Nearly everyone interested in the markets pays special attention to the monthly employment situation report. Briefing.com gives it the highest rating for importance. CNBC commentators today said that everyone was breathless, waiting for the announcement. (This article is Part Three in our series on the Birth/Death Adjustment.)
In a way it makes sense. Employment is a crucial measure of the economy. Severe job losses have piled up month after month in the current recession. Everyone cares. Everyone is interested.
It is also seen as a recent data point, partly because it is announced at the beginning of the month.
In a way it does not make sense. There is a wide "confidence interval" of over 100K jobs for sampling error alone. This does not consider the revisions. The sample is only partly complete with the "early returns" for the first announcement. That is the one that gets the market attention. The two monthly revisions include information from late-reporting companies and also "concurrent seasonal adjustments."
We have not even started with issues other than sampling error.
The Bureau of Labor Statistics (BLS) has created an excellent statistical process for counting every job in one month, counting them all in the next month, and determining the difference. Since there are over 130 million jobs, the error in the result is remarkably small, an envious accomplishment for anyone who understands statistics.
A Universal Error -- Impugning the Birth/Death Adjustment
Since the report is so important and the BLS is so open about methods, one would expect everyone to understand the process. Unfortunately, that is not so.
There is a thriving market for pundits who criticize the methodology, take statements out of context, and confuse seasonally adjusted data with non-adjusted data. Since no average reader can be expected to understand the methodology, these criticisms, usually from popular blogs and pundits who are not economists or statisticians, have gained general acceptance among market participants.
The overall result is to discredit the work of the BLS. This criticism has been proven wrong. (See here.) The actual result is known about nine months later when we have information from state employment records. We all wish we had better data sooner, but for now, the scorecard comes later.
In Part One of our series we showed that the estimation of job creation was not just the Birth/Death adjustment. In fact, that is only about 10 or 15 percent of the estimation of new businesses. Most of it comes from the imputation of business births from business deaths. This process, the imputation step, is "concealed" within the sample, so to speak. It captures the cyclical element of the economy very effectively.
In Part Two of our series we noted that most observers seem unaware that there is always significant new job creation, even in recessions. This job creation is on the order of 100K jobs per business day.
Why the Mistake?
Why are so many so wrong in interpreting the data? The answer is easy.
The critics ignore the fact that the estimation of job creation is a process with multiple steps. They ignore the imputation step that captures cyclicality, focusing only on the Birth/Death adjustment, which is merely a residual factor.
The residual factor is a rather stable component. It is a residual, something left over after the cyclical element has been recognized. It is small relative to overall job creation.
In making this mistake, the critics look only at the Birth/Death adjustment and expect it to reflect the economic cycle. Here is a typical example. Our quoted source is seen as a leading authority on the employment report, and most of the information he provides is very accurate and helpful.
A major modification to the NFP measure is the Birth Death adjustment. Changes to the BD were proposed in 2001, and implemented a few years later. This attempts to capture early improvements in employment at the start of a recovery was the goal. The trade off is it wildly overstates strength at the end of a cycle. For example, in 2007, approximately 75% of reported new jobs were due to this adjusatment.
Please note the argument. The writer mistakenly expects the residual to respond to the economy. It does not. It is rather stable. Let us look at the data.
The blue bars represent the actual residual, a series that remains fairly stable during the business cycle through the last recession. The critics complain that the residual becomes a larger portion of net job change. In fact, the process is accurately capturing the residual factor. It should become larger as a percentage of net job changes, and it does.
Briefly put, the critics make the mistake of ignoring the imputation step, the most important part of the process, and focusing on the residual adjustment.
Why This Matters
Here at "A Dash" we have had some very bearish forecasts on employment, including tomorrow's report. We have no reason to make things seem better than they are. The employment situation remains very negative.
As always, our motives are to make the best use of available data. The multi-year criticism of the BLS and the methodology used has been shown to be incorrect. Despite this, the myth prevails. This is due partly to the lack of any mainstream media coverage of the BLS viewpoint.
The mistake will become more important when an economic recovery begins. Those who blindly ignore the actual process of estimating job creation will be left behind.
For some months we have sent private emails to professional economists who misinterpret the data. Most of these sources have backed off after giving further study. In future articles we will be more explicit in highlighting those who do not understand the results.