Economic update

Strong job market, fueled by immigration, raises questions for the Federal Reserve

  • The US job market continues to beat expectations. More new jobs were created in September than in any month since January. Employment was up in most industries, except for financial services and information. Meanwhile, the unemployment rate remained steady at 3.8%. Plus, the number of initial claims for unemployment insurance, while up slightly last week from the previous week, remained roughly at a level not seen since January. Thus, although there are headwinds, the US economy continued to hum as the third quarter ended. It is widely expected that GDP growth for the third quarter, when reported later this month, will be strong. The question now is how the Federal Reserve will interpret the data.

First, here are the details: The US government releases two reports on the job market; one based on a survey of establishments, the other based on a survey of households. The establishment survey found that 336,000 new jobs were created in September, the biggest increase since January. In addition, the government upwardly revised the job gains for July and August by a combined 119,000. This means that the softening of the job market was not so soft after all.

By industry, the September data indicates that there was a strong 17,000 increase in manufacturing employment, including a job increase of 8,900 in the automotive sector. The survey is conducted on the 12th of the month and the auto worker strike began on the September 15. In addition, retail employment was up 19,700, transportation and warehousing were up a modest 8,600, information was down 5,000, and financial services was up only 3,000. However, some industries saw bigger gains. For example, professional and business services were up 21,000, health care/social assistance was up 65,900, leisure and hospitality were up 96,000, and government employment was up 73,000 (mostly state and local government).

The government also reported that average hourly earnings of private sector workers were up 4.2% in September versus a year earlier, the smallest increase since June 2021. Thus, wage inflation is easing somewhat. Still, wage inflation hasn’t moved much since March. Thus, wage inflation has not eased to the degree that the Federal Reserve would like to see. Moreover, a survey by the Conference Board finds that most employers expect to offer 4.1% wage increases in 2024. If so, the Fed has more work to do to suppress inflation.

The separate survey of households found that employment grew roughly in line with the growth of the working-age population. Thus, the participation rate remained unchanged while the unemployment rate remained unchanged. Although employment has grown strongly since the pandemic ended, it remains below the pre-pandemic path. That is, it is lower than would have been the case if the pandemic had not happened and if job growth had been steady ever since. One reason is that, although participation has rebounded since the pandemic, it remains below the pre-pandemic level. Specifically, the participation rate was 63.3% just prior to the pandemic. Today it is 62.8%. Given the tightness of the job market, employment cannot grow much faster unless there is a significant increase in participation or in immigration.

As for immigration, it is now accelerating, contributing to strong job growth. In fact, since April 2020, more than half of job growth in the United States was attributable to foreign-born workers. Indeed, the industries that saw the biggest job gains (health care, social assistance, leisure, and hospitality) often employ large numbers of immigrants. Construction employment also grew strongly, and it is estimated that most of that involved foreign workers. If this continues, immigration will boost the size of the labor force relative to demand for labor, thereby suppressing wage inflation. It is worth noting that, in the decade just prior to the pandemic, immigration accounted for half of US population growth. Then it shut down during the pandemic and is now reviving.

Immediately following the release of the jobs report, bond yields surged before partially reversing. In the futures market, the implicit probability that the Federal Reserve will hike rates before the end of this year increased from 40% the day prior to the jobs report being released to 50% afterwards. For months, the Fed has signaled that its goal is to weaken the labor market to suppress wage inflation. Strong job growth suggests the Fed might need to do more. However, the sharp rise in immigration could be doing the Fed’s job already. Moreover, if inflation data in the coming months is especially good, the Fed might choose to stay the course.

Also, it is important to note that, historically, monetary policy has tended to act with a lag. High interest rates are already taking a toll on some sectors of the US economy. Thus, the economy will likely decelerate in the coming months, even absent another rate hike. High mortgage interest rates have stifled housing market activity. High auto loan rates have added to the cost of purchasing a car, thereby reducing discretionary household income. And high bond yields are inhibiting some companies from raising new funds for investments or transactions. Therefore, it is possible that the Fed will decide not to raise rates.

Bond and currency market volatility: Causes and implications

  • In most advanced economies, bond yields are rising. In the United States, the yield on the 10-year government bond hit 4.79% last week, the highest since 2007. In Germany, the yield on the 10-year bond hit 2.97%, the highest since 2011. And in Italy, the yield hit 4.95%, the highest since 2012. Other countries experienced similar patterns. This likely reflects increasing optimism about economic growth given recently better-than-expected economic data, especially in the United States. In addition, it likely reflects the consequent decision by major central banks to keep interest rates elevated for longer than previously expected.

Some observers wonder if the rise in bond yields reflects increased concern by investors about the sustainability of fiscal policies. In the case of Italy, this is very likely a reason for higher yields. However, in many other advanced economies, it is not clear if concerns about fiscal policy are playing a role.

In the United States, some observers worry that the budget deficit is unusually high given the low level of unemployment. This year it will likely be 7% of GDP at a time of historically low unemployment. Moreover, they worry that, under current law, the Congressional Budget Office expects future deficits to continue rising as a share of GDP. In part, the recent rise in the US deficit reflects the impact of higher bond yields. In any event, rising bond yields in the United States, which do not reflect rising expectations of inflation (as indicated by the stable breakeven rate), suggest that investors worry that the US government will be competing for scarce funds with businesses that are intent on investing. In fact, business investment has held up surprisingly well given the tightening of monetary policy. Moreover, it is expected that, in the years to come, businesses will have to invest heavily in new technologies, redesign of supply chains, clean energy, and climate change mitigation. Thus, the demand for capital will be high, thereby putting upward pressure on borrowing costs.

