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By Georg Vrba

The Federal Reserve's is expected to extend its easing measures until the job market improves "substantially", the stated goal is a decline of the unemployment rate to 6.5%. One can use the unemployment rate model to provide an estimate of the future unemployment rate (UER). This model suggests that the unemployment rate will decline to 7% by the end of 2013, and to 6.5% by the middle of 2014; the implication being that the Fed could abandon its easing measures fairly soon, which should affect bond and stock prices adversely.

Additionally, reaching the Fed's UER target level early will also bring the onset of the next recession nearer. After the target level of 6.5% is reached, the model shows that it is possible that the lowest level of the unemployment rate will be about 6% in the middle of 2015, and could then rise to about 6.5% again by the second quarter of 2016, with a recession starting then.

The growth of the unemployment rate (UERg) has been negative since the end of September 2010, for 140 weeks so far, and the current level of UERg is -8.4%. The unemployment rate must continue to decline further while UERg is negative. Only when UERg becomes positive again, which usually signals a recession start, will the unemployment rate increase again. (The criteria for the model to signal the start and end of recessions are given in the original article.)

By relating the typical growth rate pattern of the UER which prevailed during previous in-between recessions periods to the present period we can attempt a forecast.

Table 1 below lists the length of the periods and also the corresponding average value of UERg when UERg was negative between previous recessions. One can see that average value of UERg ranged from -7.5% to -9.3% (surprisingly all of similar magnitude). The length of the periods ranged from 103 to 418 weeks, with the average for the last four periods being 280 weeks. (The short 1981 period between the two recessions was not counted, because UERg never went negative then.)

Applying UERg of -8.5% and the 280 weeks when UERg was negative to the current in-between recession period, then we have approximately another 140 weeks to go before UERg becomes positive again, which would herald the beginning of a possible recession. Also over the past 140 weeks of negative growth the average of UERg was -7.1%. So if UERg was to average -8.5% over the full 280 week period, then we can expect even lower negative growth rates in the near future, because we have only about 140 weeks left to achieve this. This means that the unemployment rate should show significant declines over the next several months, according to the model.

From this scenario one can determine the applicable UER and UERg into the future from May 2013 onwards. This is graphed in the chart below (black projection line of UERg) and the estimated UER values are listed in Table 2 at the end. Obviously this is only an educated guess, because one does not know the exact length of time for which UERg will remain negative, nor its actual future values, but this is about as near as one can get based on past history.

The green graph in the chart depicts UERg. The shape of the UERg graphs for the period when UERg was negative between recessions have similar patterns, and one can reasonably expect this pattern to be repeated again. One can see that the UERg graph between 2010 and 2015 looks similar to the previous in-between recession graphs of UERg. It will certainly take many weeks from now before UERg reaches zero, 140 weeks according to the estimate, and the unemployment rate must decline over this period, because of its negative growth rate. Also if UERg follows the assumed pattern, then the earliest new recession start would be at the beginning of 2016.

In Table 2, lower down, are the actual "real-time" values of the UER from January to May 2013, and from June onwards the expected values based on the estimate. The Fed's target 6.5% unemployment rate may occur in June 2014 as indicated in the rose colored cells, and the yellow colored cells indicate a possible new recession start. It is interesting that a new recession may occur when the unemployment rate is likely to be 1% lower than what it is now.

Should the actual future reported values of the unemployment rate be higher than what is shown in the table, then a 6.5% unemployment rate may occur later. Alternatively, if the reported values are lower than the listed ones, then the unemployment rate of 6.5% may be reached earlier than anticipated by the model.

Conslusion

We can anticipate the Federal Reserve's easing measures to end fairly soon, possibly in the fourth quarter this year, when the UER is expected to be 7% according to the model.

The St. Louis Fed president said he expects the U.S. unemployment rate, 7.9 percent in January, will drop to the "low 7s" by year's end, which he said would meet the Federal Open Market Committee's test of "substantial improvement" in the labor market needed to end purchases. "Almost anybody would have to say that would be substantial improvement compared to where we were at the time of the launch of QE3," he said. [Bloomberg]

One can expect the stock market to react negatively to this event, and rising bond yields will cause bond prices to decline as well. One should also keep in mind that a new recession may start in the beginning of 2016.




Georg Vrba is a professional engineer who has been a consulting engineer for many years. In his opinion, mathematical models provide better guidance to market direction than financial "experts." He has developed financial models for the stock market, the bond market, yield curve, gold, silver and recession prediction, all published in Advisor Perspectives. The models are updated weekly at http://imarketsignals.com/.

Source: When Will The Fed's Easing Measures End? The Unemployment Rate Is The Key