ATFX - Why is the U.S. job market still so strong? | Barron's Cover

The trade-off between a return to price stability and a slowing labour market has been at the heart of the Fed's 18-month campaign against inflation. Mainstream economic thinking and decades of economic history suggest that for inflation to fall back to its target, the Fed must slow economic growth, and with it rising unemployment, millions of Americans will lose their jobs or, in theory, inflation will remain high.

Since early 2022, Federal Reserve officials have been reminding people of the impact that anti-inflation action could have on the labor market, with Chairperson Jerome Powell saying that the "pain" caused by anti-inflation on the labor market was an "unexpected result." Six months ago, the Fed's projections showed that the unemployment rate in the United States would rise by more than a percentage point to 4.6% by the end of 2024. If anyone expects a more optimistic outcome, it may require an almost naive adherence to one of the most worrisome quotes in economics: This time is different.

However, so far, this time is indeed different.

The Fed has raised interest rates 11 times since March 2022 to a range of 5.25-5.5 per cent and headline inflation has fallen by two-thirds year-on-year to 3 per cent from a peak of 9.1 per cent. However, the US unemployment rate is now at a historic low of 3.8 per cent, only slightly higher than the 3.6 per cent it was when the Fed first raised rates, and there are few signs that it will rise any time soon.

"Indeed, what we are seeing is progress in fighting inflation without rising unemployment," Mr. Powell said at his most recent press conference on September 20.

The strength of the US labour market has surprised Federal Reserve economists, who have cut their unemployment forecasts by half a percentage point, and Wall Street economists, who have postponed or withdrawn their recession forecasts. It has also forced a rethink of the entrenched assumption that a weaker labour market is necessary to restore price stability.

If a weaker labor market is not a necessary condition, as it seems likely, the Fed could finally achieve the "soft landing" that many have been dreaming of.

To judge how long this can last, it is important to understand why the labor market is so strong. If the factors that keep unemployment low remain the same, the Fed can keep interest rates within a restrictive range while reducing inflation without causing "pain" to the economy. Otherwise, even if the recession may come later than expected, it will eventually come.

The strength of the labour market has not been driven by a single factor, but by a combination of factors, including massive fiscal stimulus, unexpectedly high labour force participation, a rebound in immigration, a boom in small business start-ups and continued growth in "face-to-face" services, particularly healthcare, in the wake of the COVID-19 pandemic.

While savings accumulated during the epidemic have dried up, consumer spending continues to grow, providing support for labor market growth.

All of these factors are responsible not only for the increase in labour supply, but also for the fact that labour demand has remained strong enough to withstand higher interest rates. Together, these factors have contributed to a period of such strength that even if the labour market is now loosening, the ensuing slowdown looks more like a return to normal than the start of a recession.

Nick Bunker, head of research at Indeed Hiring Lab, a job site, said: "The U.S. job market has grown very fast over the past two years, so weaker hiring intentions or fewer job openings have not led to a significant increase in unemployment."

To be sure, signs of a cooling economy are more pronounced than they were a few months ago. Job growth has slowed, reflected in an average of about 150,000 jobs a month over the three-month period, compared with an average of about 240,000 jobs a month over the previous three-month period. Job openings have fallen 21 percent since the start of the year. The temporary worker services industry is seen as a leading indicator of the overall job market, as employers tend to lay off temporary workers before making larger layoffs, and the size of the temporary worker services industry has shrunk month by month this year.

But these trends are less worrisome in the broader context. Monthly job growth is far outpacing what is needed to keep pace with population growth. Indeed's data shows that the number of job openings is still 26% above pre-epidemic levels, and that the data is currently fluctuating in a narrow range, not falling. The temporary worker services industry shrank only because some companies had to hire temporary workers because of labor shortages during the epidemic, and now these companies that have recovered are hiring permanent employees again.

Next, the outlook for the labor market will be more difficult to judge, but for now, the future looks promising.

"We don't know what will happen next year, but so far so good," said Mike Konczal, director of macroeconomic analysis at the Roosevelt Institute.

The labor force participation rate still has room to rise

Although the proportion of Americans who are working or looking for work remains below historical levels, tight job market supply has pushed up the labor force participation rate.

The graph shows the change in the labor force participation rate

The recession is in the shadows.

The healthier the US economy, which was already healthy when the Federal Reserve first raised interest rates last year and may even be stronger than many economists thought at the time, will be better able to withstand the drag of high interest rates.

Low- and middle-income Americans have benefited in particular from the massive fiscal stimulus launched in response to the impact of the epidemic on the economy. With the help of these stimulus measures, they have paid down debt, improved their credit situation, and locked in low interest rates on fixed-rate mortgages and loans. This group of workers also saw the highest real wage increases of any worker, according to the Federal Reserve Bank of Atlanta's wage tracking tool. According to recent data released by the Federal Reserve, the wealth of the lowest-income households in the United States rose by nearly 75% from Quarter 1 in 2020 (when the epidemic broke out) to Quarter 1 in 2023, and it remains strong.

That helps explain why consumer spending has held up even as excess savings have dried up during the epidemic. While lower-income households spend less overall than higher-income households, they spend a larger share of their income, and when they begin to retrench, that could have a significant impact on how consumer spending changes. Sustained healthy consumption has fueled growth in the labor market, which in turn has spurred more consumption.

