Some Disappointments, but Unemployment Rate Continues to Fall

While payroll gains came in well below consensus and have slowed materially over the last three months, the unemployment rate fell another tenth, continuing its steady decline. Since December of last year, the unemployment rate has fallen four-tenths. We take the decline in the unemployment rate as more significant for monetary policymakers than the recent slowing in job gains. The June decision to hike was already a near certainty, but this report raises the probability of a September hike (which we saw as above 50% even before today’s data) and could provide a basis for a faster pace of rate hikes if inflation recovers, employment growth picks up, and the unemployment rate continues to fall. 

Let’s start with the disappointments. The payroll employment gain of 138K in May, was sharply below the consensus expectation of 182K. The gains over the previous two months were revised down by a total of  66K, and the average change over the past three months is just 121K. We also suspect that the past three months overstate the slowing in job growth, especially in light of the seasonal noise that often accompanies the May-June employment readings. The current six-month average gain of 161K seems like a better indicator of momentum in the labor market—still a robust pace, but a step down from the 200K per month pace observed late last year. We have been projecting a slowing in job growth, but not so much so soon. That said, we expect the pace of employment gains will remain above the 80K-100K threshold consistent with a  stable unemployment rate throughout the forecast, and we are projecting further downdrift in the unemployment rate. 

The key question is, what signal we should take from the sharply slower employment growth in recent months for our assessment of the underlying strength of economic activity. Here, we have two possibilities: The first is that softer payroll figures are a signal of a slower increase in economic activity. After all, we have emphasized that we often look to employment gains as a better indicator of underlying strength in economic activity than the GDP data. The other possibility is that the smaller job gains may reflect a pickup in productivity growth. We have been projecting a modest pickup in productivity over the next couple of years. On balance, we are sticking with our belief that we remain in a 2%-growth economy. 

The 0.2% gain in average hourly earnings was also a bit disappointing, though the 12-month increase was unchanged at 2.5%. Looking across other measures of wage inflation, some pickup in wage growth is apparent, though it is a disappointingly modest one, especially in light of the numerous anecdotal reports of how hard it is to hire workers. 

Now for the positives: The unemployment rate declined an additional tenth in May, and at 4.3% is the lowest since 2001. We have been surprised by the magnitude of the decline in the unemployment rate this year, and we will be lowering further the path for the projected unemployment rate in our next forecast. 

For most of the past year, the decline in the unemployment rate occurred against a backdrop of a participation rate that was moving sideways—suggesting that a tightening labor market was giving a cyclical boost to 

participation that was in line with our expectations. But the decline in the unemployment rate last month was accompanied by a drop in the participation rate. While it is too early to tell, we may be at the end of that cyclical boost to participation, and we could soon return to a demographically-driven decline in the participation rate of two to three tenths per year. Also notable in the May employment report was the two 

the tenth decline in U-6, with the differential between U-6 and U-3 narrowing further to around its pre-crisis level.  This further weakens the case that U-3 understates the degree of slack in the labor market. 

The June decision to hike the fund’s rate was already close to baked in the cake. Today’s report, if anything,  reinforces that view. We expect the slowing in inflation to be temporary, but the decline in the unemployment rate to be more enduring. So we continue to believe that the FOMC will remain on course for further hikes in the fund’s rate over the next couple of years and will start the normalization of the balance sheet this year. 

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