Even The Fed Is Getting Nervous About This Recovery

Washington's economic reports often come and go without much impact on the outlook. But every once in a while there's a real eyepopper--like the July employment report. Last month's job data look more like an economy in recession than in recovery. The numbers not only confirm that the upturn is laboring, they fuel concern that the rebound could fizzle out by yearend.

If that sounds like an overstatement, consider the following: In July, payrolls shrank for the second consecutive month. The workweek fell sharply, erasing big gains in May and June. And weekly earnings posted the second-largest drop on record. It's not the kind of report you expect three months or so into a recovery.

The numbers clearly got the attention of the Federal Reserve Board. The Fed eased monetary policy on Aug. 6, for the first time since Apr. 30, by cutting the federal funds rate on interbank lending by a quarter point, to 5 1/2%. The easing could lead to a lower prime rate, currently at 8.5%, but profit-starved banks may hold off until the Fed takes an even bolder move by cutting the highly symbolic discount rate.

Even though the spread between the prime and banks' cost of funds is already gaping, banks seem to be in no hurry to boost lending. Instead, their emphasis is on satisfying stricter regulators, meeting higher capital requirements, and dealing with existing bad loans. Consequently, further Fed easing may be necessary to end the credit crunch, but another rate cut will also depend upon future reports on economic growth and inflation.

After seeing the employment report, analysts had expected a cut in the federal-funds rate at the upcoming policy meeting on Aug. 20. Taking the action now only underscores the Fed's concern about the fragile state of the economy. Indeed, the Fed's own report on business conditions in each of its 12 districts, indicates that the recovery is slow and uneven.


Worries about weak money growth also prompted the Fed's action. The central bank's favorite money measure, M2, had been expected to rise for the week ended on July 22, but it fell a steep $5.5 billion.

The pace of M2 growth has dropped to an annual rate of only 2.7% from the Fed's fourth-quarter base, barely above the bottom of the central bank's 2.5% to 6.5% target range. The July employment report heightens concern that exceptionally weak money growth for the early stages of a recovery may be inconsistent with the Fed's desire for a sustainable upturn.

The weak job data also put the kibosh on inflation fears. So much so, that the bond market rallied after the Fed's move. Past easings often have pushed long-term interest rates higher on bond traders' fears that easier money might fuel faster price growth.

But this time, long-term rates declined, even with the upward pressure from the Treasury Dept.'s record $38 billion quarterly refunding. The rate on 30-year Treasury bonds, for example, fell to 8.17% on Aug. 6. Only two weeks earlier, it stood at just under 8.5% (chart).


Lower long-term rates will eventually help the economy's credit-sensitive sectors, but for now, the labor markets make it clear that the recovery is off to a rocky start. Nonfarm businesses let go 51,000 workers in July, following a cut of 21,000 in June. Employment had jumped by 151,000 in May, so it remains only about 80,000 jobs above the recession's low point in April.

The most disturbing feature of the July employment report was a sharp drop in the workweek. Work time had risen from 34 hours a week in April to 34.3 hours in May and to 34.5 hours in June, engendering hope that the recovery was firmly in place. When companies start stretching their workweeks after a recession, it's usually a good sign that they will be adding workers in the months ahead. In July, however, the workweek tumbled back to 34.1 hours, calling further job gains into doubt.

As a result, aggregate hours worked in July fell below the second-quarter average (chart). Since overall work time is a good proxy for economic activity, that means the economy is off to a poor start in the third quarter.

Job declines last month were concentrated in services and construction. Builders handed out 22,000 pink slips, suggesting that the housing rebound may have cooled off in July. But it certainly implies that the recent strength in home construction has not offset the ongoing weakness in commercial and industrial building.

But the recovery's biggest problem could be in services. Service producers cut their payrolls by 41,000 workers in July. But the losses were greater than that suggests. The small, but rapidly growing, health care industry added 35,000 workers last month. Excepting that rise, service employment fell by 76,000 jobs in July, and it is no higher than it was in April (chart).


Service employment could be a drag on the economy for months to come. The reason is poor growth in service productivity that is keeping upward pressure on labor costs at a time when service prices are slowing down. The result is a squeeze on profit margins that is forcing cost-cutting, and that means layoffs.

Productivity, measured as output per hour in the nonfarm economy, rose at an annual rate of 1.9% in the second quarter, fueled by a sterling gain of 3.6% in manufacturing. The overall gain was the largest in nearly three years, but that's because output per hour always improves in the early stages of a recovery, as production outpaces employment growth.

Service productivity managed to increase last quarter as well, but there has been no long-term improvement in nearly a decade. Over the year, service productivity has hardly grown. Service industries are now coming to grips with their past failures to improve efficiency, and the price of those shortcomings is service jobs.

Excluding health care, which accounts for only 10% of all service jobs, service employment is in the sharpest contraction in the postwar era. Since about 75% of all jobs are in services, an economic recovery will not be assured until service employment begins to grow again.

There is still no sign that manufacturers are ready to start adding workers, either. Factory employment rose by 13,000 in July, but the Labor Dept. said that the job count in the auto, textile, and apparel industries rose because some temporary shutdowns and layoffs that usually happen at this time of year did not occur until after the government's survey period. Otherwise, factory employment would have fallen last month.

About the only upbeat report on manufacturing came from the National Association of Purchasing Management. The Purchasing Managers' Index rose to 51.8% in July, and it hovered above 50% for the second consecutive month (chart). That's a dividing line between a rising and falling factory sector.

However, other factory data aren't so reassuring. The latest survey of manufacturers' expectations by Dun & Bradstreet shows a loss of confidence in July by factories about orders, employment, and prices. A more concrete indication of that was the July drop in the factory workweek, to 40.7 hours, from 40.8 hours in June. That means industrial production last month slowed from its rapid pace in recent months.

Finally, perhaps the most ominous number from the labor markets was the steep 1.3% drop in average weekly earnings in July. That means personal income apparently fell at the beginning of the third quarter. The decline comes after consumer spending in the second quarter grew three times faster than incomes. Obviously, third-quarter outlays are on a weak footing, and the recovery cannot continue if consumers don't lead it.

At best, the July job data portend an exceptionally sluggish recovery with questionable staying power. At worst, they may be saying that, for a broad swath of the economy, the recession never really ended.

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