Laying the groundwork for a US rate rise

Despite July's non-farm payrolls missing expectations, and a slight uptick in the unemployment rate, the Federal Reserve will find it difficult to justify keeping rates near zero for much longer.

The US labour market continued to improve during July but there remains significant spare capacity across the economy. Nevertheless, it is time that the Federal Reserve began to lay the groundwork for its next policy move, signalling to the market that rates might rise earlier next year than is commonly expected.

Non-farm payrolls rose by 209,000 in July, missing market expectations, following solid gains since February. Job creation in June was revised up to 298,000 (from 288,000). This was the sixth consecutive month that non-farm payrolls rose by over 200,000 during which the labour market has posted its strongest gains in over eight years.

Private non-farm payrolls rose by 198,000 in July, while government payrolls were up by 11,000. Local government is driving public sector employment, with the federal government continuing to cut jobs over the past year (although less so in recent months). Government payrolls -- at all levels -- remain well below their peaks.

Graph for Laying the groundwork for a US rate rise

The service sector continues to drive the recovery, gaining a further 151,000 jobs in July. Over the past year, the services industry has accounted for 86 per cent of job growth, which is broadly in line with its medium-term trend.

Jobs in the construction sector continue to rise but remain well below the pre-crisis level. With investment continuing to rise and some tentative upside for residential and non-residential construction, jobs should continue to expand in the near-term.

The unemployment rate rose modestly to 6.2 per cent in July -- the first rise since February -- to be 1.1 percentage points lower over the year. Around half of that decline is due to a fall in the participation rate -- which actually rose slightly in July -- and this partly reflects a combination of an ageing population (‘baby boomers’ retiring) and some Americans giving up on find work following a lengthy period of unemployment.

Graph for Laying the groundwork for a US rate rise

The participation rate is expected to trend lower over the next decade, weighing on economic growth; however, I wouldn’t be surprised if it ticked up temporarily on the back of improving economic conditions. That might prove sufficient to encourage some Americans to re-enter the workforce, following a lengthy period of inactivity.

With millions of discouraged workers waiting for an opportunity, there remains considerable spare capacity across the US economy. Nevertheless, with the labour market improving inch-by-inch that spare capacity is slowing eroding, resulting in a modest rise for inflation.

The personal consumption expenditure deflator rose by 0.2 per cent in June, to be 1.6 per cent higher over the year. The core PCE deflator -- the Fed’s preferred measure of inflation -- climbed by 1.5 per cent over the past year.

This remains below the Fed’s upper target for annual inflation of 2 per cent but the recent pick-up, if maintained, may bring forward the Fed’s thinking on rates. Other measures of annual inflation are either at or around 2 per cent. 

Graph for Laying the groundwork for a US rate rise

One reason to be unconcerned about inflation is that wage growth remains modest. This reflects the fact that much of the recent job gains have been in lower paid occupations. This also explains why an improving labour market hasn’t necessarily translated into stronger household spending.

But if the recent pace of job creation is maintained, greater competition for available talent will result in wage growth heating up and inflation pushing further towards the Fed’s upper target. In the near-term though inflation is little risk of getting out of control.

With the unemployment rate set to fall below 6 per cent in upcoming months, it is difficult to see how the Fed will justify keeping rates at the zero lower bound for too much longer. As it stands, the current stance of policy is rather extraordinary for an economy with solid job creation and an unemployment rate of around 6 per cent.

The Fed is all but certain to finish its asset purchasing program when it meets in October. But in the meantime, it should give serious consideration to also adjusting its communication, preparing markets for the possibility that rates may rise a little earlier than expected.

By no means is 2014 a possibility, but a rate rise in early-to-mid-2015 could certainly be warranted based on recent job growth.