Fiscal spending is also crucial for the construction industry, which has historically been vulnerable to rising interest rates.

In the early years of Mr. Biden's presidency, the federal government approved hundreds of billions of dollars to boost domestic chipmaking and rebuild the nation's infrastructure, and while borrowing costs have risen sharply, demand for manufacturing projects will not fade. The spending is intended to stimulate private investment on top of public funding from the government, further fueling the growth in construction activity and, in turn, the demand for more labor.

Construction jobs continue to grow. The picture shows new residential construction in Buckeye, Arizona.

After years of sluggish construction following the 2007-08 housing crisis, which led to a shortage of single-family homes in the US, residential construction has boomed. At the same time, demand for housing has surged as millennials are buying at a peak and people who can work remotely are moving from urban centres to the suburbs. Moreover, as interest rates climb, fewer homeowners locked in ultra-low mortgage rates from previous years are listing their homes for sale, exacerbating the tight supply problem. Demand has shifted to new construction, and the share of new homes in total home sales has begun to rise.

As a result, construction spending has surged, rising by more than 31% since February 2020, with no sign of peaking. Construction employment grew by 5% over the same period and continues to grow.

Julia Pollak, chief economist at ZipRecruiter, said: "Fed rate hikes would normally result in a big drop in construction employment, but that didn't happen this time."

Employment in the construction industry

The recession is in the shadows.

Small businesses, which provide nearly two-thirds of new jobs, are another factor in the strength of the US labour market. Their health is critical for labour demand to remain strong. Expectations were that higher interest rates would affect the start-up of small businesses by increasing the cost of starting a business, including loans. There was also talk that the collapse of several US banks this spring would have a negative impact, making it harder for start-ups to obtain the necessary financing.

But the reality is not as expected. When the US economy reopened in 2020, the number of new business applications per month hit a record high, and the trend has remained strong. After levelling off in 2022, new business applications have risen again since the start of the year and are 55 per cent above February 2020 levels, according to US Census data.

What's more, the data show that these new businesses are highly likely to hire. Since before the epidemic, the number of so-called "high propensity" new business applications (for entities that could be converted into operating companies that pay wages) has increased by more than a third.

A strong economy, fiscal stimulus and thriving small businesses have all helped prevent a sharp fall in labour demand at a time when the Federal Reserve is committed to slowing economic growth. Another important factor is an increase in the labour force participation rate, which has contributed to the increase in supply.

The overall labour force participation rate - the share of Americans who are working or looking for work - has not fully recovered from a sharp drop in the aftermath of the epidemic, to 62.8 per cent. However, higher immigration and a record high proportion of "prime-age" working women have contributed to the higher-than-expected labour force participation rate. Before the outbreak, the US government had expected the overall labour force participation rate to fall below 62 per cent by the end of next year, mainly due to an increase in the number of retirees due to the aging of the US population.

Importantly, the labor force participation rate is likely to continue to rise. Elise Gould, a senior economist at the Economic Policy Institute, points out that the Labor Department's data show that the share of people who find a job without much time is at a high level. That means, Gould notes, "the worker pool is much larger than the unemployment rate suggests."

"It shows there is room for growth," Mr. Gould said.

It is reasonable to assume that most of the above trends will continue.

As Gould points out, continued growth in the labor supply is a crucial step toward achieving a "soft landing," because it will help rebalance the job market and reduce upward pressure on wages without undermining employer demand. If this trend continues, the labor market can also remain strong.

Boosting worker productivity also helps keep the labor market strong. Diane Swonk, chief economist at KPMG, said that boosting productivity is "the number one way to maintain wages without raising unemployment."

Productivity is hard to measure and has been low for much of the past decade. But Mr. Swank and other economists argue that this may be starting to change, in part because changes in the labor market over the past few years have shifted workers to better-suited, more productive jobs, and as the quit rate falls, the output of workers who adjust to new jobs increases.

At the same time, the growing popularity of artificial intelligence technology promises to be the main way to increase productivity, and may already be doing so. Research by University of Chicago economist Chad Syverson shows that when a new technology is just emerging, its contribution to productivity is often underestimated, as is the case with artificial intelligence today, because its output is intangible.

"It is worth bearing in mind that we may underestimate real productivity growth for some time," says Mr. Sieverson.

No one knows where the US economy will go. If inflation picks up again, interest rates will be much higher than expected, making it harder for the job market and the broader economy to maintain their current strength. But for now, the recent slowdown in job growth has clearly not weakened the labour market, which remains highly resilient even in the face of high inflation and rising interest rates.

The Fed's ultimate goal is to rebalance supply and demand in the labour market. The Fed's policy tools are designed to damp demand, and the decline in job openings shows that the Fed's jobs are working. But factors such as healthy consumer spending, increased fiscal stimulus and a boom in small business start-ups are keeping labour demand high. At the same time, rising labour participation is bringing relief to supply problems, and new technologies are expected to help workers become more productive. That said, while unemployment remains low, there has been significant progress on both sides of the supply-demand rebalancing equation.

If the labor supply and demand situation continues to improve, and the balance between supply and demand is successfully achieved without causing a surge in layoffs, it will be unprecedented in modern history, but then again, much of what the U.S. labor market and the broader economy have experienced over the past three years is also unprecedented.

"I do think this time is different, because what the labor market and the economy are going through is completely different from what it was in the past," Mr. Pollack said.