The December Employment Report showed the job market to be in good shape. The pace of job growth slowed in 2016, partly reflecting tighter labor market conditions. The unemployment rate edged up, following an unusually large drop in November. It’s unclear how much slack remains in the job market, but tight conditions should lead to faster wage growth. Average hourly earnings rose 0.4% (+2.9% y/y) in December. These figures tend to be choppy (the three-month average was up 2.7% y/y). While the job market news has remained good, there is more uncertainty as investors try to gauge the size and timing of fiscal policy changes and how the Federal Reserve will respond.
Annual benchmark revisions to the establishment survey data are due in February, but early indications are that the story is unlikely to change much. Private-sector job growth slowed in 2016, while government payroll growth has picked up somewhat. Hiring at small firms was strong in 2014 and 2015, a healthy sign for the economy. However, the ADP Employment Report suggests that hiring at small firms has slowed in recent months, offset partly by a pickup in hiring at larger firms.
While job growth has slowed, it’s still beyond a sustainable pace (that is, stronger than would be consistent with the growth in the working-age population). As a consequence, the unemployment rate has declined. However, there are potential workers on the sideline – not officially counted as “unemployed,” but willing to take a good job if available. At this point in the cycle, the unemployment rate ought to level out as these workers return to the labor force. Labor force participation and the employment/population ratio have been little changed over the last year, but improvement is clearer for the key age cohort (those aged 25-54). As members of this key age cohort move into better jobs, opportunities should open up for younger workers. We still have some way to go before we are at full employment, but we are on our way.
As the job market tightens, wages will be bid up. Average hourly earnings rose at about a 2.0% annual rate in 2013 and 2014, picking up to 2.5% in 2015. While the monthly wage figures are uneven, the trend in wage inflation appears to be gradually higher. Note that while nominal (current dollar) wage growth has picked up, real (inflation-adjusted) wage growth has slowed relative to a year ago. But while real wage growth, the key driver of consumer spending, has slowed, it remains moderately strong by historical standards.
The labor market is the widest channel for inflation pressure. The Fed’s inflation hawks (mostly district bank presidents, not all of whom vote on monetary policy) worry that firms will pass higher costs along, and are more inclined to raise short-term interest rates sooner. The moderates (including Chair Yellen) seem willing to err on the side of waiting a little too long.
The Fed policy outlook is clouded by the uncertain outlook for fiscal policy (timing, magnitude), but the Fed will respond to the economic implication of policy changes in Washington once they occur. Uncertainty should be a major factor for the markets.