United States

Tight labor market may push the Fed to accelerate policy normalization

INSIGHT ARTICLE  | 

In the June 8, 2017 issue of The Real Economy, RSM's Chief Economist, Joe Brusuelas, examines the latest U.S. labor market data. The following is an excerpt from that issue. For more information, read the full edition of The Real Economy.

The U.S. labor market posted another solid month of growth in May, reinforcing our core view that a tightening labor market will likely push the U.S. Federal Reserve toward increasing the pace of policy normalization this year. In our estimation, the labor market is tighter than the topline data implies, and the central bank is running the risk of falling further behind the curve than it already has. The market has priced in an 88 percent probability of an additional 25 basis point hike at the June 14 meeting. Given the strength of hiring across the economy this year, we do think that the probability of rate increases at both the September and December meetings is rising.

Total employment expanded by 138,000 in May and the unemployment rate declined to 4.3 percent with average hourly earnings improving by 2.5 percent on a year-ago basis. Seasonal adjustment issues in May often damp overall job growth, so we don’t think that the slowing in the topline reflects broader economic problems. Rather, we think it reflects issues finding skilled and semi-skilled workers to fill available positions, which reflects our core view of a tightening labor market. The economy only needs to generate about 80,000 jobs per month to meet the demand for new entrants into the labor market.

The combination of very strong job growth in the most dynamic areas of the economy, and a dwindling supply of skilled workers to fill positions in the service and goodsproducing areas of the economy, are in the process of creating the conditions for a move below 4 percent unemployment rate during the next 12 months. This result will be rising inflation via the wage channel and narrowing profit margins for businesses.

RSM’s own proprietary data on middle market hiring indicates that firms expect to post fresh cyclical highs in hiring and compensation this year, which reflects the underlying strength in the data and supports our view on monetary policy. In fact, middle market businesses continue to report that it is far more difficult to recruit and retain workers at this point in the business cycle than one might think by simply looking at the monthly payroll estimate. Based on our RSM quarterly Middle Market Business Index, and a deeper dive into metro statistical area data, the labor market is far tighter than topline data implies.

Job growth in four of the more dynamic labor markets— Boston, Seattle, San Diego and San Jose—connected to technology, life sciences, scientific research and development imply that the current data is likely understating job growth and overall employment.

For example, based on metro statistical area data comprised by the Bureau of Labor Statistics (BLS), the San Jose-Sunnyvale-Santa Clara area, otherwise known as Silicon Valley, is said to have essentially seen job growth of only about 12,000 workers (1.064 million total workers in April 2016 vs. 1.077 total workers in April 2017) during the past year, and has actually lost jobs during the past six months. The story was the same in Boston (42,000), Seattle (48,000) and San Diego (19,000), where job growth during the past year was less than the margin of error (+/-50,000) in the monthly BLS survey.

At this point in the business cycle, most economists would point to a tight labor market and diminishing returns on productivity from hiring additional workers as the likely cause of the stall in hiring in the aforementioned metro areas. While that may be the case in some areas of the economy, we don’t think that is the case in the most dynamic areas of the country. In our estimation, what is most likely happening is that the jobs being created by the most innovative portion of the economy are in new areas that the BLS has not yet adequately captured with up-to-date NAICS codes. If one digs into the data, there are no NAICS codes for jobs linked to artificial intelligence, cloud engineering, solutions architect or internet of things engineer-all jobs available-in the four aforementioned metro areas. How does one classify "chief disruption officer" or “financial quant in charge of algorithmic trading?”

It is probable that jobs created in the technology, financial and manufacturing sectors, using both sophisticated technologies and off-the-shelf technology, are likely being substantially underestimated. It does not take much of a leap to wonder if this is not being measured correctly, what does it mean for our capacity to accurately measure productivity, inflation and set monetary policy?

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