Last week’s tame headline job-growth figure of 75,000 — combined with net downward job revisions of 37,000 for the last two months and the parallel weakness in wages (up just 0.1 percent month-over-month) — is fueling the fire of those expecting a sharp weakening in the economy in the second half of the year and a quick cessation of Federal Reserve rate hikes. The bears, on a temporary hiatus after news of a stunning 5.3 percent annualized increase in real GDP for the first quarter, are back in town and ready to cash in on the newfound weakness.
But before we give the bad-news bears too much credit, it makes sense to look beneath the surface of the May jobs report. The unemployment rate dropped to 4.6 percent without the labor-force participation rate falling, one sign that labor market conditions remain tight. Non-supervisory production-worker wages were revised up to 0.6 percent month-over-month for April, which means low-end wages have risen above a 4 percent annualized pace thus far during the second quarter. That’s still higher than inflation, any way it’s measured.
Meanwhile, job growth based on the household survey, from which the unemployment rate is calculated, advanced by a strong 288,000. Other leading indicators, such as initial jobless claims, suggest that jobs growth should be running closer to 200,000 a month.
So why isn’t it? One reason could be that productivity growth continues to advance at an astounding pace: Upwardly revised non-farm productivity for the first quarter advanced at a 3.7 percent annual rate. Non-financial productivity, which is easier to measure, has averaged 4.2 percent annualized growth during the last 18 recovery quarters, an unprecedented occurrence.
While wage rates have begun to recover, the current gap between productivity (and profits) on the one hand and real compensation on the other is as large as it has ever been. While some bemoan this fact, it is important to remember that profits and productivity correlate positively with real compensation over the long term. Similar gaps between these variables during the mid-1960s and late 1990s presaged unemployment rates falling below 4 percent and significant upward pressure on real wages and compensation. In other words, the gap is a reason to be bullish on labor, not short the consumer.
Upside surprises and productivity growth have resulted in downward revisions to unit labor costs for the first quarter, causing many to assert that there is no inflation threat and thus the Fed should take a permanent vacation. It is worth pointing out, however, that unit prices in the non-farm business sector are up at the fastest pace since 1991. Unit prices for the non-financial sector are rising at more than twice their average rate during the last two decades. In short, weakness in unit labor costs has not stopped companies from raising prices. Inflationary pressures are a monetary/liquidity phenomenon, not a relative price issue. Neo-Keynesian partial-equilibrium arguments based on the relative cost of labor or foreign goods remain popular on Wall Street, but these substitute fallacy for fact. If there is excess liquidity in the system, prices tend up.
Against this backdrop, the Fed faces serious challenges: Even if growth slows, the central bank will have to tighten in order to reduce excess liquidity and contain inflationary pressures. And once it accomplishes this task, it will have to avoid being seduced by what could look like a perfect picture of the Phillips Curve (low or falling unemployment and rising inflation), but won’t be. Sensitive, forward-looking price-level indicators in the commodity, credit, currency, and money markets provide an immediate feedback loop about the supply-and-demand balance for monetary liquidity and the tightness or ease of financial conditions. They will thus tell the Fed when enough is enough — but the balance of sensitive price-level indicators suggests the Fed’s job is not yet done.
– Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.