Fueled by tax cuts and low interest rates, the U.S. economy has been exceeding expectations on almost every front lately -- except job creation. Retail sales remain strong, according to an Oct. 15 Census Bureau report. Intel (INTC ), General Motors (GM ), and Merrill Lynch (MER ) have led a wave of companies beating third-quarter earnings forecasts. A stock-market surge is boosting the confidence of CEOs and small investors alike. Exports are up smartly, businesses are investing, and a surge of tax receipts is helping to reduce the budget squeeze across the country. Economists predict the Commerce Dept. will announce on Oct. 30 that gross domestic product grew in the third quarter at annual rate of between 5.5% and 6.5% -- the best since 1999.
Job growth, however, has been the missing link. Although the U.S. economy created a modest 57,000 jobs in September, it lost jobs in the third quarter as a whole. In fact, the third quarter was a spectacular anomaly: the only time in at least 40 years in which the economy actually shed jobs while growing at a rate of 5.5% or better. In September, 9 million people were jobless. Nearly a quarter had been out of work for at least half a year.
But here's the good news: The job market has almost surely turned the corner. In the months to come, the economy is likely to build on its September gain and generate more jobs. Early signs of a pickup, especially in the tech sector, are already showing up. On Oct. 14, Intel Corp. said profits more than doubled from a year earlier on a 20% revenue gain. The next day, IBM (IBM ) announced a 5% gain in operating earnings and predicted it would need to add 10,000 jobs next year in key skill areas, including services, hardware, and software. Economists and policymakers, once gloomy, are getting optimistic about a broader jobs resurgence as well. Initial claims for unemployment insurance in early October fell to an eight-month low of 382,000. Fed Chairman Alan Greenspan is hopeful that the jobs market is turning up, while Federal Reserve Board Governor Ben S. Bernanke told Congress on Oct. 14 that he expected "significant improvements" in employment.
What has changed? In a nutshell, demand is so robust that employers have reached a tipping point. They can't fill all the orders they're getting without hiring more workers. Beyond tech hiring, the stock-market rally signals future hiring in the financial services sector. And even manufacturing -- where outsourcing has taken a tremendous toll -- is hiring selectively as the global economy gains speed. J.P. Morgan Securities Inc. estimates that world growth in the third quarter was the fastest in three years.
LACK OF CONFIDENCE
To be sure, it will take many months for the Great American Job Machine to crank up fully. Labor markets turn slowly. And with the sustainable rate of productivity growth higher than it was a decade ago, it takes stronger economic growth than before to generate jobs. Industries such as textiles, low-tech electronics, and autos are likely to see continued job losses because of rapidly improving productivity or foreign competition.
But don't worry about a repeat of the third quarter, when the lack of hiring was extreme by any standard. To get an idea of how big the jobs shortfall was, try comparing the third quarter with other recent quarters when the economy grew as strongly. Since 1960, there have been eight quarters when the economy grew at an annual rate between 5.5% and 6.5%. On average, employment in those quarters increased at a 3.4% rate. If history had repeated itself, the economy should have created 1 million nonfarm jobs in the third quarter. Instead, jobs fell nearly 150,000 from their second-quarter average, for a shortfall of about 1.2 million.
The killer was lack of confidence. Manufacturers, wholesalers, and retailers, disbelieving the strength of the recovery, squeaked by with selling goods off their shelves. As a result, the ratio of inventories to sales hit a record low in the quarter. Now, these companies have to restock -- which means more production and more jobs.
SOFTWARE IS FIRMING UP
Nowhere is such news more welcome than in the hard-hit tech sector. The good news extends beyond Intel and IBM. The Labor Dept. says jobs in computer-systems design rose in September. Job losses seem to have stopped in software and data storage, among other areas. EMC Corp. in Hopkinton, Mass., which makes storage systems, has stabilized employment at 17,000 -- after a one-third decline in its payrolls since 2001.
In manufacturing, just a partial revival in employment would go a long way toward ending the jobless recovery. Going by the historic pattern for similar growth spurts, the sector should have created more than 70,000 jobs in the third quarter. Instead, it lost more than 150,000. Manufacturing accounted for about 19% of the quarter's job shortfall, even though it accounts for only about 11% of all jobs.
A cyclical rebound in demand won't bring back all those manufacturing jobs -- not with productivity growth and offshore competition so strong. But it will help. David Huether, chief economist at the National Association of Manufacturers, estimates that only half the factory jobs lost are gone for good. He predicts a rebound in industrial machinery, electronics and computers, transportation gear, and fabricated metals. The latest good news for the sector, on Oct. 15, was a sharp rise in the New York State manufacturing index measured by the Federal Reserve Bank of New York.
FEELING FLUSH AGAIN
In the service sector, too, companies are feeling stretched. On Oct. 3, the Institute for Supply Management reported growing backlogs of work in insurance, entertainment, business services, and construction, among other sectors. That, too, points to more hiring. Likewise, a pickup in retail sales is likely to trigger hiring at store chains, where 19,000 jobs were lost in the third-quarter. And financial services companies are feeling flush again. The Standard & Poor's 500-stock index is up 19% so far this year, including a rise of 5% in the first half of October alone. On Oct. 15, Merrill Lynch & Co. CEO Stanley O'Neal, fresh from reporting higher-than-expected earnings, announced the end of a two-year salary freeze, raising hopes that new jobs will soon follow. And strengthening tax receipts should help strapped state and local governments, which lost more than 30,000 jobs in the third quarter -- when, if historical patterns had held, they should have added more than 140,000.
How strong will the job recovery be? It's hard to tell, because more than ever before, employment growth comes from the creation of brand-new jobs. Creating work from scratch takes considerably longer than rehiring people to old ones, argue Erica L. Groshen and Simon M. Potter, economists at the Federal Reserve Bank of New York, in a recent paper. Employment won't really go gangbusters until innovation spawns new industries. Doug Henton, president of Collaborative Economics, a Mountain View (Calif.) consulting firm, sees the future in the nexus of information technology, biotech, and nanotechnology.
These days feel a lot like the anxious mid-1990s. Back then, people worried that bad times were here to stay. What they didn't see were the good times right around the bend.
By Peter Coy in New York, with Robert D. Hof in San Mateo, Calif., Michael Arndt in Chicago, and bureau reports