As I indicated yesterday, if the Fed is narrowly focused on the long-term path of inflation and arriving at a NAIRU-style full employment threshold, the data are relatively categorical that liftoff must begin this summer. However, I believe the underlying strength of the economy is weaker than the headline numbers suggest because the financial system is still over-levered, household debt is still high, and wage growth has been lacklustre. While I think Ray Dalio’s talk of 1937 is overblown at this point, I do think a Japanese 1997-style downdraft should be a concern. I don’t believe the Fed shares those concerns. But today’s jobs numbers may give the Fed enough pause to delay raising interest rates.
Before I get into the numbers, I want to frame the issue properly. The economic paradigm the US is using is heavy on monetary accommodation as the sole tool to make cyclical policy adjustments. The Fed is effectively the only game in town when it comes to macro policy. To the degree fiscal policy now plays a role at all, it is as a marker for how much deficit reduction can be accomplished. Monetary policy has been extra loose to offset the lack of fiscal policy and this has created a conundrum for the Fed.
On the one hand, monetary policy has only derivative effects on the real economy via portfolio rebalance and credit channels. It cannot create jobs or increase median wages directly. Monetary policy can only help to the degree increased credit and asset prices result in a generalized improvement in the economy that trickles down to average hourly wages and jobs. As a result, it has taken an extremely long time for the impact of monetary policy to pass through to decent job and wage growth. And while I have been bullish on the recent cyclical prospects for the US, I believe we are late in the economic cycle.
On the other hand, monetary policy has immediate and direct effects on credit markets and asset prices. As yields have remained low and long-term yields have declined due to a decline in the market expectation of the path of future rate hikes, credit markets have been buoyant and asset markets have soared. For example, high-yield bond issuance has soared since the financial crisis in 2007-2009 (click link or chart).
High yield bond issuance shows a hockey stick-style kink upward post-financial crisis (source: Bloomberg) pic.twitter.com/Lh4enWq5Wy
— Edward Harrison (@edwardnh)
As the high yield market hit an air pocket in Q4, high grade bonds have moved to the fore. In Q1 2015, high-grade bond issuance in the US surged to a record $341.9 billion. And US equity markets, supported by low discount rates and portfolio rebalancing, are still near record highs over 300% above 2009 lows.
In sum, the excesses in credit and equity markets have the Fed concerned about financial stability but the plodding improvement in the real economy leaves the Fed concerned that it still has work to do. But this is to be expected when monetary policy is the only steer of countercyclical macro policy.
This is the background against which we saw a jobs number that was well below expectations. I would highlight the following data points from today’s March report.
- Non-Farm Payrolls: +126,000 vs. consensus estimates for +245,000, lowest since 2013
- NFP revisions: January and February revised down an aggregate -69,000
- Moving Average: NFP: 12-months before March +269,000
- Unemployment rate: 5.5% unchanged
- Average hourly earnings: +0.3% m-o-m and +2.1% y-o-y
How should we look at these weak numbers?
I would call this convergence to the downside. Up until now, the jobs data had been so unequivocally good that the Fed was forced to lower its (artificial) NAIRU threshold. And rate hikes are still possible starting in June. But, macro data in Q1 have been extremely poor. And the most worrying aspect of this has been the consumption data, where retail sales have declined for three months in a row. The jobs data for Q1 have now converged toward that weakness, as the downward revisions mean that we saw a paltry net +57,000 jobs added this month. This should be enough to take June off the table. Even if we get to 5.2% unemployment by May’s report, that’s not a level which guarantees a rate hike. And this wobble in the data should give the Fed doves enough data support to push back the timetable of rate hikes.
But this is only one month’s data. We will have to see if there is follow-thru into Q2.
As I emphasized yesterday, although jobs are a lagging indicator, we should expect to see some ripples of distress in the job market before a recession hits us full bore. This could be the first sign of labor market distress or it could be an aberration. We just don’t know yet. What we do know is that jobless claims eventually become a contrary indicator when they are as low as they are now. We are bumping along the lower potential limits of initial jobless claims, and have been for some time.If job market distress does occur, I would expect it to be reflected in rising jobless claims before an actual recession occurs. A rise in claims would create a shock to consumption that in a best case scenario is temporary. In a worst case scenario, it combines with the existing slowdown in inventories, investment, and exports to tip the cycle down. I still do not believe we are there yet, however.
From a market perspective then, policy normalization means that the forward guidance timetable is short due to the data dependence of the Fed’s reaction function. Volatility will rule the roost until we have ascertained whether Q1 was a rough patch or a harbinger of more weakness to come.