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For the Week Ending December 08, 2017

Ten years ago this month, the U.S. economy slipped into the deepest recession since the 1930s. What a difference a decade makes. To be sure, some firmly believe that bubbles are forming (bitcoin anyone?) that will soon deflate and bring the economy to its knees, much as the bursting of the dot.com and housing bubbles presaged the last two recessions. But any judgment as to whether assets are overvalued and/or when they might burst is debatable, to say the least. That said, the Federal Reserve has become increasingly concerned about speculative behavior in the financial markets and its potential consequences for the real economy. While not an overriding factor, the desire to curb undue risk taking by investors seeking to bolster returns has reinforced the Federal Reserve's commitment to gradually lift short-term interest rates.

Of course, the overriding influence behind the rate-hiking strategy is the economy. With two quarters of above-trend growth on the books and a third in the making, the Fed believes that it is amply justified to remain on a rate-hiking path. If anything, recent data suggest that future increases may come faster than is currently priced into the financial markets. That prospect becomes more likely if the strength shown in the data stokes higher inflation, as the Fed anticipates. So far, however, the inflation genie remains firmly bottled up, something that remains a mystery to policy makers given the time-honored underpinnings that have historically generated upward price pressures. Most notably, the economy continues to create jobs that outpace the growth in the labor force, driving the unemployment rate down to a 17-year low. Despite the ever-tightening job market, however, upward wage pressure - a major catalyst driving inflation - has remained muted.

That dynamic continued to play out in November, according to Friday's jobs report. During the month, the economy generated 228 thousand new jobs, modestly higher than expected and well above trend. Unlike the previous three months, the recent hurricanes had a negligible effect on the November employment data, albeit post-hurricane rebuilding likely boosted the demand for construction workers. The main story last month was the broad-based nature of job growth. For the sixth consecutive month, more than 60 percent of private industries expanded payrolls, the longest such string of months since 1998. Simply put, the robust pace of job growth is spreading and touching a broader swath of the population.

The November payroll increase brings the average gain over the past three months to 170 thousand, almost spot-on with the average over the past six and 12-month periods. This year's pace is modestly slower than the 187 average monthly increase in 2016, but a slowing trend is to be expected as the job market moves closer to full employment, making it harder for companies to find qualified workers. Indeed, at 170 thousand, the monthly pace is not only healthy, but well above labor force growth and, hence, not sustainable over the long term. Aside from the strength in construction hiring, which may be hurricane related, the trend in two other sectors is particularly encouraging.

Manufacturing payrolls for one, expanded by 31 thousand, bringing the average for the year to date to 16 thousand a month. That may not seem like much, but it is a vast improvement over 2015 and 2016 when virtually no jobs were created in the industrial sector. Since the summer, the hiring pace has strengthened, averaging 27 thousand a month from August through November, as manufacturers are benefiting from stronger global growth, the weaker dollar and a pick-up in capital spending. Indeed, the revival in manufacturing jobs is a sign that the hard data may finally be catching up to the soft data reported in an array of surveys. For some time, both national and regional surveys of manufacturers have shown considerably more strength than actual activity in this sector. But manufacturing production has accelerated in recent months and job growth is now following suit.

Another positive sign is the pick up in retail-related employment. Payrolls increased by 19 thousand in the retail sector, the strongest gain since January. Part of this strength may reflect the longer than usual 5-week time span between the October and November surveys, which captured seasonal hirings in November that might otherwise have been picked up in the October jobs report. Still, the average for the two months yields a solid gain that supports expectations for a strong holiday shopping season. Again, those expectations are based on surveys and other anecdotal evidence that are not entirely reliable. But retailers would not be taking on more seasonal workers than they normally do unless they had firm reasons to expect robust sales over the holiday season.

With the sturdy job gains in November, the Federal Reserve has more ammunition to support another rate increase at its upcoming policy meeting next week. We concur with the widespread expectation that it will follow through with a quarter-point hike, lifting short-term rates to a range of 1.25-1.50 percent. Even so, the meeting is likely to feature some resistance from Fed officials who remain concerned about the persistent low inflation rate, which received little pressure from accelerated wage growth in the latest employment report. Average hourly earnings increased by 0.2 percent in November, lifting the annual increase from 2.3 percent to 2.5 percent. But that nudge higher only recaptures half of the setback that took place in October, when the year-over-year increase in earnings plunged from 2.8 percent to 2.3 percent. Growth in earnings has been stuck in a narrow range around 2.5 percent since the middle of 2015 despite the sharp fall in the unemployment rate.

In November, the jobless rate held at a 17-year low of 4.1 percent, after starting the year at 4.8 percent. The last time the rate was this low, in late 2000, worker earnings were rising at more than a 4.0 percent pace. To some extent, the slowdown in worker earnings in October can be forgiven because of the hurricane effects. The September strength in earnings growth reflected the layoffs of low-wage workers in the leisure and hospitality industries, just as the post-hurricane rehiring of these workers lowered the average wage increase in October. But the November data was relatively free of these hurricane-induced compositional shifts in the labor force, which makes the soft rebound in average earnings last month all the more discouraging to inflation doves. From their lens, if the job market were as tight as indicated by the low jobless rate, why aren't wages increasing faster?

This question has been vexing policy makers as well as academics for some time and there are no easy answers. It may well be that wages are less sensitive to unemployment changes than in the past, resulting in a shifting of the so-called Phillips curve. Many see this as a global phenomenon. In Japan, there is not a whiff of inflation even though the jobless rate there plunged to under 3.0 percent, the lowest in more than 20 years. A similar condition prevails in Germany, where tame inflation coexists with a 3.6 percent jobless rate. But many believe that the trigger point in the U.S. is 4.5 percent, which was only just pierced in May, and it takes at least six months for wage pressures to show up. By this reckoning, we should see an acceleration in wage growth starting early next year, and the Fed needs to stay ahead of the inflation curve by adhering to its rate-hiking course.

It remains to be seen how low unemployment can go before the labor market is stretched to the limit. By many metrics, it is already there. In addition to the official unemployment rate, the broader underemployment rate, which includes workers stuck in part-time positions and those too discouraged to search for job, is also below its long-term average. But the labor force participation rate remained at a low 62.7 percent in November, indicating there is still a large pool of workers outside of the labor force that can still be lured in if given enough incentive. This potential supply of workers may be one factor holding back the increase in wages of existing workers.

Put another way, companies may believe that they can resist higher wage demands because they can substitute existing workers with those on the sidelines if need be. Indeed, the turnover rate among newly hired workers is considerably higher than normal. An alternative measure of this possible slack is the number of workers not in the labor force that want a job. In November, there were 5.23 million of such potential workers. That's down from a peak of over 7.0 million in 2012, but still nearly a million higher than at the low just prior to the recession. The good news for wage earners is that this outside supply is dwindling fast, having dropped by more than 600 thousand over the last three months.

On balance, job growth continues to outrun the increase in the labor force as well as the working-age population. This trend, as noted earlier, is not sustainable and would eventually absorb all of the slack in the labor market and then some. That inflection point may be a ways off, but we believe that wages will come under upward pressure next year and underpin a modest increase in inflation. What's more, with the passage of a sizeable tax cut highly likely to take effect in 2018, the risk is that economic growth will speed up and create more pressure on the job market than is currently envisioned. That combination of strong growth and an ever-tightening job market is a recipe for higher inflation, which heightens the odds of several more rate increases by the Fed next year