Tighter Labor Markets Inspire Further Reflation and Rate Normalization

At the end of 2016, the nonfarm payroll print came in at 156,000 jobs gained for the month of December, which was a bit under the consensus expectation of 180,000 jobs, but it still represents a solid number for a labor market that needs to be regarded as very close to, if not at, full employment. That puts the 3-month, 6-month, and 12-month payroll moving averages at 165,000, 190,000 and 180,000, respectively. Further, while the unemployment rate ticked up last month, to 4.72%, we believe continued labor market strength this year will allow the rate to march toward the low-4% region by year end, underscoring the fact that the economy is operating at a high level today.

We think it’s likely that the U.S. economy will perform solidly this year, as remarkably improved corporate and consumer confidence levels translate to greater spending over time, and as goods-producing sectors of the economy emerge from a very long-term recession into positive growth territory. Indeed, the fourth quarter of 2016 saw considerably stronger hiring in the goods-producing sectors than the remainder of last year. When this is married to consistently solid service sector growth rates, this recovery in manufacturing/goods sectors will be a key feature of the economic landscape in the year ahead. Moreover, if there was any question as to the degree to which expectations/confidence can translate into genuine economic activity, we would refer to the fact that the “Consumer Confidence: Expectations” measure is a very strong leading indicator of real year-over-year Personal Consumption Expenditures (see graph), and since PCE is still driving 70% of GDP that factor should not be discounted.

Arguably, however, the most important data point in today’s report was the bounce back of the average hourly earnings number, creating year-over-year earnings growth of 2.93%. Assuming we continue to see final demand growth hold up in the year ahead, then we think labor market tightness should continue to put upward pressure on wages. Additionally, there are indications that recent wage growth appears to be taking hold in the segments of the labor force most sorely in need of it, namely the lower-and-middle-income job categories. Further, in the first half of 2017 we shall see statutory minimum wage increases from 14 states and the District of Columbia, which should continue to pressure wages (and inflation) upward at the margin. That dynamic, combining the implementation of minimum wage hikes alongside organic wage increases, particularly on the road to full employment, presents a furthering of the reflationary impulse we have been describing for a few months. It also provides the Federal Reserve with an economic backdrop that justifies the central bank to potentially move rates at least two times in 2017.

Our view is that the core of the Fed’s policy-setting committee hasn’t significantly changed its posture over the past few months (though other members appear to be more ready to move on rates), and that the committee overall is likely comfortable letting inflation run a bit hotter for a while as growth and the potential fiscal impulse plays out. Still, data over the coming months may press the Fed to move rates higher at a quicker pace going forward, a possible development that we will be watching for. While describing the uncertainty over the fiscal impulse in its recent meeting minutes, the Fed did suggest that the economy’s anticipation of these initiatives, and the commensurate increase in corporate and consumer confidence, could translate into better corporate spending and stronger consumer data, a view with which we agree. In turn, this could influence the Fed toward moderately more aggressive tightening, which presents something of a tension.

After all this time, when monetary policy has held the recovery on its shoulders and fiscal policy has been absent, is it possible that this dynamic may reverse somewhat, with monetary policy holding back the effectiveness of fiscal expansion? The changing composition of the FOMC this year, along with the advance of fiscal policy, should allow markets to focus a bit less on each Fed announcement and speech. In the end, we greatly hope policy makers can take a more balanced approach that both allows interest rates to slowly normalize and re-rates growth and inflation to healthier, higher, levels in the year to come.