US economic data pointing up, bolstering Fed tightening bias
On Friday, the US jobs data showed that the US real economy is weathering the oil price decline very well as oil sector jobs account for little in the overall economy. Despite the capital expenditure effect on future growth, the US economy remains in the 2-3%ish range. And given the data showing labor participation increasing along with huge numbers in the past three months on jobs, I believe the Federal Reserve is still on track to hike mid-year. Some thoughts below
By now, you’ve seen plenty of breakdowns of the jobs report. So I am just going to post the headline data and move to the analysis. Here are the most salient points:
- Unemployment rate: 5.7% versus 5.6%, the month prior
- January 2015 jobs: non-farm payrolls up 257,000
- Revisions to prior data: November 2014 up to 423,000 from 353,000 and December 2014 up to 329,000 from 252,000
- Average hourly earnings: up 2.2% y-o-y and 0.5% m-o-m
- Labor participation rate: 62.9%, up from 62.7% the month prior
Here’s my breakdown of what each data point means.
The unemployment rate’s increase is due to the increase in labor participation as discouraged workers re-enter the workforce. This is a good sign because it suggests a job market that is still on the upswing and could mean this economic cycle has room to run.At the same time, the uptick means that headline unemployment numbers have further to fall before they reach some policymakers’ potential red lines like 5.0%. Overall, given the job market health, the uptick is not worrying. Rather, it gives the Fed more policy space to focus on broad measures of unemployment and wage growth.
The actual non-farm payroll number of 257,000 is in line with the 250-350,000 range I first set out in July of last year. At the time, I was increasing my trend job growth number from a lower 200-250,000 job range due to data coming in from the real-time job indicators in the weekly claims reports. Jobless claims have continued to remain at a sub-300,000 level, pushing us to the upper end of the 250-350 range. For example, rolling 3-month average payroll growth is now 336,000 jobs. Meanwhile the rolling 12-month number is 261,000 jobs, at the lower end of my range, suggesting we are moving upward in trend job growth. Combined with lower inflation at 0.8% as oil prices have declined and a 2.2% increase in average hourly earnings, the data are supportive of a 3%ish consumer spending growth trend.
When we look at revisions, two things stand out. First, the delta is important for economic directionality because the data are revised up when small and medium-sized businesses are adding headcount and revised down when SMEs are reducing headcount. Clearly, we are seeing more SME headcount, which suggests better economic and/or credit outlook for SMEs, something that is critically important to maintaining this economic cycle. Second, the largeness of the revision numbers speaks to a robustness as these are the best numbers we have seen since the late 1990s. In fact, 2014’s private payroll growth of 3.127 million was the best since 1997. The only caveat I would add is that November was better than December, which was better than January, a pattern we should be wary of.
In terms of the Fed’s reaction function the 2.2% average hourly wage growth number is important. The 0.5% increase month-over-month is likely just a statistical aberration. But the 2.2% y-o-y growth combines with 0.8% inflation to mean that real incomes are starting to rise meaningfully, something we want to see. Now, empirical evidence connecting wage growth to inflation is weak. Moreover, after a bout of deleveraging, wage growth is what we need to repair household balance sheets. Nevertheless, the paradigm the Fed is using says that wage gains presage consumer price inflation. So I expect the increase in real wages to be a signal for the Fed to raise rates sooner than later. The June rate hike is still on the table.
And to the degree that labor participation is increasing at the same time that average hourly earnings are as well, the Fed is likely to see the economy as moving ever closer to full employment. On the one hand, increasing labor participation means a stalling or reversal in unemployment figures as discouraged workers enter the workforce. This should give the Fed more policy space as it can point to still elevated long-term unemployment and to elevated broader measures of unemployment. But on the other hand, the Fed’s reaction function is still very much geared to the wage inflation leads consumer price inflation paradigm and this means that increased labor participation, on the whole, will increase the tightening bias.
What does this mean in terms of economic growth? In July, when I upgraded my view on the US, I said “I would push up the trend growth level to 2.5 to 3% based on the labor cost and jobless claims numbers, meaning while 2014 is a 2% trend due to the hiccup in Q1, we are now in a rolling 2.5 to 3% trend growth phase. On the other hand, we should expect mean reversion at these levels.” I stand by those comments seven months later with two caveats. First, I think the increase in the jobs numbers and the decline in oil prices has pushed trend consumer demand up to a 3%+ number, with the risk to the upside. That’s bullish for GDP growth. On the other hand, the cut in capex due to troubles in the oil patch is going to be huge. And 2014 GDP growth actually ended at 2.4% before revisions, which is outside the rolling 2.5 to 3% number I had previously given.
On the whole then, I think we have moved up from a 2.5 to 3% trend growth phase to a 3.0 to 3.5% trend growth phase. Consumer demand and capital expenditure are working at cross purposes in keeping that number in place but the bump up is due to consumer demand’s relative importance over business investment. When the Q1 2014 number is replaced by a better Q1 2015 number, the rolling 12-month number should be well above 3%.
With this in mind, it is still hard to gauge where we are in the economic cycle. I tend to think we are late cycle and perversely that means rate hikes as the Fed follows the data rather than leading it. The Fed will react to the increased trend growth and the better jobs outlook by becoming more hawkish, substantially increasing the potential for rate hikes mid-year. June is still on the table. Given that a rate hike could mean inversion of the yield curve unless long-term rates spike in the coming months, we should see this as supporting my contention that the Fed is reactive and not pro-active. It will be hiking rates into cyclical mean reversion, which is negative for stocks, more so if we are late in the cycle. Despite the uptrend in growth, I still like safe assets in the US.