PRESSURE INCREASES ON LABOR MARKET
The disconnect between the Fed and the market regarding the path of interest rates will likely narrow further in 2017; however, the disconnect between the Fed and the market on the labor market will likely widen. The market may view a potential slowdown in the pace of job creation as a recession signal, while the Fed may continue to see it as consistent with a labor market near full employment.
Since early 2010, the unemployment rate has dropped from nearly 10% to the most recent reading of 4.6%, a new cycle low. In its most recent set of economic projections (released in mid-December 2016), the Fed’s policy arm, the Federal Open Market Committee (FOMC), projected the unemployment rate at 4.5% by the end of 2017, just a modest improvement from current levels. Fed Chair Janet Yellen has noted that although the unemployment rate is not the perfect measure of slack in the labor force, if she had to focus on just one number, that would be it. Of course Yellen has often noted that the Fed watches a “broad range of labor market indicators” to gauge the health of the labor market. On balance, all but a handful of these indicators have returned to their pre-Great Recession levels.
One of the reasons the Fed cares about the labor market is that less slack in the labor market leads to wage pressures. Wages represent around two-thirds of business costs and, over time, higher wages lead to higher inflation. Wage inflation (as measured by the year-over-year gain in average hourly earnings) has moved from a low of near 1.5% in 2012 to near 3.0% at the end of 2016, but has not yet reached its pre-Great Recession pace of 4 – 4.5%. But the market, and perhaps even the Fed, may be surprised by how quickly wages could accelerate toward pre-Great Recession levels even if job creation slows in 2017.
In the six years from early 2010 (when the U.S. economy began regularly creating jobs again after the end of the Great Recession) to mid-2016, the economy created a total of just under 15 million jobs, or an average of just under 200,000 per month. Since the middle of 2016, job creation has slowed to 175,000 per month and is likely to slow further over the course of 2017. A few Fed officials are on record saying monthly job growth as low as 80,000 per month would be sufficient to push the unemployment rate lower, but the center of gravity of the Fed probably sees that number closer to 100,000 – 125,000. As we look ahead to 2017, we continue to expect a slowdown in job creation as the recovery matures, but in our view it would take a slowdown to around 25,000 – 50,000 jobs per month to signal that a recession is imminent. The market, on the other hand, may see a fairly typical later-cycle slowdown in jobs to the 100,000 to 125,000 per month range as a recession signal.
INFLATION BUBBLES UP, BUT DOESN’T BOIL OVER
In the aftermath of the Great Recession, inflation expectations have swung between concerns over hyper-inflation in the years following the launch of quantitative easing (QE) in 2009 to concerns about deflation in late 2015, as the impact of sharply lower oil prices and plenty of spare global capacity exacerbated already slow GDP growth. In general, slow economic growth, spare capacity (available labor and production resources), and the globalization of product and labor markets have all acted as restraints on inflation in recent years, and except for a few brief periods in 2009 and early 2015, the Consumer Price Index (CPI) has exhibited neither hyperinflation (as feared in response to central bank “money printing”) nor protracted deflation. Instead, the CPI experienced stagnant or declining (but still positive) growth, also known as disinflation, for much of this recovery. Fears of deflation by late 2015 had led to ramped-up efforts by central banks outside the U.S. to expand QE and a year-long delay in the Fed raising rates a second time.
By the second half of 2016, in the U.S. at least, the factors pushing inflation higher may have begun to win the battle over disinflationary forces, marking an important transition for the economy [Figure 2]. For most of 2015 and 2016, as headline CPI was held down by falling oil prices, inflation in the service sector (which accounts for 80% of GDP and two-thirds of the CPI) accelerated to a new cycle high of 3.0%. Goods prices (one-third of the CPI), which have been in a deflationary environment for most of the past three years, remained in negative territory for the majority of 2016, but as oil prices stabilized near $45/barrel in late 2016, goods deflation began to give way to year-over-year price increases. If oil and gasoline prices stay in their recent ranges, the CPI for commodities will turn positive in early 2017 and push overall CPI above the Fed’s 2% target.
Despite a slow rate of growth, the economic expansion that’s been in place since the end of the Great Recession has been very durable. While there are increased risks from a possible policy mistake, the potential positive economic impact of tax reform and a looser regulatory environment is likely to help the expansion continue, or even accelerate, in 2017.
John Canally is chief economic strategist for LPL Financial.