In mid-June, all the Federal Reserve’s 17 senior officials expected at least one increase in short-term interest rates by the end of the year and most were looking for two. Bear in mind, that outlook followed a weak initial payroll figure for May. In contrast, the financial markets have mostly priced out a Fed move for this year. Is the Fed trapped?
At the consumer level, inflation pressures appear to be mostly consigned to shelter and healthcare. No surprise, the strong job gains of the last few years have fueled housing demand. Home prices are rising. However, in the CPI calculation, the BLS seeks to separate the asset value of a home from the service it provides (shelter). So, it substitutes the rental equivalent for homeowners. Homeowners’ equivalent rent, which accounts for nearly a quarter of the CPI, rose 3.2% y/y, while rents (for actual renters) rose 3.8%. Core inflation (which excludes food and energy) rose 2.3% y/y, but if you exclude shelter, it would have risen 1.4% y/y. Bear in mind that the Fed uses the PCE Price Index as its chief inflation gauge, which is trending well below the CPI over the last several months.
Yet, it’s not past inflation that the Fed is worried about. Monetary policy is concerned with future inflation. Inflation is a monetary phenomenon, but we observe it through pressure in resource markets. Commodity prices are low, but seem unlikely to fall much further. There is excess capacity in manufacturing, so we aren’t going to see bottleneck inflation pressures developing anytime soon. The labor market is the widest channel for inflation pressures and is clearly the greater focus for the Fed. While there are signs of slack in the job market, conditions have grown tighter, and the Fed anticipates further improvement in the months ahead. Wage pressures have remained moderate, but many Fed officials expect stronger wage gains in the months ahead. State and local minimum wage increases may also add to pressures over the next few years.
One question Fed officials should be asking themselves is whether firms will be able to pass along wage increases or be forced to absorb them. In the Great Inflation of the 1970s and early 1980s, union membership was a lot higher than it is now and labor’s position in wage bargaining was a lot stronger. Wage growth responded quickly to increases in prices. Inflation soon became imbedded in the labor market, and wringing inflation expectations lower was costly (a major recession in the early part of the 1980s). Hence, many Fed officials see their main task as “keeping the inflation genie in the bottle.” However, Fed Chair Yellen may be more inclined to let the labor market run for a while. Stronger wage growth means stronger income growth, and stronger consumer spending (provided that the wage gains are not offset by higher prices). Views on wages and prices aren’t binary. There will be a range of opinion amongst Fed officials on how much pass-through we may see. Moreover, pass-through ability is likely to change over time.
A broad acceleration in wages need not be something for stock market participants to fear. Labor-intensive firms will face higher costs, but consumer demand (and overall economic growth) ought to be higher. In the late 1990s, the Fed, led by Alan Greenspan, tested how far the labor market could go. The unemployment rate fell, but that understated the strength, as labor force participation rose. Job losses were unusually elevated in the late 1990s, but job creation was even stronger. It was an unusually transformative time for the U.S. economy.
Given the current backdrop, getting the balance right is likely to be more challenging. The population is aging. Job turnover is going to be slower. Productivity growth has slowed and may not pick up again, which means that wage increases would become a greater restraint on earnings growth. Stronger wage gains would likely lead to some restructuring of the economy. The markets should be considering the long-term uncertainties, but there’s strong hope that things are going to turn out okay.
The monthly job market report is valued for its timeliness and its ability to drive the outlook for a number of sectors, including manufacturing, construction, and retail sales. Still, the figures are statistical estimates and seasonal adjustment is often difficult. The upside surprise in June followed a downside surprise in May. Such large month-to-month swings are unusual, but they do happen from time to time. Yet, if the weak May number was an anomaly, then so too was the figure for June. Job growth appears to have slowed, but not terribly.
There is a seasonal pattern in jobs. A steep fall in January (marking the end of the holiday shopping season) is followed by strong gains in the spring. Last year, the economy added 4.098 million jobs between January and June. This year, 3.962 million were added over the same period – slower, but not by a lot.
The three-month average reduces a lot of the noise in the monthly payroll figures. Job growth for the first half of the year was slower than in 2015 – the question is why.
