Inflation’s Evil Twin: Breaking Down the Labor Market

This year it is all about inflation, inflation and more inflation leading to outsized rate hikes. But investors would be wise to look at the Federal Reserve’s (Fed’s) other important mandate, unemployment, to see how the job market is reacting as the aggressive rate hikes continue this year. Often referred to as inflation’s evil twin, a persistently tight labor market can result in further wage gains, presenting a major hurdle to the Fed’s demand-reduction assumptions, and at worst risk an embedded 1970s style wage-price spiral. The headline unemployment rate doesn’t tell you much of anything based on how it is calculated, but the underlying metrics can give investors an early indicator of a change in policy stance should things turn quickly south in the labor markets.

Three key underlying employment statistics - structural, frictional and cyclical - outside of the headline unemployment number may help investors to better understand the Fed’s policy responses.

Labor force participation is the proportion of working age population working or actively looking for work. The US labor force as of September 2022 was 165 million persons, so small changes in this metric can have large impacts on available workers.¹ For example, if the US were to move back to the pre-pandemic participation rate of 63.4% (just 1% from where we are in September 2022), the official unemployment rate would move to approximately 4.7% assuming current levels of job creation in just six months.²

Women are the largest gender component of the available workforce but their participation rates are lower than men and have not recovered since the pandemic. Also, the trend in Baby Boomer retirements do not bode well for a significant rebound this decade with 75 million expected to retire by 2030.³ This is a structural longer-term issue that speaks to supply and demand for jobs, many of them service and technically related, which will keep pressure on wages over this time frame. The good news for the Fed is this is a slow moving metric and recent trends are positive.

Another trend that was in place prior to the pandemic was rising wage growth. One problem compounding wage growth since the pandemic is the increase in percentage of amount of the workforce switching jobs (approximately 3% or 5 million in the latest series), as these workers are receiving the outsized wage gains. While this is normally the sign of a healthy job market, the levels run counterproductive to the inflation mandate. Compared to the level of available jobs, this is a metric the Fed would like to see reversed back to historical 2-3% trends. The good news here is that these metrics peaked earlier this summer, suggesting that rate hikes are having an impact.

Over the past 24 months payroll growth has been higher than in previous recovery periods, but more importantly it has exceeded what is necessary to maintain a stable unemployment rate given our current labor participation and employment-to-population ratios. Currently it is estimated the economy only needs to create about 80-100k jobs each month to account for population growth, the new additions to the workforce and the level of those leaving the workforce (retiring).²

If we are creating more jobs than this then we are lowering unemployment rates (all else being equal in the workforce) and actually increasing wage pressure as there are fewer available workers to fill posted jobs. It is a fantastically complicated situation but suffice to say that market watchers wanting a signal the Fed hikes are working would expect to see negative jobs created in the ensuing months. The good news for the Fed here is that the trend is negative.

When is the Next Big Report?

The next employment situation report from the Bureau of Labor Statistics (BLS) is Friday, November 4, 2022, conveniently right before elections.

The forecast for unemployment rate is expected to remain at 3.5% and NFP down 20k jobs to 240k as of this writing, which would not show much weakness if the numbers come in as expected. However, investors should look deeper at the trends. The Fed would like to see the following:

• Labor Participation: Fed would like to see this number continue to tick up, which would increase slack in the labor force, but they have no real control over it.
  
  
• Job Quits/Wage Growth: Fed would like to see these numbers continue down, which would show rate hikes are slowing demand for labor on the margin.
  
  
• Non-Farm Monthly Payrolls: Fed would like to see job creation much lower than it is now, something closer to 80-100k which would put unemployment over 4% by end of year and closer to the NAIRU (non-accelerating inflation rate of unemployment) if the creation level is sustained.

Until there is more convincing evidence inflation is slowing and the job market metrics commensurately weakening and do not fall off a cliff, the possibility of a softish landing increases. However, in the meantime, we continue to believe that portfolios may benefit from continued inflation protection via low-duration/high cash flow sectors such as energy and certain Real Estate Investment Trusts (REITs) as well as all short duration fixed income.

Important Disclosures & Definitions

1 US Bureau of Labor Statistics, September Employment Situation Summary, September 2022

2 Federal Reserve Bank of Atlanta Jobs Calculator

3 “The Great Retirement: Are Baby Boomers Causing Today’s Labor Shortage?”, Adecco Blog, 02/08/2022

Federal Open Market Committee (FOMC): a branch of the Federal Reserve System, the FOMC determines the direction of monetary policy by directing open market operations. The committee is composed of the seven members of the Board of Governors and five Federal Reserve Bank presidents.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

AAI000194