WEEKEND ECONOMIST: Jobs reality

Interest rate markets rallied hard in the wake of the June Employment Report mainly because employment was reported to have fallen by 27,000 against market expectations of a flat result.

In contrast, the market forecasts for the unemployment rate were spot on, with the forecast for a rise in the unemployment rate from 5.1 per cent to 5.2 per cent proving to be correct.

Westpac forecast a fall of 25,000 jobs in June although we agreed that the unemployment rate would "only" rise from 5.1 per cent to 5.2 per cent.

The reason why our jobs number was so much different to the market forecast, although we had the same unemployment rate forecast, was that we expected a fall in the participation rate from 65.46 per cent in May to 65.32 per cent in June.

That fall in the participation rate would see the labour force contract by 13,000. If there is no change in the participation rate the labour force will be estimated by the Bureau of Statistics to increase by around 13,000 which incorporates an estimate of a monthly increase in the working age population of around 20,000 adjusted for a participation rate of around 65 per cent.

Our expectation of a fall in the participation rate was based around the current "whip saw" pattern of the participation rate. Last November the rate was 65.46 per cent, dropping to 65.16 per cent in December and then ranging between 65.42 per cent and 65.22 per cent over the first half of 2012. The June estimate was 65.24 per cent. Over the last seven months the participation rate has averaged 65.3 per cent and for each of the six changes between months a rise has always been followed by a fall.

The impact of the participation rate on the number of jobs is important. For example, a fall in the participation rate will mean a fall in the workforce. With around 95 per cent of the workforce in jobs any reduction in the workforce is likely to be associated with a fall in the number of jobs.

In the case of the June Employment Report the fall in the workforce of 20,000 which was due to a fall in the participation rate from 65.42 per cent to 65.24 per cent explains much of the fall in the number of jobs of 27,000. For that reason we do not see the 27,000 fall in the number of jobs to be as disturbing from the perspective of the state of the labour market as appeared to be the market's response.

If, for instance, the job reduction of 27,000 had been associated with a steady participation rate then the unemployment rate would have jumped to 5.5 per cent and the signal from the labour market would have been seriously disturbing.

Looking forward it is worth noting that the current read of 65.24 per cent for the participation rate is near the low of the 65.46–65.22 per cent range, so a rise in the participation rate is likely in July. That would see an increase in the workforce of around 30,000 which would almost certainly assure an increase in employment. However that increase would need to be more than the increase in the workforce to be a "healthy" jobs report.

The market, however, is likely to interpret a jobs number of, say, 20,000 as "strong" whereas we would see such a number as being insufficient to bring down the unemployment rate and therefore a neutral to soft number.

Taking a longer term view it is unhelpful to try to estimate the monthly fluctuations in the participation rate. In the first nine months of 2011 the participation rate averaged 65.64 per cent compared to the average of 65.3 per cent over the seven months to June 2012.

Explanations for the movements in the participation rate can include the "discouraged worker effect" and the structural change which is currently impacting the Australian labour market.

The "discouraged worker" effect is likely to partly explain the fall in the participation rate as the higher rate last year reflected the strong jobs growth in 2010 while the softer rate in 2012 could reflect the weaker jobs growth in 2011. Given an improvement in jobs growth in the first half of 2012 it is reasonable to expect that the participation rate will at least stabilise in the second half of 2012. Our forecasts assume an "average" participation rate of 65.31 per cent in the second half of 2012. That compares with the average of 65.64 per cent in the first nine months of 2011.

With our assumption of a steady participation rate over the second half of 2012 the key to the unemployment rate is whether monthly jobs creation can average around 13,000. That would hold the unemployment rate around current levels. Our forecast is that the unemployment rate is likely to increase to around 5.8 per cent by year's end. That will require net jobs growth over that six month period of around zero.

Recall that such a forecast is predicated around a steady participation rate. If, for instance, the participation rate was to move back towards the average of 2011 then significantly more jobs would need to be added to hold the unemployment rate at 5.8 per cent but, as discussed above, that is likely to be the case. If the participation rate falls further then less jobs will be required but, as discussed above, that is also likely to be the case.

Over the first half of 2012, 86,000 jobs were added with the participation rate averaging 65.29 per cent. We are expecting the participation rate to average 65.31 per cent in the second half of 2012.

Adding zero net jobs in the second half will be a material step down in job creation.

Figures 1 and 2 below provide some support for our view.







Figure 1 shows the relationship between the Westpac Melbourne Institute Index of Employment Expectations and the unemployment rate. Note the clear lead relationship between the two series. We have noted (see the July edition of the Westpac Redbook) that Unemployment Expectations tend to be contemporaneously related to actual job shedding which in the early stages of the cycle is associated with offsetting jobs creation. The next stage of the cycle is a slowdown in offsetting jobs creation which then impacts the unemployment rate. We expect to be moving into that period through the second half of 2012.

Figure 2 provides further support for this view with the Westpac Jobs Index (a weighted average of the Westpac ACCI; NAB; and PMI business surveys) pointing to a likely deterioration in the jobs market.

This profile for the unemployment rate would make a very strong case for the Reserve Bank moving rates clearly into the expansionary zone. Note that the Governor currently assesses interest rates as "a little below medium term averages".

Bill Evans is chief economist for Westpac.