Latest Employment Data Highlights the Fed’s Challenge

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

As the pace of inflation has eased over the past several months, regular readers of our commentaries know that we have increasingly focused on the employment picture as a harbinger of things to come for Federal Reserve rate policy, the path forward for inflation and, ultimately, the economy. That’s because while the supply/demand imbalances, first in goods and then services, were a driving force for elevated price pressures through much of 2022 and into the first half of 2023, those distortions have largely abated (much as we had forecasted) and have left wages as the one remaining ember that could reignite inflation. We believe now, unfortunately, a tight labor market and wage pressures could fuel inflation going forward. Indeed, history suggests that the Fed views 3.5 percent annual wage growth as the upper limit the economy can absorb and still achieve an annual inflation rate of 2 percent. As such, since the end of the era of embedded inflation from 1966 to 1982, each time wage growth reached 4 percent, the Fed has raised rates, which has coincided with a recession that drove wage growth down. While the Fed has recently praised progress in bringing inflation under control, it remains wary that the continued tight job market could cause a repeat of the period of embedded high inflation from 1966 until 1982, a period characterized as being driven by a wage–price spiral in which rising wages were used to pay ever-rising prices. We believe this nagging concern is captured in the minutes from the Fed’s December meeting, which highlighted that “participants also noted, however, that their outlooks were associated with an unusually elevated degree of uncertainty and that it was possible that the economy could evolve in a manner that would make further increases in the target range appropriate.” Additionally, the minutes warned that market behavior could act as a premature easing of financial conditions and fuel growth that would require the Fed to take a higher-for-longer stance on rates or perhaps raise them should growth start to pull inflation higher.

Employment data released last week highlights the difficulty the Fed faces in cooling the economy and labor market enough to bring wages down to a level consistent with 2 percent inflation while not keeping rates too high for too long. Indeed, the big report for the week, the nonfarm payroll report from the Bureau of Labor Statistics (BLS), showed that while the labor market has cooled from the red-hot levels at the beginning of last year, it has not eased enough to bring wages down to the level the Fed has indicated it believes is consistent with its goal of 2 percent inflation.

The nonfarm payroll report for December showed that hiring increased, with 216,000 new positions added, up from November’s revised reading of 173,000 and above Wall Street estimates of 175,000. However, we believe the number of private jobs added is a more telling measure of the underlying economy since government hiring is impacted by the economic cycle with a lag. With that in mind, the latest data shows that 164,000 new private-sector positions were added in December. It’s worth noting that revisions to October and November readings resulted in a net reduction of 71,000 positions in the total number of positions added for the two months combined. The latest revised numbers put the average monthly gain in private payrolls over the past six and three months at 134,000 and 115,000, respectively, suggesting that while still strong, the trend in hiring is slowing.

BLS data also showed temporary help services—a leading indicator of the labor market—fell by 33,000. This is a timely measure because employers typically let go of temporary workers before cutting permanent staff. The latest decline puts the year-over-year decrease in temporary workers at 7.4 percent, a level consistent with the previous four recessions (including the brief contraction at the beginning of COVID) since the 1990s.

Digging further, the bulk of the new jobs were for health care/social assistance (+74,000) and leisure and hospitality (+40,000). The breadth of industries hiring did tick up to 59.6 percent, which is an encouraging development considering the narrowness of past readings had suggested the strength of the job market had grown fragile with age.

The BLS’s other jobs report, the household survey, showed 683,000 job losses in the month and the unemployment rate at 3.7 percent. While this report tends to be more volatile given its smaller sample size, many economists view it as a better measure than the nonfarm payroll report during inflection points in the employment picture. With that in mind, it’s worth noting that during the past nine months, the household report has shown an average of 40,000 jobs added each month—far fewer than reported by the nonfarm data—and consistent with pace recorded in fall of 2007, when the economy was headed into the great financial crisis. The total number of unemployed people now sits at 6.268 million, up slightly from November’s level of 6.262 million. The latest figures show the number of unemployed grew by 570,000 since the beginning of 2023. Importantly, as it relates to remedying the supply and demand imbalance in the labor market, labor participation fell in the most recent survey to 62.5 percent, down from 62.8 percent in November. Keep in mind that in December Federal Reserve Chairman Jerome Powell highlighted a recent rise in the number of people joining the workforce as an encouraging sign that the tight labor market—and resulting wage pressures—could retreat further.

Given the aging demographics of the U.S., we believe it is unlikely we will see a sustained uptick in labor participation and instead expect the workforce to grow by between 50,000 and 90,000 workers per month. Our view is shared by the non-partisan Congressional Budget Office and the BLS, which have both forecast a shrinking labor population in the coming years.

Despite the reports suggesting a softening trend in the employment picture, wages remain elevated. Average hourly earnings for production and non-supervisory employees rose by just more than 0.3 percent from November and are up 4.3 percent year over year, down 0.1 percent from November’s year-over-year pace. While the pace of wage growth has slowed over the past few months and is markedly below recent highs, it remains well above the 3 to 3.5 percent range we believe is necessary for the Fed to achieve its goal of 2 percent annual inflation. Put simply, it appears that demand for workers is easing more quickly than wages. As a result, the Fed may need to keep rates higher for longer. Unfortunately, once the labor market begins to weaken, the trend tends to quickly gain momentum, and that is why we continue to view a recession as the base case for the economy. This was a point discussed in the minutes from the Fed’s latest meeting: “Several participants noted the risk that, if labor demand were to weaken substantially further, the labor market could transition quickly from a gradual easing to a more abrupt downshift in conditions.” While we believe a higher-for-longer stance by the Fed will lead to a recession in the coming months, we expect the contraction to be mild and short-lived. Fortunately, with inflation falling as it has, the Fed should have room to cut rates to soften the length and depth of the blow of an economic downturn.

