The February employment report showed a gain of 236,000 jobs and a decline to 7.7% in the unemployment rate, but the trend for hiring appears to be same old, same old. After a downward revision of -15,000 to the two previous months data (leaving a very modest 119,000 gain in January), the three month average gain of 191,000 is just slightly ahead of the 182,000 pace in the prior three months. Large gains in construction spending more than account for all of the improvement in job growth, with gains in manufacturing being offset by weaker retailing as the Christmas hires are wound down. Revisions also made the tone of the numbers somewhat better as education jobs were reduced by -40,000 in December and January and construction jobs rose 27,000. During the past six months, the private sector continued to add 200,000 per month pace while the government sector sheds -14,000 a month – almost precisely the pace averaged during the past two years. With government headwinds continuing and growth still trapped in a 2% real GDP world, we see little reason for this pattern to change until after the budget battles are resolved maybe mid-summer.
The biggest change in income trends is not in the number of workers being hired, but in what they are being paid. Average hourly earnings have been rising sharply over the past four months, appreciating at a 3.4% annual rate in comparison to the modest 1.3% pace in the prior year. As we noted two months ago, the breakout in wage gains from a level roughly equal to the rate of inflation is consistent with what happened in 1994 and 2004 at the start of those cycles. We strongly believe that the next 1% gain in consumer spending power will come from higher wages for existing workers, not from additional jobs for those currently unemployed or out of the workforce. Indeed, it may be the recent wage acceleration that has muted the impact of the 2% rise in FICA taxes as the three year holiday ended. For example, government workers received their 2% wage hike in January just as taxes went up, leaving them with virtually unchanged spending power. True, they were losing ground to inflation, but the synchronicity of higher income and higher taxes means no abrupt adjustment was needed in January. Significant wage gains in late 2012 and early 2013 for private sector workers are likely having the same aggregate effect.
The distinction between wages and bodies is important to recently strong sectors like housing and autos. Given the steady pace of job gains, much of the improvement in these areas has been from falling interest rates broadening the pool of potential buyers. If interest rates have hit bottom, as many expect, and job growth remains steady – there should be limited improvement in unit sales. However, as wages rise, the price per unit may rise – especially if workers are able to leverage their additional income with increased borrowing opportunities. Quality may trump quantity as we move forward in the economic cycle.
Steady job growth and rising wages may also delay the day that the Federal Reserve begins to hike interest rates. The Fed has indicated that they will remain accommodative until the unemployment rate falls below 6.5% — unless core PCE inflation (not core CPI) rises above 2.5%. Job growth over the past two years has reduced the unemployment rate at a 0.7% a year pace. However, rising wages may slow that rate of decline by attracting workers back into the workforce. Our interpretation of a declining work force participation rate is that workers cannot find market wages that keep them working or looking for work. As labor markets tighten and raise wages – as seems apparent for more skilled jobs already – more will be attracted away from college or retirement at least slowing the decline in labor force participation. That may make it over two years before the Fed’s target is reached – consistent with their expectation that they will not raise rates before mid-2015.
We believe that wages are rising because the economy is already behaving like the unemployment rate is 6.2% — not the 7.7% advertised in today’s report. The adjustment is because the number of long term unemployed – more than 27 weeks – remains roughly 20% higher than at the same point in the previous three cycles. We believe most of these long term unemployed will never work again and are simply waiting for social security, disability, other retirement or exhaustion of their unemployment benefits before leaving the workforce. Thus, we reduce the unemployment rate by 20% to get a more accurate read. Note that if we reduce the Fed’s 6.5% target by the same 20%, we get 5.2%, which many analysts regard as full employment. Bottom line, we think the Fed is targeting a modified full employment level and will not raise rates before it is achieved unless actual inflation raises its ugly head.
Federal Reserve Vice Chairman Janet Yellen spoke at the National Association for Business Economics meeting last Monday and laid out an excruciatingly clear path for Fed policy. She indicated that the Fed can be thought of as adding accommodation as long as they are buying assets. When they stop buying assets (and they have not yet even indicated they will slow their pace) they will remain accommodative at that level of the balance sheet (currently estimated to be $4 trillion dollars, with a T) until the 6.5% target is achieved — and maybe after! Their first move in the tightening cycle will be to raise short term interest rates. Reduced reinvestments in the balance sheet would come later, and the last step would be the sale of assets. Some like Bill Gross (and us) believe that the Fed will never sell any securities, they will simply let them mature off the balance sheet.
At the NABE, a lot of discussion was about the impact of rising interest rates – when that “inevitably” occurs – on the Fed’s balance sheet. In our view, this is a far too focused concern about monetary policy. The Fed is in absolute control of the short end of the yield curve.
With over $3 trillion in excess reserves now and probably $4 trillion before the Fed is done, competition between banks will keep short rates pegged at risk adjusted levels above 16 basis points as long as that is what the Fed offers. Assume that a staggering $500 billion in new short term lending were suddenly demanded – and over $4 trillion in excess reserves started bidding for that business – how could rates rise? All of the action will be at the long end of the curve – especially because the market is far less sanguine about inflation risks that the Fed if and when economic growth accelerates. As we noted last week, higher long rates act as a very direct governor on the housing market – cutting into bank capital as higher rates translate into lower home prices. We note that Bank of America came out today with an aggressive 8% appreciation rate for housing in 2013. The call was based on no movement by the Fed and easier access to credit for homeowners. Bottom line, a tightening from the Fed would be a problem. We are less certain about the easing of credit standards as the FHFA and FHA have made it clear that their standards – which account for more than half of the market – will be tightening in the future as part of the curtailment of government interference in markets.
Finally, we are less concerned about the Fed’s potential losses because we see their current position as a hedge or insurance against another economic collapse. As commodity traders, we understand that it is usually best when you are losing money on your hedges, because it means you are making even more on the big idea trade. If and when long term interest rates rise, it is most likely to be because of strong economic growth. That consequence would result in stronger tax revenues from the $16 trillion economy (at the average pace of 19% of GDP) at the same time the Fed is reducing its interest repatriation to the Treasury by a modest amount on a $4 trillion portfolio. Capital losses at the Fed are unlikely as it does not mark to market. If the acceleration in rates is due to inflation – even an unexpected inflation spike — we do not think that would be hard to extinguish. A sharp tightening – a la Volker squeeze – is now a well-accepted part of the Fed’s arsenal. Indeed, this week NABE awarded former Fed Chairman Paul Volker their first lifetime achievement award – and we believe the selection was very well deserved.