Jobs squeeze adds to pressure on the Fed to hike rates

The US economy added fewer jobs than hoped in December. Just 199,000 people found work according to the non-farm payrolls data while there were a net 141,000 upward revisions to the past couple months. Combining these figures gives us an employment gain of 340,000, which is well below the consensus forecast of 450,000.

In reality this is an even bigger miss given many of the forecasts were submitted ahead of this week’s data flow which had shown excellent readings for the ADP payrolls numbers, the ISM employment indices, the Homebase data and a Job Openings and Labor Turnover Survey (JOLTS) report that hinted at even larger upward revisions to the historical payrolls numbers.

The Omicron wave shouldn't have had much of an impact given the timing of the survey (week of December 12) so most of the softness is going to be put down to supply constraints (labour force participation rate remains woefully low at just 61.9%) given all the labour demand surveys are so strong. The unemployment breaking below 3.9% and wages rising 0.6% month-on-month are probably of more significance to the Federal Reserve in this instance.

So where does this leave us? Well, despite having an economy that at the end of 3Q 2021 was 1.4% larger than it was pre-pandemic, there are still 3.6 million fewer people on company payrolls. Given this week’s JOLTS data showed there at 10.5 million job vacancies this reinforces the message that it is a labour supply problem rather than any issue with demand.

This difficulty in finding suitable workers is pushing up pay rates, as we see in today’s report, with the National Federation for Independent Businesses (NFIB) reporting yesterday a record net 48% of small businesses raising worker compensation and a record net 32% expecting to raise pay further in coming months.

Despite higher pay being on offer there is scant evidence of former workers returning to the labour force with the participation rate at 61.9% and the employment ratio at 59.5% of the population of working age. Consequently companies are having to recruit from competitors, which is why the quit rate hit a new series high with 3.4% of all private sector workers moving jobs in November. This creates broader pay pressure as companies seek to retain staff they currently have by paying them more.

Given the US is largely a service sector economy and employment costs are typically the largest cost this adds to inflation pressures – particularly in an environment where companies appear to have pricing power and can pass these costs onto customers.

The recent minutes to the Federal Reserve’s December FOMC meeting showed that officials really want to get the ball rolling on normalising monetary policy. They effectively admitted they got the inflation call wrong and now also recognize that the labour market is in a much tighter position than they had previously thought likely – an unemployment rate of 3.9% proves that. Consequently, having suggested just 9 months ago that it would be 2024 at the earliest before the first interest rate rise, the Fed are now saying they are likely to hike rates three times this year and three times next.

The upward pressure on interest rate expectations is not going to let up soon. Next week we expect to see headline inflation break above 7% year-on-year with core inflation breaching 5% YoY while later in the month all eyes should be on the 4Q employment cost index. With the NFIB and the Fed’s own Beige Book reporting broadening wage pressures another 1% quarter-on-quarter rise in this index could really tip the balance in favour of a March rate hike and open the door to the possibility of four rate increases this year. For now we are more cautious and think May will mark the starting point for higher policy rates on the basis that the Omicron wave clouds the near-term economic outlook, but this is a fast moving situation and the Fed have signaled they want to get back in control.