Labor Market Tightens Further; Some Questions About Trend in Inflation

Payroll employment posted an unexpectedly small gain of just 98K in March. We comfortably looked through that soft figure and expect a strong rebound in April. 

▪ Even with the March reading, the 3-month average gain is 178K, still well above the level consistent with a stable unemployment rate. 

▪ Other labor market indicators, including the very low level of initial claims for unemployment insurance,  remain consistent with strong momentum in employment growth. 

▪ We do nevertheless continue to expect a gradual slowing in payroll growth over the forecast, from  187K per month in 2016 to 173K this year and to 138K by 2019. 

While the gain in payroll employment was surprisingly small, the unemployment rate fell two-tenths to  4.5%, two-tenths below the median FOMC estimate of the NAIRU. 

▪ We would not be surprised to see the unemployment rate reverse a tenth of last month’s decline in April,  but some downtrend should be expected given the recent strength of payroll employment. ▪ Given that the pace of GDP growth is projected to remain above trend through 2019, we expect the unemployment rate to decline further, reaching 4.2% by the end of 2019. 

The March CPI report was surprisingly soft, which raises questions about the degree of progress that has been made over the last year toward the 2% inflation objective. 

▪ In February, the 12-month inflation rate for the core PCE reached 1.8%, clear progress from the 1.6%  rate at the beginning of 2016. 

▪ The gradual firming in core inflation provided improved confidence that core inflation was headed toward 2%, and was key to broadening the consensus for three hikes this year. 

▪ In March, however, core CPI declined for the first time since 2010, and the 12-month rate slipped two tenths to 2.0%. 

▪ The March PCE inflation reading will be released next Monday, but the translation from core CPI to core  PCE suggests the 12-month rate for core PCE could slip from 1.8% to as low as 1.6% in March. ▪ If core PCE inflation were to drop back to a pace of 1.6%, all the progress toward the 2% objective that had been achieved over the last year would be reversed. 

▪ While we view the decline in core prices in March as largely transitory, we did take some signal from the data that the upward trajectory of inflation will be even shallower than we had previously assumed.  This led us to lower core PCE inflation this year by a tenth to 1.8%. We are projecting that core inflation will reach 2% in 2018 and edge up further to 2.1% in 2019.  

▪ The decline in the unemployment rate to a level well below the NAIRU should eventually result in an overshooting of the 2% objective by 2019. However, the relative “flatness” of the Phillips curve will limit the size of that overshoot, at least over the next few years. 

To date, the upturn in wage inflation has been modest. But a further tightening of labor markets should result in some additional acceleration of wages over the forecast period. 

▪ Our favorite measure for wage inflation, and the one followed most closely by the Fed, is the ECI for private compensation. That measure, which had been running at or below 2% during most of the expansion, edged up to a 2.2% year-over-year rate in late 2016. 

▪ We expect ECI to pick up a bit further to a 2.5% pace this year, 2.7% in 2018, and 2.9% in 2019.  Those increases are expected to outstrip the advance in consumer prices, and the accompanying gains in real wages should help buoy consumer spending and the overall growth of real GDP. 

Unemployment Rate Projected to Fall Well Below the NAIRU 

Interruption in the Progress Toward the 2% Inflation Objective? 

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated in the leftmost column. 

Note on Units and Transformations 

“Quarterly” values are q/q rates; “Annual” values are q4/q4 rates. For series followed by units in parentheses, “Quarterly” values are quarterly averages, and “Annual” values are q4 averages. 

* “Quarterly” values are not compounded to annual rates.

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