As we look forward to the July payroll report, to be released Friday, we consider the most important factors to look for and their potential market impact. While the knee-jerk reaction and immediate attention always falls to the headline nonfarm-payroll number and to the headline unemployment rate, today, the wage data carry outsize influence.
Fed Chairman Janet Yellen has been highlighting the importance of wage inflation in gauging the strength of the underlying labor markets. Here's a critical part of semiannual monetary policy report testimony from last month:
“Although the economy continues to improve, the recovery is not yet complete. Even with the recent declines, the unemployment rate remains above Federal Open Market Committee participants' estimates of its longer-run normal level. Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment. These and other indications that significant slack remains in labor markets are corroborated by the continued slow pace of growth in most measures of hourly compensation.”
Last December, the Fed forecast that unemployment rates wouldn't reach 6% until December 2015. Today, the unemployment rate stands at 6.1%. Unemployment rates have declined much faster than the Fed expected for two critical reasons. First, most of the decline up until the June employment report was due to falling participation rates.
That means unemployment was falling for the wrong reasons: Discouraged and/or older workers were leaving the workforce. But in the June report, we finally saw unemployment rates decline (to 6.1% from 6.3%) for the right reasons: Participation rates were stable, and more of the previously unemployed got a job.
In the bond markets, policy accommodation means zero interest rates for a lot longer than the FOMC has indicated. That can be seen in the expectation of a market interest rate that is 40 basis points lower for future Fed policy (for example, to year-end 2015) than that found in the central bank's Statement of Economic Projections.
But such expectations are vulnerable to reassessment. The support for the Fed's view of significant labor market slack increasingly relies on the relative lack of wage pressures. This makes intuitive sense. It is hard to get wage inflation when too many qualified applicants exist for a given job.
The Fed's preferred measure of labor market inflation, the Employment Cost Index, captures not only wages but also bonuses, benefits, Social Security and taxes.
Unlike the wage figures we receive each month, the Bureau of Labor Statistics publishes the ECI only quarterly. However, its breadth and stability over longer time frames are useful.
INDEX HAS BEEN STABLE
The index has been broadly stable, showing nominal year-over-year increases of 2% since the onset of the recovery. Hence, Ms. Yellen concluded in July that measures of wages display “a slow pace of growth.”
But wages are a lagging economic indicator. More forward-looking indicators (survey-based measures in particular) suggest that wage inflation is about to accelerate and that in two to three quarters, the Fed's preferred measure of wage inflation will show significant acceleration. If so, monetary policy may be too accommodative then.
Any signs of wage inflation in Friday's report will be critical to the outlook for Fed policy. Faster acceleration in wage inflation suggests a faster period of liftoff from zero interest rates.
BOLSTERING FED'S VIEWPOINT
Conversely, a continued lack of inflation or a rise in the participation rate and higher unemployment rates (as increasing numbers of previously discouraged workers return to the labor force) will bolster the Fed's viewpoint.
In contrast to that view, leading indicators for wage inflation point to the Fed needing to raise rates sooner than markets expect.Given the high degree of complacency in short maturity exposures in bond markets, investors should consider how much risk they are taking in this area of the yield curve.
When low for longer gets mugged by the reality that the Fed cannot maintain its zero interest rate policy for as long as the bond market expects, short-duration strategies will be the most vulnerable area of that market for investors.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.