There is still a fair amount of noise in quarterly averages of payroll gains. So, some of the first half slowdown could be a fluke. However, more likely, firms have reduced their hiring. The ADP estimate of private-sector payrolls has shown a slower trend in hiring by large firms, which are likely more sensitive to the global outlook. Hiring has remained relatively strong for small and medium-sized firms, although somewhat slower this year. Anecdotally, many businesses report difficulties in hiring qualified workers (that is, those willing to work for what the firm wants to pay). With population growth slowing, the job market will tighten more rapidly than it would otherwise. Long-term unemployment and the percentage of people working involuntarily part-time are still above normal levels, suggesting that there is still a lot of slack in the job market, but they have been trending in the right direction.
The Fed needs to set monetary policy with an eye to where the economy is likely to be 12 months from now. It’s easy to imagine that the job market will be even tighter. Most Fed officials see this as justification for moving to a more neutral policy position. However, wage growth is still relatively moderate, hardly suggesting a “tight” job market. Moreover, the risks to the outlook are weighted to the downside. The problems in the rest of the world, and there are many, from Brexit, to shaky Italian banks, to a major restructuring in China, will have some impact here. However, the flight to safety has pushed long-term interest rates down, which ought to provide further support to the housing sector and should be stimulative for business fixed investment. Still, while the Fed is expected to remain in tightening mode (that is, pondering an increase in short-term interest rates), it is unlikely to act anytime soon.
Economic growth in the U.S. is expected to be moderately strong in the near term – not too fast, not too slow. However, the financial markets are likely to remain battered off and on by ongoing worries about the rest of the world.
While the Brexit vote and initial reaction (over-reaction?) is behind us, there will be a lengthy and uncertain process of disentanglement from the European Union. Brexit has dominated the market action, but we should be seeing greater interest in the U.S. data. Recent figures suggest a pickup in economic growth in 2Q16. Running contrary to this strength, growth in nonfarm payrolls appeared to slow significantly in the first two months of the quarter. The question is why? This Friday, we should get answers. The July Employment Report will be the key driver for the near-term economic outlook.
Recall that nonfarm payrolls rose far less than expected in May (private-sector jobs up 25,000), while figures for March and April were revised lower. A strike at Verizon subtracted about 35,000, and while those workers will return in the June payroll total, payroll growth was still lower than expected. Mild weather may have pulled forward seasonal job gains. The soft May figure could represent statistical noise (the monthly change in payrolls is reported accurate to ±115,000). There could be issues with the seasonal adjustment (perhaps an earlier end to the school year). Amid uncertainty about Brexit and the presidential election, firms may have slowed their hiring, or perhaps firms have had a more difficult time finding qualified workers as the job market has tightened.
Growth in payrolls was already expected to slow this year as the unemployment rate declined. We only need about 100,000 jobs per month to be consistent with the growth in the working-age population and much of the slack generated from the financial crisis has been taken up. Still, wage growth, while higher than in 2013 and 2014 (+2.0%), has remained relatively lackluster (+2.5% y/y). Anecdotally, firms report difficulty in finding qualified workers (that is, workers willing to work for what the firm wants to pay). With minimum wages moving higher, wage growth should pick up over time.
The early Easter shifted some spending from March to April. The May figures were moderately strong, suggesting a robust pace in second quarter spending. Granted, this follows a soft first quarter, but averaging the two quarters, inflation-adjusted spending growth is likely to have been close to a 3% annual rate in the first half of the year. Take that with a grain of salt. The upcoming annual benchmark revisions could alter that view.
The one area of clear weakness in the economy has been in capital investment. Much of this weakness has been concentrated in energy exploration, which won’t fall forever (hence, will no longer be a drag on overall growth). Yet, ex-energy, business fixed investment has been relatively soft, consistent with a soft global economy and a slow patch in manufacturing, not an outright recession.
Capital spending rises and falls over the business cycle, but for the economy as a whole, the consumer drives the bus. Better wage growth ought to offset a slower trend in job growth and keep consumer spending on a moderately strong path.
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