February’s labour market data was strong enough to suggest that the economy will weather the coming interest rate rise, but contained no indication that the economy has really approached full employment, and no reason to believe that the labour markets are incubating an outbreak of inflation. No reason, in other words, to think that the Fed is behind the curve.
The headlines mainly concentrated on the 235k additions to non-farm payrolls, which is hardly surprising since this was the second consecutive month in which payrolls were stronger than expected (January produced 238k). In addition, there were 95k new jobs in goods-producing industries. This is the highest total since March 2000, with construction adding 58k and manufacturing 28k. The surge in industrial sector activity had already been highlighted in the previous week’s ISM manufacturing PMI as well as a swathe of regional manufacturing activity reports.
The Fed has a dual target: attaining the maximum sustainable level of employment, and maintaining price stability. So the two questions for policymakers (and those who depend upon their decisions) are:
are we approaching the maximum sustainable level of employment?, and
is this yet threatening price stability?.
Despite the strength February’s data, the broader labour market report suggests the answers are ‘no’ and ‘no’.
First, although demand for labour is surging, there are as yet no signs that this is resulting in a bidding war. Consider, for example, average hourly earnings, which came to £26.09 per hour in February: these rose just 0.2% mom in both January and February which is identical (to one decimal place) to the trend which has been in place since 2011. In yoy terms, hourly wages rose 2.8% yoy, which compares to January’s CPI of 2.5% (trending to 2.8% in February), or a PCE deflator of 1.9%.
The central puzzle of labour data in the US has, precisely, been that there has been negligible wage pressure despite the net job openings rate rising to record levels in early 2016 and staying there. It suggests that supply of labour continues to match demand.
One possible reason for this lack of wage pressure is simply that the job openings rate is not being calculated accurately - or rather that it incorporates an unrealistically restrictive count of the labour force. In fact, the openings rate measures only the number of openings as a percentage of total employment, not of potential applicants. And how one measures the number of potential employees, and consequently, what one estimates to constitute ‘full employment’ is controversial. However, given the lack of wage pressure, we can be certain the current unemployment rate of 4.7% does not signal ‘full employment’.
There are two possible, and linked, reasons why this should be so. First, it could be argued that the official unemployment rate provides too narrow a count of those who could wish to be more fully employed. In fact, the US published six separate estimates of the unemployment rate, with different counts, producing significantly different results. The headline unemployment rate (U3) measures those without a job, but actively looking and available for work, and expresses this as a percentage of the labour force. It is this which stands at 4.7%. But the widest measure (U6) also includes:
those marginally attached to the workforce (defined as not currently in the labour force, but wanting full-time work and looking for it over the last 12m) and;
those discouraged (the long-term unemployed no longer seeking employment).
The U6 unemployment rate is peaked at 17.1% in 2009 and is still 9.2%. The gap between the official U3 rate and the U6 rate is still 4.5 percentage points, approximately a percentage point higher than pre-crisis levels. The February 2017 U3 unemployment rate of 4.7% is virtually the same as the January 2007 rate of 4.6%; but the Feb 2017 U6 rate of 9.2% is still significantly higher than the 8% low of March 2007. This wider gap is one indicator of the number of people gone ‘missing’ from the labour force since the crisis.
But it is not the only indicator, or even the chief indicator. The second reason to suspect that the U3 unemployment rate may be over-estimating the tightness of the labour market is - famously - the uncertainty about the labour participation rate. Between 2007 to 2015-2016 the average participation rate dropped by 3.3pps from 66% to 62.7%, with the male rate dropping 4.1pps to 69.1% and the female rate dropping 2.6pps to 56.7%. Of the major demographic groupings, the sharpest fall was in males aged 16-19, where participation rates dropped from an average 41.2% to just 34.8%.
Participation rates typically fall during recessions, as deteriorating labour market conditions discourage people from seeking work. When the business cycle recovers, so, typically, will the labour participation rate. But during the ‘new normal’ of sustained but acyclical grinding expansion there has been no such recovery, but merely a stabilization at lower rates. Two major factors seem to be at play. The first is demographic: a more elderly population has simply retired; by 2015, those aged 55yrs or older represented 23% of the US labour force, a postwar record. The second is more about choice: the great recession persuaded a higher proportion of youngsters to choose extending their education rather than entering an unfriendly labour market. This seems borne out by the data: between 2007 and 2015-2016 the rate for males aged 16-19 fell by 6.3pps, from 41.2% to 34.8%.
Whilst these factors may have been exacerbated by the great recession, there are in addition much longer-term trends which have resulted in a gradual erosion of participation rates since the 1950s. Chief amongst these is the seemingly relentless decline of opportunity (ie, effective demand) for low-skilled labour, and consequently the relative lack of real wage growth.
The literature about the decline in the US labour participation rate is extensive, and has grown mightily in the last few years. And for good reason: with a civilian population of 254 million, a single percentage point change in the participation rate brings in an extra 2.54 million potential or actual people into the labour market. During February, the participation rate rose 0.1pp to 63%, but this brought in no fewer than 340k people into the workforce, dwarfing the 245k added to non-farm payrolls. If half the decline in the participation rate since the great recession is reversed during an upswing, it brings in an extra four million new workers into the supply/demand equation.
This is why the US labour participation rate is currently the single most important piece of economic data the world has to offer. For it is this which will determine what the US’s potential growth rate is, what the Fed will recognize as the ‘maximum sustainable level of employment’, and consequently how US monetary policy will develop over the coming years. For the short term, the strength of labour demand encourages an early interest rate rise; for the longer term, the rise in the participation rate suggests caution about how far, and how fast, those rises will be pushed.