08 August, 2017
The labor market's impact on interest rates
The economy's impressive run of job creation continued in July with a strong net increase of 209,000 jobs. Meanwhile the unemployment rate fell by 10 basis points to 4.3 percent. That matches the cyclical low rate from May. Prior to May's reading, the last time the unemployment rate was this low was May 2001. The unemployment rate remains low despite workers coming in from the sidelines due to labor scarcity and strong demand. The labor force participation rate, which bottomed out in September 2015, has increased 50 basis points since that low point.
Commentators frequently overlook this fact when focusing on the somewhat random month-to-month changes in the data.
Wage growth remains the key blemish in the data. We continue to believe that wage growth reflects economic reality: low labor productivity growth and tame inflation. The question remains: at what point will the labor market reach "full employment" and translate further tightness into stronger wage growth? Just a few years ago, this level was thought to be somewhere around a 6 percent or 6.5 percent unemployment rate. That proved to be wildly incorrect. While we believe that the labor market now likely hovers near this full employment rate, we will not know for sure until we pass this number and wage growth starts to spike. If the labor market continues along its current trajectory, the Fed will certainly begin shrinking its balance sheet by selling assets this autumn. But if growth (particularly wage growth) accelerates, then the third rate hike of 2017 should be a go, likely in December, because the Fed wants to be out in front of potential wage and price acceleration. The Fed will see four more months' data before they have to make that decision. Tepid wage growth is restraining spending and inflation. Maybe not for long, but that third rate hike is on the clock.
Shadow Factors Holding Labor Market Back?
As strong as the labor market has been, it could potentially grow even stronger. In addition to the factors that we have previously discussed -- such as labor scarcity, skills mismatch, location mismatch, and video games -- there are a few shadow factors limiting the labor market. People abusing opioids are often physically unable (or unwilling) to work and failed drug tests limit the pool of available labor. Many open positions have fallen victim to the "qualifications creep" phenomenon – positions whose responsibilities have remained largely unchanged over time, but now require higher skills and education levels often associated with more complex work. And many of the unemployed are simply not interested in available positions. Between July 2016 and July 2017 roughly 50 percent of the net job increase has come from just two major industry categories – business and professional services and education and health services. Obviously, the former has driven demand in the office sector since many of those jobs utilize physical office space. The latter is often thought of as being "feminine," which translates to fewer men being interested in those positions. Changing the perceptions surrounding this industry could do a long way toward better job matching in the labor market.
What does young-adult employment signal about the apartment market?
Employment for people between the ages of 20 and 34 continued to perform well in July, with a job growth rate twice that of all other age cohorts. These ongoing job gains for younger workers should continue to support household formation, the key driver of apartment demand, by enabling younger workers to move out of their parents' homes (the number of children living with parents continues to hit record-high levels) or out of shared apartments.
Income growth for this group has generally been accelerating. Wages for production and non-supervisory employees, a good proxy for younger workers, grew by 2.4 percent over the last year. That level of wage growth should continue to support apartment rent increases even as apartment rent growth decelerates.
ISM Indexes finally telling the truth?
Both the ISM Manufacturing and Non-Manufacturing Indexes declined in July. Some of the decline appears to be just some cooling off after a heated nine months. But in recent months the elevated levels of the indexes have produced somewhat misleading results. Often such lofty readings indicate far stronger economic growth than what we have recently seen. The lower readings for July do not signal an economic contraction. Rather, they continue to indicate that the economy continues its broad expansion across sectors, and are more reflective of the economic growth rates that have actually been occurring.
Moving on to tax reform?
With healthcare reform dead for now, Congress appears to moving on to tax reform. But we don't expect this to be any easier. While the administration anticipates draft legislation next month and passage as soon as November, political realities might derail that plan. Congress has until September 30 to pass legislation to continue to fund the federal government or face a shutdown. Congress must also increase the debt limit by mid-October or run the risk of defaulting on federal debt. Given the scant time on the legislative calendar between now and the end of September, it appears increasingly likely that Congress will not have finalized plans for either spending or the debt in place and will likely resort to temporary measures to buy more time. This is important because Congress has been unable to pass a budget. And without a budget in place, the Senate will not be able to use reconciliation which means they will need Democratic votes. Something far more modest and less impactful on the economy than widespread tax reform, such as temporary cuts in corporate and income tax rates, remains a far likelier possibility.
What we are watching this week
If inflation is going to save that third rate hike, it needs to get going. Headline and core inflation for July, as measure by the consumer price index (CPI) will be released this week. Both are expected to show accelerations compared to last month. Headline CPI should be near the Fed's 2.0 percent target rate while core CPI should continue to be a bit below target. Final demand producer price index (PPI) data for July will also be released this week. We expect only a slight increase from June, but in recent months the PPI data has provided little guidance on more relevant measure of inflation such as the CPI.
Thought of the week
Year to date, the US dollar has depreciated by roughly 9.0 percent against a basket of major currencies. This has been supporting exports and profits of US corporations and could boost inflation in the latter half of the year.