The June jobs report showed 850,000 new jobs added and was in many ways a Goldilocks report that will likely reinforce the strength of financial markets. But the underlying trends in the labor market defy any prior cycle in ways that could add to inflation, complicate Fed policy and have important implications for growth.
Another strong report in June
Payrolls rose by 850,000 in June, a better than expected gain driven once again by significant hiring in leisure & hospitality, which added 343,000 jobs. The government added 188,000 jobs, meaning private sector hiring was 662,000—still a strong number, but not quite the blockbuster of the reported headline. Our economy added 3.3 million jobs in the first half of 2021, the result of powerful economic momentum and the continued post-pandemic reopening.
Jobs recovery continues, but is incomplete
Source: Bureau of Labor Statistics, as of July 2, 2021.
The unemployment rate rose to 5.9%, up from 5.8% in May, a seeming inconsistency given the strong payroll increase. Remember, the unemployment rate comes from a different data release than the payroll report, and sometimes the two contradict each other. The household survey showed jobs falling by 18,000. These numbers don’t tend to diverge for very long, and we don’t read much into it.
Outside of the robust jobs recovery in leisure & hospitality, June saw continued strong gains in other “reopening” areas including retail trade and transportation, which together added 166,000 jobs. Other sectors, however, continue to see more tepid hiring trends. The manufacturing sector, for instance, added only 15,000 jobs despite business confidence remaining exuberant, with the manufacturing ISM at 60.6 in June. Construction jobs fell by 7,000, the third consecutive monthly decline. This is in sharp contrast to other housing market data, which shows high demand for new construction. Increasingly, anecdotal evidence is showing sluggish hiring is due to a constrained labor supply.
Labor supply-demand mismatch
This deserves significant airtime. The U.S. economy has 6.8 million fewer jobs than it did pre-pandemic, but we also have 9.2 million job openings and 3.4 million people who have dropped out of the labor force for a variety of reasons. I often remind readers that the labor market is one of the most inefficient markets out there. But this extreme, sustained mismatch is driving several trends that have huge implications for the economy.
Wages are at the top of my list of data to watch in Q3. The focus on inflation is already intense given CPI at decade highs in May, but to a large degree this jump in consumer prices was anticipated. Higher wages, however, are highly unique at this stage in an economic recovery. Typically, average hourly earnings fall during the first several years of an expansion. Right now, wage pressure is looking more typical of what we see in a mature, overheating expansion.
Wages are accelerating post-COVID
Source: Bureau of Labor Statistics, FS Investments, as of July 2, 2021.
Note: Average hourly earnings monthly gain, average of 2015–2019 vs. Jan.–Jun. 2021. 2020 excluded because of significant distortions.
In the first half of the year, monthly wage growth far outpaced pre-COVID trends. This was particularly true for leisure & hospitality, retail trade and transportation/warehouse workers. Rising wages for these groups have huge implications because they cover enormous swaths of employment. The top four categories shown in the graph above together account for 39% of all jobs.
Clearly the labor shortage is exerting upward pressure on labor costs, with enormous implications for inflation. Businesses facing higher costs must choose to either suffer lower profit margins or raise consumer prices. During the last expansion, businesses chose the first option and, despite rising wage pressure, did not pass along those higher costs to consumers; as a result, inflation stayed well controlled. This time around, this dynamic needs to be watched carefully.
In June, average hourly earnings rose 0.3%, a more moderate gain, and details suggest some of the sharp wage price increases may be fading or normalizing. Take leisure & hospitality as an example: In June, wages fell -0.6% after five months of rapid acceleration. But the average wage of $18.04 per hour is still 6.3% higher than in January 2020.
Labor shortage, growth and the second half of the year
This is the real meat of the labor market discussion and how it connects to economic growth. There has been a significant drop in labor force participation, which remained at 61.6% in June, well above the pre-COVID rate of 63.4%. People not only quit or lost jobs during the pandemic, but many then decided to not look for jobs in the future.
The reasons for this are myriad: early retirement, concerns about getting COVID-19 or the need to care for children. Households remain flush with savings and many are still receiving unemployment benefits. In the coming quarter, as supplemental unemployment ends and consumers burn through savings, we may yet see some portion of these people return to the job market.
But at what price? A Fed labor market survey asks workers how much they would have to earn to reenter the workforce and take a new job (an economic concept known as the reservation wage). The March 2021 survey showed the reservation wage has risen to $71,403/year, a 15.6% increase from a year prior.
Less labor force participation also has big implications for GDP. At the end of the day, our economic growth is determined by how fast productivity is rising and how many more bodies we have to create output. Labor force growth was already set to decelerate to close to zero throughout this decade due to demographic trends. The consensus expects U.S. GDP to grow far above potential in the coming years, with 2021 growth of 6.6% and 2022 growth of 4.1%. But with fewer workers, these growth rates will become much harder to attain. In the second half of the year, if the participation rate remains low, expect growth forecasts to be revised down, perhaps significantly.
The Fed’s job just got even harder
The Fed’s recent swing toward hawkishness is in part a response to strong growth, signs of higher inflation and evidence that the economy remains on track to return to full employment. On the surface, the full-employment concept reflects the equilibrium rate at which our economy can add jobs without causing wage pressures to overheat. Indeed, in 2016, when the unemployment fell below the Fed’s estimate of full employment, the Fed started raising rates. Lower labor force participation, however, artificially lowers the unemployment rate.
Source: Bureau of Labor Statistics, Federal Reserve, FS Investments, as of July 2, 2021.
The Fed has messaged that it is looking at a huge variety of employment metrics, not just the headline unemployment rate number. Nevertheless, markets may simplistically focus on the rapidly falling unemployment rate. Finally, full employment is only an estimate; it cannot be directly observed. Less than a decade ago, the Fed’s estimate of full employment was 5.6%, very close to where unemployment is right now. This may cause a headache for Fed Chair Powell, who is clearly trying to message more patience on the rate hike front, and could further widen the divergence on the part of the FOMC.
Good news for investors for now
For investors, Friday’s jobs report was good news. Our economic recovery continues and growth is strong. There is a broad expectation that labor supply will return in the fall as schools fully reopen, extra unemployment benefits disappear and household savings wane, driving more people to seek jobs. But inflation will remain the market focus, and wage dynamics are an important part of the inflation cycle that is still overlooked. Interest rates remain low, equities are reaching for fresh highs and credit spreads continue to tighten. What could possibly go wrong? Looking ahead, wage inflation and labor force dynamics could complicate the Fed’s ability to navigate the early steps of removing financial market support. Unfortunately, Fed messaging around rate hikes often can be the big spark that ignites volatility.