The month of May had a lot of moving parts for markets with the French election returning relative calm to Europe and the appointment of a respected special counsel relieving some measure of Washington’s political stress for now. Equities hit new highs while a pullback in inflation from February’s highs eased Fed policy concerns even as labor markets seemingly tightened further. A Q2 growth rebound appeared likely with continued job gains while the bond market was not suggesting concerns about inflation. However, the May employment report could change the market’s views on the likely pace of growth and Fed policy.
The US unemployment rate fell to a 16-year low as steady job growth kept the Fed on track to raise interest rates at the June meeting, even as the number of new jobs disappointed. The relatively modest increase in May payroll employment, 138,000 versus expected 185,000 with negative revisions suggests slowing in the pace of labor market improvement. Importantly, this followed a long sequence of large monthly gains with household employment up 800,000 this year. Meanwhile, survey evidence suggested the standard unemployment rate (UNR) could decline further, perhaps suggesting a new normal. Despite the unusually low UNR, average hourly earnings increased a modest 0.2% m/m, leaving the annual growth rate unchanged at a “muted” 2.5%. Importantly, if this proves correct and the UNR were to decline below 4%, even if inflation remains modest, the Fed will probably continue policy normalization, raising rates, perceiving a new normal driven by cheaper data with other products of technology and demographics making 2% inflation more difficult to achieve. The Fed could perceive its job as cyclical balance, viewing secular change as beyond their scope.
Philadelphia Fed President Harker said in a post-labor data presentation that imperfect inflation data of the last few months is not a big deal, still supporting three 25bp hikes this year. He called the economic outlook “pretty good” suggesting 2.3% 2017 GDP, adding there is little slack left in the labor market, that “we’re essentially at normal now,” and that wage growth should be 2.5-3% and UNR maybe 4.2% next year. He added that we won’t need to create jobs at the same intense pace of the past few years; that job growth of 100k/month is more or less the rate needed in a normal, healthy economy; and that we should reach the Fed’s inflation goal around year-end “despite a couple of months trending in the wrong direction.” He added that, “it’s a mistake to get caught up in a single report” or even a quarter’s worth of data. The slowdown in payroll employment growth over the last year or so has been concentrated in low wage jobs, probably indicating the overall mix of jobs being created has improved—probably indicating more room to go to full employment than commonly thought. Meanwhile, the May employment report’s softness may be “one-off,” but it would seem underlying employment growth is trending lower.
Inflation, or the lack thereof, could add caution to the Fed’s perception of normalcy. The fact that inflation has unexpectedly slowed or lost momentum even though traditional measures of labor market tightness have continued to improve could suggest something very different is happening in this cycle, breaking the link between inflation and unemployment. The latest core PCE deflator slowed to 1.5%, down from 1.8% January/February, as did the headline deflators. This second-longest post-war business cycle is noteworthy given the absence of potential recession catalysts. A classic recession catalyst is perceived inflation that forces Fed policy tightening, inducing some degree of liquidity crunch. However, this time, global excess capacity in commodities and tradable goods has hampered pricing power, forcing different measures of cost cutting and financial engineering to prop earnings, enhancing supply pressures. The apparent absence of inflation would seem to leave a potential deterioration in credit quality as the factor that could eventually trip things up, though not anytime soon.
Softer payrolls are unlikely to halt the June Fed rate hike as activity here still seems on course for a Q2 rebound led by consumer spending. Healthy private consumption is signaled by recent personal spending (and import) data. The weakish May employment report should not be inconsistent with economic growth. Rebounding confidence supports the notion that activity will regain Q2 momentum following the soft Q1. Earlier fears that global economic activity was weakening appear overdone also, based on recent data. The combination of improving growth amid softening inflation obviously complicates the central bank job and not just here. Pro-investment fiscal policy and budget reform would be extremely helpful, and while this appears unlikely until late this year or even perhaps 2019, that it is clearly on the table is a big plus. Important and helpful regulatory reform could come much sooner. Meanwhile, the breadth of equity market performance typically signals increasing momentum, particularly given the performance of such a diverse array of sectors.
Finally, April JOLTS (Job Openings and Labor Turnover Survey) reported job openings as plentiful although the hiring rate fell to the lowest level since April last year. Still, the bottom line would appear to be that labor market conditions were unchanged while labor market momentum improved in May. Moreover, labor market conditions appear to have improved since last year and are arguably consistent with pre-Recession levels. Stay tuned.