Regular readers of our economic commentaries will recall that we assign a great deal of importance to the health of the labor market. Jobs create income, income supports spending, and personal spending accounts for over two-thirds of economic activity. This linkage is critically important in this eighth year of an economic cycle, and is furthermore an important support of corporate earnings in an environment where corporate earnings desperately need the support.
The May employment report was a disappointment on almost all fronts, as the economy added a mere 38,000 jobs during the month. Even adjusting for the Verizon strike, the figure is the poorest month of employment growth since the labor market recovery began in 2010. The headline unemployment rate declined to 4.7% but was driven largely by a drop of 458,000 people in the labor force. The participation rate dropped back to 62.6%. At the risk of clutching at straws, the one gratifying element of the report was that average hourly earnings continued to grow at an annualized pace of 2.5%.
There is a benign interpretation of this data. Just as Dr. Pangloss in Voltaire’s Candide opined that despite the suffering of mankind, we live in “the best of all possible worlds,” perhaps this is the best of all possible labor markets. The economy has added 13.5 million jobs over the course of this recovery, and it is possible that we are nearing what economists refer to as “full employment.” That doesn’t mean that everyone has a job, but that there is an optimal match between job openings and the skills on offer. The jobs opening report released by the Bureau of Labor Statistics might offer some evidence of this. New job openings have increased each month this year, and as of April (the last reported month) stand at an all-time high of 5.8 million openings, up 3.7% from the previous year. If this is the case, future employment reports may be similarly disappointing, although we should see evidence of a tighter labor market in a longer average workweek and accelerating wage growth.
The Federal Reserve noted this apparent downshift in labor market activity and opted to leave interest rates unchanged at the June Federal Open Market Committee (FOMC) meeting. Without explicitly referring to the possibility that the economy is nearing full employment, the statement following the meeting noted that “the pace of improvement in the labor market has slowed while growth in economic activity appears to have picked up. Although the unemployment rate has declined, job gains have diminished. Growth in household spending has strengthened.”
Decent economic activity and rising household spending ought to allow the Fed to bump up interest rates another notch, but weak job gains clearly stayed its hand. Unlike the previous two meetings, the vote to leave interest rates unchanged was unanimous. Furthermore, an updated projection of the future path of interest rates revealed that six members of the committee expect only one more interest rate increase this year.
The market interpreted this as a dovish outcome – an indication that the Fed is likely on hold for some time to come. Two-year bond yields dropped 6 basis points on the announcement (but have since risen back), and the market-derived probabilities of interest rate hikes at the July and September meetings of the FOMC plummeted. The futures market now implies a scant 6% probability of an interest rate hike in July, and only 19% in September.
We read the statement and Chairman Janet Yellen’s press conference following the meeting slightly differently and conclude that the Fed very much wants to raise interest rates again this year. First of all, one poor jobs report is not enough to divert the course of Fed action, although it clearly weighed heavily on this meeting. We find it interesting that, although absent from the official statement, Yellen explicitly referred to the potential disruption from the U.K. referendum on EU membership (scheduled for June 23) and acknowledged that it factored into the committee’s decision. The next labor market report is due to be released on July 8 and will indicate whether the May report was an aberration or the start of a new deceleration trend in employment.
Second, for the first time in the statement following the meeting, the Fed acknowledged a broader pickup in economic activity, as well as stronger growth in household spending. We wish that someone during the press conference had asked about the possibility that the economy is nearing full employment and expect that the Fed will watch for evidence of that in future data on wage growth and hours worked. Even if the June report disappoints on the headline level, it may nonetheless offer evidence of a labor market nearing its optimal potential.
Third, although the market focused on the decline in the so-called “dot plots” – the projection of each committee member of where interest rates would stand at year-end – we believe that this is more a function of the calendar than a shift in policy. There are only four FOMC meetings left in 2016, one of which (November 2) occurs a mere six days before the presidential election. The Fed is a (relatively) apolitical body, but raising rates so close to Election Day is probably not ideal. That leaves just three meetings at which the Fed might raise interest rates, and the indication that it is likely to do so at one of those three meetings does not strike us as a meaningful change in intended policy direction.
We ultimately believe that the Fed would like to raise interest rates further in order to re-establish traditional monetary policy as an effective economic tool. At present, the Fed lacks the ability to respond to an economic slowdown by lowering interest rates, leaving it with some version of quantitative easing as the only viable response. Yes, other central banks are experimenting with negative interest rates, which argues that low rates (or no rates!) are not an impediment to interest rate declines. We’ve discussed in previous writings why we believe the Federal Reserve is averse to joining that experiment. The implications for global trade, the commercial paper market, the money market industry and consumer behavior are all economically disruptive – and would swamp whatever benefit the Fed expected to derive from applying a negative sign to policy rates. Putting the traditional monetary tool back in the toolbox therefore implies higher rates over time.
Whereas we would welcome the ability to earn a reasonable rate of return on traditional fixed income assets, our investment strategies and policies are not driven by the timing or pace of central bank action. Having said that, near-term developments in the labor market now have magnified implications for the course of Fed policy and the economy, and that influence is magnified further in an election year. There are five monthly job reports on the calendar between now and Election Day, and each one will be scrutinized for its economic, policy and political implications. Stay tuned.
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