Slowing inflation tempers payrolls triumph

While strong payrolls data raises the possibility of a December taper, disinflationary pressures may see the Federal Reserve hold off for a time.

Job creation in the United States maintained its pace during November and beat market expectations. It was a payrolls report that will spark further discussion of when the Federal Reserve will begin tapering its US$85 billion asset purchase program. But it wasn’t all good news on Friday, with inflation slowing to a level that may raise some concerns within the Fed.

The report confirms what has been suspected for several months, conditions in the labour market have improved. The market proved its resilience during the 16-day government shutdown in October, which threatened to unravel consumer and business confidence. Instead, businesses continued to hire at a solid – if unspectacular pace – during October and November.

Non-farm payrolls rose by 203,000 in November and expanded by 2.3 million jobs over the past year. Private non-farm payrolls rose by 196,000 in November, while government payrolls were up by 7,000. Fiscal consolidation has stopped being a drag on job creation.

The unemployment rate fell to 7.0 per cent in November, from 7.3 per cent in October. This partly reflects the reversal of the government shutdown in October which had an effect on the unemployment rate data but not the payrolls information (since the two use different survey techniques).

Unlike some of the recent improvement in the unemployment rate, the change in November did not reflect falling labour force participation. In recent years, the unemployment rate has been pushed down significantly by ‘baby boomers’ beginning to retire and the long-term unemployed giving up on the labour market. That was not the case in November.

Normally an unemployment rate of 7 per cent would justify much tighter monetary policy but with the participation rate so low, the labour market is weaker than indicated by a simple measure of unemployment.

Nevertheless, hitting the 7 per cent threshold is a small but significant step for the US economy – though not as significant as we thought back in June. Back then Fed chairman Ben Bernanke communicated the tentative timeline for winding down the Fed’s asset purchasing program, stating that he expected the unemployment rate to be at 7 per cent when it ended their purchases. Instead they haven’t even begun to taper.

Obviously the 7 per cent target proved a mistake, a communication failure that resulted in financial market volatility ahead of the Fed’s September meeting. The current threshold of 6.5 per cent – after which the Fed will consider raising short-term interest rates – could also be reached without the Fed convinced that they have a sustainable recovery on their hands.

It seems almost certain that the Fed will revise its threshold down further in the near-future – which will only prove again how problematic ‘forward guidance’ has been.

To complicate matters further the personal consumption expenditure (PCE) deflator – the Fed’s preferred measure of inflation – slowed to just 0.7 per cent on a year-ended basis, well below the Fed’s upper target of 2 per cent. The core measure, which excludes volatile items, rose by 1.1 per cent over the year to October.

The Fed may be concerned that tapering right now will increase the disinflationary pressures in the economy, which would be compounded further by the expected rise in the US dollar once the taper commences. The Fed may view the lack of inflation as an indication that domestic demand growth is not sustainable without considerable support.

Despite slowing inflation, the payrolls data undeniably raises the possibility of a December or early-2014 taper of Fed’s asset purchasing program. But I sense that there is no widespread agreement amount committee members heading into the 17-18 December meeting.

On that basis I do not expect the taper to commence until early 2014 but I wouldn’t be a surprised if the Fed adjusted its ‘forward guidance’. Markets need the Fed to be more transparent surrounding the taper and the outlook for monetary policy. The Fed has failed to communicate their intentions clearly or provide any sense of certainty to market participants despite their many attempts.

However, the Fed should be more decisive when they meet a week from now. A token cut (say US$5 billion) to their asset purchasing program would send a firm and welcome signal to the markets. This should be followed with a statement that asset purchases will be wound down in a slow but systematic fashion unless job creation slows.

A slow and steady approach allows markets to adjust their behaviour and expectations without the rug being pulled out from under them. It should reduce the disruption and volatility expected from a rapid winding up of the program.

Concerns about inflation are justified but let the labour market worry about that. If this level of job creation is sustainable then disinflationary pressures will eventually disperse as job competition creates wage inflation.

The labour market has already proved that it is resilient; the government shutdown and Fed uncertainty could easily have been enough to spook businesses. But hiring continued and the Fed needs to trust that this will remain the case and finally pull the trigger.

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