Looking ahead to 2015, the labor market is expected to play the key part in the Fed’s path to policy normalization. However, as we learned from New York Fed President Dudley last week, the Fed will also consider the reaction in financial markets.
Recall that the employment report is comprised of two separate surveys. The Establishment Survey, which covers about 144,000 businesses and about 554,000 individual worksites, yields data on nonfarm payrolls, hours, and earnings. The Household Survey, which samples about 60,000 households, provides data on the unemployment rate and labor force participation (as a rule, the Household Survey does not generate good estimates of levels, such as the size of the labor force or the number of unemployed, but you do get reasonable estimates of ratios, such as the unemployment rate).
Job growth has been relatively strong this year. In fact, in the first 11 months, nonfarm payrolls have risen more than in any year since 1999. Nonfarm payrolls were reported to have risen by 321,000 in November, the largest monthly gain in nearly three years. However, one should take this large gain with a grain of salt. There is a fair amount of noise from month to month and the data are subject to revision. Still, the underlying trend in payrolls is encouraging. Average hourly earnings rose 0.4%, but that too is subject to revision and followed a modest 0.1% rise in October – up 2.1% from a year ago, still well below what might be considered a “normal” pace (3.5% to 4%).
The Household Survey data were less impressive in November. The unemployment rate was unchanged at 5.8%. The employment/population was flat (at 59.2%), up only gradually over the last year (58.6% in November 2013). The e/p ratio for the key age cohort, those aged 25-54, was up moderately over the last year (76.9%, vs. 76.0%), suggesting that labor market slack is being taken up only gradually.
The percentage of people working involuntarily part time and the long-term unemployment rate have both been improving, but they remain relatively high by historical standards.
Monetary policy is expected to be driven by Fed officials’ interpretations of the job market data in the months ahead. How much slack remains in the job market? How rapidly is that slack being taken up? How much wage pressure are we likely to see, and will firms be able to pass higher labor costs along? These are going to be hard question to answer. As we saw in the November Employment Report, the data often send conflicting messages. Monetary policymakers will have to weigh the evidence, but also use that evidence to make projections.
Last week, New York Fed President William Dudley presented his 2015 economic outlook and the implications for monetary policy. What stood out were his comments on the Fed’s reaction to the financial markets’ reaction to monetary policy. The Fed not only has to react to what the data mean for the economic outlook. It also has to react to changing financial conditions. Consider the unhelpful taper tantrum in 2013, when the Fed didn’t really do anything, vs. this year’s drop in bond yields as the Fed gradually reduced its monthly asset purchases. The markets could overreact to Fed policy signals or move in the wrong direction. It’s enough to make your head spin. The October FOMC minutes show that officials were fearful that financial market participants could misinterpret a decision to abandon the “considerable time” phrase. What might the markets do when the Fed signals that a rate hike is imminent?
Ultimately, investors should not fear the Fed. The first hike in short-term interest rates should be viewed as a natural consequence of the improvement seen in the overall economy. There is some danger that the markets might overreact, but the Fed is likely to take that overreaction into account as it considers possible further action – 2015 is going to be fun!