g. an attempt by Iran to disrupt oil shipments, the price of oil will increase rapidly. The increased costs for producers at a time when many are struggling just to survive could potentially take the legs out from under the recovery. It would depend, of course, on the size and length of the disruption, but any trouble would negatively impact oil prices and that would be bad news.

But, for the moment anyway, things are looking better. We need the pace of the recovery to accelerate -- the pace is still too slow -- but at least we're finally headed in the right direction.

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