US at full employment; what happens next?
Since the Global Financial Crisis much attention around the world has focused on the concept of full employment – both where it is for any given economy and how quickly it would be achieved.
Solid progress has been made in the US with the labour market now, by many measures, at that milestone. Latest data has the US unemployment rate at 4.6% compared with a most recent range estimate of the long-run (trend) rate from the Federal Open Market Committee’s (FOMC’s) Summary of Economic Projections (SEP) of 4.7-5.0%.
Yet even that is still debatable. Much of the decline in the unemployment rate has been driven by the trend decline in the labour force participation rate with ongoing debate around the structural versus cyclical nature of that decline. At the same time, the broader (U6) measure of under-employment, President-elect Trump’s preferred measure, is at a still-elevated but cyclical low of 9.3%.
We tend to think of the concept of the ‘under-employment gap’, ie the difference between the U6 measure of unemployment and the official unemployment rate which is bouncing around cyclical lows and closed to its 20 year average. Our conclusion is that, while some slack remains at the margin in the labour market, the US is broadly at full employment.
Source: BLS, AMP Capital
From here we expect that pace of jobs growth to slow as the pool of available workers diminishes. Various estimates, including those of Janet Yellen, put the rate of growth of nonfarm payrolls required to keep the unemployment rate steady at 100,000 per month. That estimate allows for some modest cyclical rebound in the participation rate.
Further tightening in the labour market will put upward pressure on wages. Even with the disappointing November result, which saw the pace of annual wage growth (average hourly earnings) slow, most measures of wage inflation are trending higher, albeit gradually.
But with labour costs rising and in the absence of some improvement in productivity growth, firms will be faced with two choices. Either they pass the higher costs on and we get higher inflation, or they don’t and we get lower profitability. Stark choice.
In this environment, markets are pricing in a 100% probability of a 25 basis points hike in the Fed funds rate next week. While I’m always loathe to give anything 100% probability, a hike next week looks like a done deal.
That makes the outlook the more interesting part of the statement. The FOMC is getting closer to achieving its dual mandate. Full employment is either here or near, and inflation measures are either at or getting closer to 2%. The critical question for the Committee now is where the neutral levels of the Fed funds rate is, and how quickly they will want to get there.
We think the Committee will be happy to keep their forward projections (“the dots”) largely unchanged for now. That assumes two hikes in 2017.
The unknown question at this point is the quantum of any easing in fiscal policy from the new President. Large scale fiscal easing, especially at this point in the cycle when the Committee will be more confident than at any other time that they will achieve their dual mandate, seems to us to present upside risk to the US interest rate outlook for next year.
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