Jobs, the Fed, and Long-Term Interest Rates

The June Employment report showed a labor market that is far from fully recovered, but appears to be well on its way. Federal Reserve policymakers are not going to react to any one report, but the trend in nonfarm payrolls has remained strong. Is that enough to ease up on the gas pedal? Perhaps. However, it should still be some time before the Fed has to hit the brakes.

Payrolls rose by 195,000 in the initial estimate for June, while figures for April and May were revised higher. Private-sector payrolls averaged a 199,000 monthly gain in 2Q12, ending the quarter 2.1% higher than a year ago. In comparison, the working-age population is growing at a little less than 1% per year. Long-term unemployment declined, but remains elevated. Unemployment rates for teenagers and young adults remain high. Job gains were mixed in June. Manufacturing continued to shed workers, reflecting weakness in exports. There were decent gains in professional and business services (not just temp help services). We’ve also had strong gains in retail (+2.0% y/y) and leisure and hospitality (+3.7% y/y), both low-paying sectors.

Within leisure, jobs at restaurants and bars rose 4.0% y/y and accounted for a quarter of overall job gains in 2Q13. Note that there is a longer-term trend of households having more meals outside the home. However, the second quarter strength is likely related to gains in the stock market and rising home prices. The top 20% of income earners account for a little over half of personal income and half of consumer spending. Surveys show that upper income households are feeling a lot better about the economic situation. No doubt, it’s great to be in the top 1%, but it’s also good to be in the top 20%. The other 80% don’t have much in financial assets. Real wage gains have been meager, but that should pick up as the economy improves.

For Fed policymakers, the June employment data should be further evidence that labor market conditions are improving significantly. It’s about the data not the date, but the Fed is likely on track to begin reducing the pace of asset purchases in October (after the September policy meeting). However, tapering is not tightening. The majority of senior Fed officials do not expect an increase in the federal funds target rate until 2015, but the Fed funds futures market is now pricing in a rate hike by the middle of 2014. Market participants have either misunderstood the Fed’s message or they don’t believe it.

Long-term interest rates normally rise in an economic recovery, but as a rule, they should not rise so rapidly that they jeopardize the recovery. In the short term, as we have seen recently, higher long-term rates can lead to even higher long-term rates (the bond market has an expression: “be on the bus or be under it”). How much of a rise is too much? It’s hard to say. Initially, the increase in mortgage rates will prompt a spurt in housing activity, as those that had been on the fence become more motivated to act before rates go up even more. Later, the rise in mortgage rates may dampen activity. Lower income households are already getting priced out of the housing market. It will take some time to determine the full impact.

Small firms tend to account for the majority of the job creation during an economic expansion. Credit for these firms is still relatively tight (and the ones with good credit don’t necessarily want to take on additional financial obligations until they see a more significant pickup in the demand for the goods and services they produce). Uncertainty about healthcare costs for small businesses has been a major concern in the second half outlook for job growth. Firms with more than 50 employees that did not provide health insurance would face a penalty starting in 2014, but not for their employees working less than 30 hours per week – and the calculation was based on the prior six months (which means that firms had to make staffing decisions now). However, the Obama Administration has announced that it is delaying these penalties until 2015.

The strong payroll gains suggest a puzzle. Estimates of real GDP growth for 2Q13 have been coming down recently (a 1.5% annual rate or less). That’s hard to reconcile with the pace of payrolls. Productivity may be falling. A drop in productivity implies a squeeze on profit margins (as the labor cost per unit of output is rising). As we head into the earnings reporting season, pay close attention to the details. What do firms say about the composition of earnings? Are they coming more from top-line growth or from cost-cutting? What guidance do firms give about the next quarter or two?

Last week, the Bank of England and the European Central Bank moved (independently) toward providing forward guidance on short-term interest rates. In next week’s monetary policy testimony, Bernanke is likely to stress the Fed’s forward guidance. This should put downward pressure on long-term interest rates.

© Raymond James

Read more commentaries by Raymond James