A Reality Check For Bernanke

by: Robert Brusca

The MFG PMI undercut a growing surge of optimism last week, but this week the Non-MFG PMI is all-but off the charts-- and with it, optimism is back in play. The Fed will find less reason to be skeptical about the degree of job growth that the economy is and has been posting.

This ISM reading is now part of a complex puzzle, since anything that makes the economy look firmer while showing inflation forces stronger puts the Fed's feet to a hotter fire. .Just last week Ben Bernanke testified relentlessly that the economy's recovery was incomplete, that jobs were growing but that the basis for job growth was still poor and therefore, the prognosis was guarded. The Chairman continues to emphasize the value of the unemployment rate while being skeptical about the sustainability and impact of the upward momentum.

By rising to a reading of 57.3 in February from 56.8 in January, when it surged, the (Non-MFG) headline marks really impressive performance. The index last moved lower in September, six months ago.

The PMI standing in its ordered queue of historic values is at the 79th percentile; the activity index also is up sharply in February, in the 92nd range percentile of its queue. That means historically it has had observations higher than this month's observation only 8% of the time. Impressive!

New orders stood in the 85th percentile, backlogs are in the 75th percentile, the employment metric backed off to a raw reading of 55.7 in February from 57.4 in January, and still stands in the 97th percentile of its historic queue-- a very high reading and a good message for continued strong job growth.

Activity, orders, employment and price components are each more than 10% above their respective historic averages. This is very good news since the services sector is the jobs sector, and services is embedded in the Non-MFG index as the major part of the index.

Strong service sector, but suddenly so…

For now, the Non-MFG ISM is a strong reading that augers well for the services sector. It is stronger than other direct measures we get of services usage, either from GDP (up-to-date though Q4) or for consumer spending on services (up-to-date though January). But we can see why that is the case.

The Fed Chairman has been wary of the strong job numbers because we have not seen the sort of strength in services spending and output that, along with perked up MFG, could explain the strength of the monthly jobs numbers we have been observing. But we are now getting much, much, stronger readings from the services-heavy Non MFG ISM. It seems to be closing the Bernanke reality gap.

The alleged reality gap

For Q4, a period for which GDP data are available, the reading on services in GDP (the broadest measure for services) was weak, with services spending economy-wide contracting at a 0.6% annual rate while the Non-MFG PMI averaged 52.7 in the quarter. That NM-ISM reading was even LOWER than its twelve month average at the time (54.5). Those signals were consistent. There was a pick-up in actual job growth in Q4 compared to the 12-month average but was was very minor (from 140K to 150K). The employment reading in the NM-ISM did not call for that. It was slightly weaker in Q4 than it had been for the year as a whole.

Basically, not much service sector activity was being signaled or occurred for Q4, our most complete data set. But in January, as the Non MFG ISM rose, its employment gauge moved up astonishingly strongly. January marked the strongest one-month advance in the history of the jobs component of the survey, a span of 13 years. Private service-sector job growth advanced by 176K in January, a small pick-up, but the sixth strongest monthly gain since recovery began. The Non-MFG ISM headline picked up in January to 56.8 from 53.

Even so, there was no instant magical effect on spending. The reading for consumer spending on services in January remained weak. But now, in February, the reading for the Non-MFG ISM is even higher and the average for Q1 (with two months in...) is at 57.1-- well above the Q4 reading of 52.7. The step up for current Non-MFG activity is even stronger. And the two month average of the employment index is higher too despite some step-back in February. All in All, the positive signal from the ISM is a relatively new event. Meanwhile, data revisions have made job growth across last year stronger.

The Non MFG PMI does not bear a tight month-to-month relationship to the services sector; it is never quite clear if the PMI survey is signaling the current month's results or the previous month's results. With the index moving up relentlessly as it is now, this sort of dilemma is moot. The signal here is clear, and it is a sharp counterpoint to the weakness in the MFG PMI. Timing issues for the Non-MFG PMI are common; the trend with jobs and services output eventually fall into line and that keeps the Non-MFG ISM a relevant barometer.

On Balance

With jobless claims still low, consumer confidence still improving and vehicle sales having topped the 15mln unit mark, the strong rise in the Non-MFG PMI for February - especially the rise in the current activity index - points to continued strong economic growth and continued strong job growth. The sector is an important counterpoint to the MFG sector, and perhaps something that will help calm Bernanke's concerns over the sustainability of job growth. But if it does that, it will also help raise for him a dilemma for monetary policy.

A strengthening economy with rising price pressures (which is what the NON MFG index signals this month) is a troubling thing for the Fed and its dual mandate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.