Wednesday, March 14, 2012

The US labour market and the new structural rate of unemployment

The last three months has seen 734k new jobs in the US, the largest three-month increase since 2006 (excluding the temporary Census jobs in 2010). The unemployment rate is now down to 8.3% and after two months of decline, the participation rate also staged a small recovery in February. That’s all welcome news.

One of the missing features of the recovery thus far has been the mutually reinforcing cycle of stronger growth leading to jobs growth which in turn leads to higher growth via consumer spending. The constraining factor for the economy generally has been the structural nature of the recovery. Households have been deleveraging and consumption and residential construction have been subdued.

In that environment we have looked to exports and investment to be the driving force in the recovery. That would also require a change in fortune for the US manufacturing sector after many years of decline. Indeed manufacturing has been punching above its weight in terms of jobs growth. While manufacturing represents 10% of the US economy, it has accounted for closer to 15% of the jobs growth since the trough in the labour market at the beginning of 2010.

It is no coincidence that this latest purple patch for jobs growth has coincided with a levelling off in labour productivity growth. The labour market goes through various stages as an economy moves through the cycle. Typically as an economy goes into recession jobs are lost, both as a result of lower sales and as firms look to shore-up profitability by cutting costs.

Those efficiency gains are eventually exhausted meaning that as the economy grows again, firms have to turn to hiring again to meet demand. This is the point the US economy now appears to be at. After productivity gains in excess of 6% in year to March 2010, growth has now slowed to only 0.4% in the 2011 calendar year.

Our assumption is that US firms have exhausted the productivity gains to be made from their existing workforce and are now turning to hiring new staff to meet (albeit soft) demand. While that’s a positive story for the labour market, it has negative implications for margins and earnings.

The next phase as the labour market continues to grow will be for wage pressures to start to emerge as skills shortages develop. With still elevated rates of unemployment (and underemployment) across the developed world that appears to be some way off.

However, it may not be as far away as a simple glance at unemployment rates might suggest. To cut a long story short, our thinking on the US (and other developed economies) labour market goes like this: given the structural nature of the recovery there is likely to be larger-than-usual mismatch between the skills of the available workforce and the new jobs that are being created. Structural unemployment (or as Milton Freidman called it: the non-accelerating inflation rate of unemployment or NAIRU) is likely to higher than it was pre-GFC. That means skill shortages and wage pressures will emerge earlier in the cycle.

The big question is where is the structural rate now? The easy answer is: “higher than it used to be”. In the US the pre-GFC NAIRU was generally thought to be around 4.5%. There are a couple of estimates of where it sits now. The Federal Reserve’s long-term unemployment rate forecast is in the range 5.2% to 6.0%. The International Monetary Fund thinks the structural unemployment rate in the US could be as high as 7% (see “Has the Great Recession Raised US Structural Unemployment?” WP/11/105). I think it’s closer to the IMF estimate.

The reality is we are not really going to know where it is until we get there. How we know when we are getting close is therefore going to be quite critical, especially for central banks and the setting of monetary conditions. To that end we will be watching wage and skills shortage data closely over the months ahead. It is most likely going to be a while before we have to start to fret. In the meantime, many central banks are likely to continue easing, but we believe that the first signs the easing is over, and the tightening is about to begin, will come from the labour market.