A Stronger ADP Report Is Not Cause For Concern

by: Calafia Beach Pundit

The ADP report on private sector job gains for December was decently stronger than expected (+238K vs. +200K). That appears to confirm what other indicators have been suggesting, namely that the economy strengthened somewhat on the margin over the course of the last several months. Of course, this time of the year seasonal adjustment factors play a strong role (layoffs typically surge around year end), so it's hard to get too excited. The way I read the above chart, which compares the ADP estimate to the BLS employment report, job growth today is about the same as it has been for the past few years, and similar to what it was during 2004-2006.

The market was initially concerned that this upside surprise would translate into a faster-than-expected tapering of QE, and that in turn would be bad news for future growth. I would say that the Fed would be quite justified if it thought that QE should be tapered at a faster pace, and that this wouldn't be bad news for the economy at all. There is little or no evidence that QE has stimulated growth, so an absence of QE shouldn't depress growth. As I've said many times in the past, the real purpose of QE was to provide risk-free assets-T-bill equivalents to a world that was desperate to deleverage and de-risk.

So the real issue surrounding the tapering of QE is not whether the economy is a bit stronger than expected, but whether the world's demand for risk-free assets is declining, and whether the world is becoming less risk-averse on the margin. I suspect that risk aversion is on the decline, in the same way that confidence is slowly returning, so that would suggest that a faster pace of tapering is fully warranted and not something to worry about.

If there is anything to worry about, it would be a more rapid return of confidence and a more rapid decline in risk aversion. If the FOMC members lie awake at night worrying about anything, the subject of their concerns is likely to be the return of confidence. More confidence would mean banks would be more inclined to lower their lending standards and the world would be more inclined to borrow money rather than to deleverage. Excess reserves are so huge that banks have effectively no constraints whatsoever on their ability to lend, so an increase in lending could at some point result in a significant increase in the supply of money relative to the world's demand for money. That's equivalent to an increase in the velocity of M2, and that means that the existing stock of money could support a significant increase in nominal GDP: more growth and/or more inflation.

The decline in gold prices over the past year is one symptom of a return of confidence. Similarly, the decline in credit spreads, which are now beginning to approach levels that are consistent with healthy economic growth, is symptomatic of a return of confidence. Swap spreads have been very low for a long time, and have thus correctly predicted healthier financial markets and improving economic fundamentals.