Wall Street wrap

While Wall Street focused on the Fed and the latest inflation report, other reports offered mixed news.

Job openings decline but outpace available workers: The BLS Job Openings and Labor Turnover Survey released earlier last week showed the number of job openings came in at 8.79 million in November, a decrease of 62,000 from October’s upwardly revised total and the lowest level since March 2021. The latest figure translates to 1.4 jobs for every available worker. While the latest reading remains elevated, it is well off the ratio of 2:1 seen in 2022 and is now at the lowest level since 2021. The so-called “quits” rate, which is viewed as a proxy for the level of confidence employees feel about the job market, came in at 2.2 percent, down from October’s reading of 2.3 and tied for the lowest level since September 2020.

Manufacturing continues to contract: The latest data from the Institute for Supply Management (ISM) shows the manufacturing sector extended its streak of contractionary readings to the 14th consecutive month. The composite reading for the index for December came in at 47.4, up 0.7 points from the previous month (readings below 50 signal contraction). Weakness was widespread, with none of the six major industries reporting growth and only one of 18 industries in total experiencing growth. Readings for new orders came in at 47.1, down 1.2 points from November. However, customer inventories declined to 48.1 (which indicates inventories are too low), down from November’s reading of 50.8. Backlog orders increased to 45.3 from the prior reading of 39.3 but remain in contractionary territory. It remains in contractionary territory, but employment ticked higher to 48.1 from November’s 45.8. Prices paid declined to 45.2 from November’s level of 49.9, with lower energy prices driving the reduction.

With the slump in manufacturing now exceeding a year, businesses are adjusting staffing levels. In a statement accompanying the latest report, Tim Fiore, chair of the ISM, noted, “Panelists’ companies maintained production levels month over month and continued actions to reduce head counts in December, primarily through layoffs.”

Growth in services sector shows signs of stalling: ISM data for the services side of the economy showed that the pace of expansion continued to slow, with December’s headline reading for the sector coming in at 50.6, down from 52.7 in November (readings above 50 signal expansion). While still in expansionary territory, the latest reading marks the second lowest in the past 12 months and is approaching the lowest level since December 2022. Prior to the December 2022 reading, it has not been lower since the beginning days of COVID. Industries recording growth also slipped to nine out of 18, marking the lowest number of groups reporting expansion during the post-COVID cycle. New orders declined to 52.8, down from November’s reading of 55.5. Inventory sentiment continues to suggest levels are too high, although less so than the previous month, with the latest reading at 55.3, down from 62.2 the prior month. Most striking in the report was the impact that slowing demand has had on demand for workers. The latest results from the survey showed the employment index declined to 43.3, down 7.4 points from November’s reading of 50.7. For context, the latest reading is lower than the 43.9 level recorded during the 2001 recession. Among comments from respondents to the survey was “Layoffs have increased in the professional services and staffing industries over the past several months as companies try to reduce cost amid the climate of economic uncertainty and decreasing customer demand.”  

Another sign of slowing growth: While we typically discuss national economic data, we also find it valuable to look at indicators at the state level to assesses whether trends in the national data are being distorted by a few outliers or represent a broad trend. One such report we find useful is the State Coincident Index produced by the Federal Reserve Bank of Philadelphia. The index looks at state employment numbers (among other economic measures) to calculate a state-based growth diffusion index. The latest reading based on November state data was negative 6, indicating more states were experiencing an economic contraction than expansion or stability. The latest reading follows October’s level of negative 18. For further context, September’s reading was 23. Since the series began in 1980, each time the reading went from positive—as it was in September—to negative the following month, a recession coincided.

Continuing jobless claims ease: Weekly initial jobless claims numbered 202,000, a decrease of 18,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 207,750. Continuing claims (those people remaining on unemployment benefits) were at 1.855 million, a decrease of 31,000 from the previous week. The four-week moving average for continuing claims declined slightly to 1.875 million, down 250 but still nearly the highest level since December 2021. The trend in continuing claims over the past several months is a timely market indicator that suggests the labor market is weakening and those who have lost their jobs are finding it harder to find new employment.

The week ahead

Monday: The Federal Reserve will release November data on the financial condition of consumers  through its Consumer Credit report. Consumers have begun to take on more credit card debt in recent months, but overall balance sheets have remained solid. We will be watching for changes in debt levels now that the financial cushion many consumers built during COVID has been depleted.

Tuesday: The National Federation of Independent Business Small Business Optimism Index readings for December will be out before the opening bell. Recent readings from this survey show that price pressures and the state of the labor market are top concerns among small businesses. We will be watching for any signs that suggest these challenges are easing.

Wednesday: Final wholesale inventory numbers for November will be released after market open. We will be watching to determine whether inventories are rising or falling, which could signal changes in the pace of economic growth.

Thursday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown continued but uneven progress in the disinflationary process; we will be dissecting the data to see if pockets of stubborn price pressures remain.

We’ll also get the release of the U.S. Treasury Federal Budget Debt Summary for December. In light of Moody’s decision last fall to downgrade U.S. debt to a negative outlook due to large fiscal deficits and a decline in debt affordability, this is something we will continue to monitor.

Friday: The latest readings from the BLS on its Producer Price Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by business and can indicate how prices may move at the consumer level in the future.

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