The rise in bond yields is contributing to weakness in equity prices. If the surge in bond yields continues, it could have a significant negative impact on business investment, M&A transaction volume, housing market activity, and asset prices. The latter could lead to a decline in perceived wealth, thereby hurting consumer spending.

In addition, the high yield on US bonds has created further upward pressure on the value of the US dollar as global investors seek the high returns and safety of owning US government bonds. Even though European yields have increased, investors note that real (inflation-adjusted) yields in the United States are higher than in Europe given lower inflation in the United States than in Europe. In addition, the US economy is growing faster than the European economy, thereby auguring tight monetary policy for longer. Consequently, there has been downward pressure on the euro and the pound.

Also, the value of the Japanese yen temporarily passed the psychologically important level of 150 yen per dollar, despite threats of intervention by Japanese government officials. The yen only crossed 150 briefly before reverting to a slightly higher level. That probably reflected fear on the part of investors that they could get caught on the wrong side of official intervention. There is still an expectation that the authorities will not allow the yen to drop much further.

For the United States, a strong dollar will help to suppress inflation. It will make import prices lower. However, it could, over time, have a negative impact on the competitiveness of US exports. For Japan, the weaker yen boosts export competitiveness. Yet it boosts import prices, contributing to inflation. And for Europe, lower-valued currencies can exacerbate inflation.

Oil prices reverse course

  • Oil prices are falling after a significant surge that led to a rebound of inflation in the United States. From late June until late September, the price of Brent crude oil was up roughly 30%. This was despite an evident slowdown in the global economy. Rather than driven by an increase in demand, the rise in the price of oil was driven by a reduction in supply. That, in turn, was due to Saudi Arabia and Russia voluntarily reducing output with the goal of boosting prices. The result was a sharp rise in gasoline (petrol) prices in many countries. In the United States, for example, the surge in gasoline prices caused headline annual inflation to rise from 3%in June to 3.7% in August, even as core inflation decelerated.

Yet after peaking on September 27, the price of crude oil has been declining, hitting US$84 per barrel late last week, down roughly 11% since September 27 and the lowest level since late August.

Why are prices declining? One reason is that most investors expect a further weakening of demand given central-bank policies of prolonged high interest rates. They also expect that elevated oil prices will dampen demand. Already several indicators point to a weakening global economy. If so, then investors expect that OPEC and Russia will likely cut production even more to keep prices elevated. Perhaps investors are not confident that OPEC will be able to agree on this.

Another possibility is that investors expect the poorer members of OPEC to cheat. This has happened in the past. When OPEC has agreed on production cuts meant to achieve elevated prices, some members cheat and boost production to take advantage of high prices. Yet, in so doing, they put downward pressure on prices.

What happens next? A further decline in oil prices is more likely than an increase. If so, the temporary impact on inflation we have seen in recent months will disappear and reverse. This will be good news for inflation, as well as for economic growth. If prices fall, it could influence central-bank choices.

Eurozone retail sales continue to fall

  • In the Eurozone, real (inflation-adjusted) retail sales peaked at the end of 2021 and have been falling ever since. Recently we learned that, in August, sales continued to fall at a rapid pace. Retail sales volume fell 1.2% from July to August and fell 2.1% from a year earlier. From the previous month, real sales of nonfood merchandise fell 0.9%, sales of food and related products fell 1.2%, sales through mail order/internet venues fell 4.5%, and sales of automotive fuel fell 3%. This is indicative of a weak consumer sector, despite rising real wages and low unemployment.

The decline in the volume of automotive fuel sold likely reflects the impact of a sharp rise in petrol prices. That, in turn, had a negative impact on discretionary spending on other items. Also, home prices in the Eurozone are declining for the first time in a decade, reflecting the impact of high interest rates. Weaker turnover of housing has a negative spillover effect on retail sales. Plus, lower home prices imply lower household wealth, thereby having a negative impact on spending.

By country, the month-to-month change in real retail sales was –1.2% for Germany, –2.8% for France, +0.4% for Spain, –0.6% for Netherlands, and –1.5% for Belgium.

US mortgage applications down sharply

  • In the United States, the number of applications for mortgages for the purchase of homes is down sharply, largely due to the very high mortgage interest rates. In the week ending September 29, new applications were down 6% from the previous week and were down 22% from a year earlier. Purchase market activity fell to the lowest level since 1995. In addition, applications for refinancing of mortgages were down 7% from the previous week and were down 11% from a year earlier.

The weakness of demand for new mortgages is affecting home prices. There has lately been a rise in home prices, not because of strong demand, but because of weak supply. That is, with mortgage interest rates so high, existing homeowners are reluctant to sell their homes because buying a different home could be hugely expensive. This reduces supply in the market, thereby boosting prices. Moreover, the rise in prices is stimulating new housing construction.

Weakness in housing transactions has a spillover impact on other industries, especially those that supply home-related goods and services. This includes appliances, furniture, home entertainment, and home improvement products and services. Much of these types of transactions take place through the retailing industry. Thus, housing weakness can contribute to retail weakness. On the other hand, if households choose to postpone housing transactions, they might choose to increase expenditures on services such as travel, dining, and entertainment. Moreover, they might choose to upgrade existing homes, thereby boosting home improvement expenditures.

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