Call it the Federal Reserve's Catch-22. And blame--or credit--Wall Street's increasing influence over the U.S. economy for causing it.
The Fed has made it no secret that it wants domestic demand to slow a notch in order to prevent labor-market constraints from lifting wage and price pressures. The Fed's primary lever to restrain demand is tighter financial conditions, usually achieved by raising short-term interest rates. Until recently, weaker stock prices and sharply higher bond yields, brought about by fears of Fed rate hikes, appeared to be accomplishing some of the desired tightening.
But here's the catch: Recent data on employment costs and average hourly earnings have eased fears in the financial markets about the need for the Fed to lift rates again. So, if the Fed stands pat at its Nov. 16 policy meeting, it will further encourage the stock and bond markets to rally, putting stimulus back in the economy and undoing much of the market tightening that the Fed had wanted.
Already, the 30-year Treasury bond yield has dropped from 6.4% on Oct. 26 to 6.07% on Nov. 9, reversing all of the rise since early October (chart). And since mid-October, the Dow Jones industrial average has risen some 600 points, adding back half of the wealth lost in the previous six weeks. The Fed's dilemma: If it wants the markets to help tighten financial conditions, it has to keep the threat of higher rates alive. And that will be hard to do without following through on the threat.
Low consumer inflation gives the Fed some breathing room. As a result, economists are evenly split on whether the Fed will raise the federal funds rate on Nov. 16. About half expect a quarter-point hike to 5.5%; the other half look for no change.
However, the October producer price report raised a yellow flag about the inflation outlook. Although finished goods prices fell 0.1%, core prices excluding energy and food increased a faster-than-expected 0.3%, led by cars and drugs. Moreover, further back in the production process, core prices of intermediate materials and supplies, as well as raw materials, continue to accelerate sharply. And amid strong demand, businesses may find it easier to pass these higher costs along.
Even so, the markets know that the Fed's No. 1 concern right now is tight labor markets. That's why the October employment report fueled market hopes that the Fed will hold rates steady. Even though the labor markets remained tight enough to cut the unemployment rate further, Wall Street rejoiced at the lack of any wage pressure last month, taking that as another sign that a rate hike was less likely.
Nonfarm payrolls increased by a large 310,000 after hurricane-related weakness in September, and overall hours worked rose strongly, suggesting fourth-quarter economic growth on the order of 4%. The jobless rate slipped from 4.2% to 4.1%, the lowest level since 1970, and at the current pace of job growth, the rate will continue to edge lower. Even so, hourly pay edged up a mere penny in October.
Wall Street latched on to two tidbits of the report. First, the 310,000 gain was right on market expectations, and it followed a rise of just 41,000 in September. When smoothed out over three- or six- month intervals, job growth is slowing. Second, the 1 cents pay raise means the yearly wage growth remains tame. The Dow rose 65 points on Nov. 5, the day of the report's release, while the Treasury yield slipped to 6.05% from 6.10%.
Closer examination of the October employment report, however, shows that market optimism about future monetary policy may be misplaced. Most important, the report did not answer a key concern: Is job growth slowing because businesses are not hiring, or because they cannot find qualified people to hire (chart)? The distinction is critical. If slower demand is causing businesses to scale back their need for labor, then wage pressures cannot take hold. If, instead, jobs are not rising because there are too few workers to fill them, then businesses will start to raise wages to attract qualified people. And unless those fatter paychecks are met with greater productivity, the wage acceleration will be inflationary.
Right now, more of the evidence supports the notion that the supply of labor is stretched too thin. For example, the participation rate--the percentage of adults in the labor force--has held steady at around 67% for the past year. True, that is a record high, but given the widespread perception that jobs are easy to get, more adults should be jumping into the labor pool, and the participation rate should be rising. Second, the labor force has been growing about 1% this year. That's slightly less than the adult population is growing, and the labor force is rising more slowly than it did in 1997.
An exception in this tight-labor-market era is the continued deterioration in factory payrolls. Manufacturers cut 15,000 workers in October, bringing the total number of layoffs to 262,000 so far this year. That's in addition to the 227,000 jobs cut in 1998.
The slew of pink slips is curious, given the better tone in manufacturing. Output is accelerating this year thanks to inventory rebuilding and the rebound in exports. Better productivity does not fully explain the layoffs: The factory workweek remains quite high by historical standards. Also, the factory jobless rate is no higher now than it was in early 1998, when factories were still adding workers.
A shift from factory work to service positions, which generally pay less than those on the assembly line, may partly explain why average hourly pay has not accelerated. Over the past year, hourly pay is up 3.6%, down from the expansion's peak of 4.4% in April, 1998. In recent years, factories have been heavy users of temporary workers, which are counted among service-sector payrolls, and employment at temporary- help agencies has picked up sharply this year.
In addition, higher energy prices are causing those pay raises to go less far than they did before. Wages adjusted for inflation are up less than 1% over the past year, the weakest gain in 2 1/2 years (chart).
But if demand for labor continues to outstrip supply, wage deceleration cannot continue indefinitely. Policymakers know that. Already, in its latest Beige Book, the Fed noted that "many districts report a pickup in wage increases." That language was stronger than the Fed's view on wages in the few previous Beige Books.
Because mild consumer inflation removes the urgency to hike rates, the Fed may well decide to wait before raising them again. That seems to be the betting in the financial markets. However, this is also a Fed whose hallmark has been preemptive policy. Amid tight labor markets and rising price pressures in the production pipeline, another tap on the economy's brake in 1999 could make the Fed's job a lot easier in 2000.