The Labor Shortage Is Real: Here's What That Means for the Fed and the Market

On Friday the U.S. Labor Department released the May employment report. It seems odd to call a gain of 559,000 a weak report, but with the economy still some 7.6 million jobs below pre-pandemic levels, the pace of gains the last two months is clearly disappointing. Most of the time when payroll gains are poor it reflects weak demand for labor. Right now we clearly have a labor supply issue, which suggests a very different interpretation. Here is my reaction and what I think it means for markets. The Labor Shortage Is Real We usually assume the vast majority of people who are unemployed would like a job but just can't find one. This has a straight-forward policy response. We need companies to be more willing to hire, which in turn means we need to goose demand for their products. It is obvious that lots of companies want to hire. The Labor Department's official job openings survey recently surged past its pre-COVID level and is now at an all-time high as a percentage of the total labor force. Arguably labor demand is as strong as it has ever been. Clearly the problem is that people who could work just don't want to. The question then becomes whether this is a temporary condition or a more lasting one. Are the Extra Unemployment Payments to Blame? A lot has been made of the fact that some subset of workers were making more money collecting unemployment than they were working. This was due to a supplemental $300/week that was part of the stimulus bill passed at the start of this year. There's no doubt that these extra payments are probably influencing some people's willingness to work, but how pervasive is it? It is impossible to know for sure, but it seems very likely any effect from extra UI payments is waning. With the $300/week extra payments, the break-even wage rate to go back to work is about $16/hour. If you are offered a job making more than $16/hour you are better off taking the job. For the record, the 25th percentile worker makes $16.42, so basically 75% of jobs out there pay more than this break-even wage. Second, the $300/week is only available as long as someone remains eligible for unemployment payments at all. In most states this is 26 weeks. So in most cases, if you lost your job anytime in calendar 2020, you either already have or are about to lose your benefits period. The last time Initial Jobless Claims were rising was late January, so we could mark that as the most recent time layoffs were on the rise. Most of the people laid off at that time would only have four weeks or so left on their claims. Lastly, and perhaps most damning, is that most of the job growth the last two months has come in lower wage sectors. The three largest percentage job gains in May were Entertainment/Recreation, Accommodation, and Food Services. Those same three were the largest gainers in April as well. It's the other sectors that aren't growing much. All of this suggests to me that stimulus is probably a minor issue holding back labor supply. There's almost no way this alone explains why the labor force is still 3.5 million people short of the pre-COVID level. To the extent this is influencing labor supply, that effect will be diminishing rapidly. In May, 25 states announced they would be ending the supplemental unemployment benefits early, and the program ends for everyone in the beginning of September. What if the Labor Force Just Grows Very Slowly? At the start of the year I assumed the labor force would grow pretty rapidly, especially as vaccine distribution became more widespread, the weather warmed up, and COVID-related restrictions were relaxed. I don't want to over-extrapolate from two months worth of data, but at the moment it doesn't seem like that's happening. Furthermore, it doesn't seem like anything that is quickly reversible is the cause. Maybe it is too early to say it definitively, but we should at least consider the possibility that labor force growth will continue to be relatively slow. That would have a few very important consequences. No 'String' Federal Reserve Chair Jerome Powell has recently said that the Fed was looking for a string of job growth numbers near 1 million before considering removing any amount of policy accommodation. Right now there just aren't enough people looking for work such that a string of 1 million+ job gains is even possible. Ostensibly this means the start of Fed rate hikes is now further away. Certainly that's how the bond market is currently taking it. I think that's completely the wrong take. The Goalposts Have Been Moved The Fed has been operating on the implicit assumption that everyone who was employed in February 2020 would still want a job once the pandemic was over and the economy healed. If that is your assumption, then a figure like the official unemployment rate isn't that helpful, because that calculation excludes people who have dropped out of the labor force. One alternative measure is the Employment to Population ratio, or EPOP. As the name suggests, this simply takes the total number of employed people and divides it by the total adult population. A similar measure is the Prime Age EPOP, which only counts people between the ages of 25 and 55. Both measures are around 4% below pre-pandemic levels, and if they were to fully recover it would suggest something like 8 million jobs added. If that's how Powell & co. were thinking, no wonder they wanted to see a string of 1 million+ job gains. However, if there are a set of people who were employed pre-COVID who are now satisfied to not work at all, EPOP is unlikely to recover to early 2020 levels. That forces the Fed to shift its thinking. Previously Powell could afford to assume that full employment was so far away from here that he didn't need to worry about it. If the labor force is going to grow this slowly, wage pressure is going to be all the stronger, and consequently, inflation risk is all the higher. This doesn't change anything for the Fed in the sense that they were always waiting to see Core PCE get meaningfully above 2% for some period of time before hiking. But Powell can no longer assume there will be many months of strong labor gains before wage pressure becomes a serious challenge. So I'd argue rather than this jobs figure pushing Fed hikes further out into the future, it actually makes the timing much less certain. Strangely volatility is actually trading lower in bonds, which is definitely the wrong conclusion as far as I'm concerned. Implications for Markets Let me make my last two points quickly. A growing labor force is key for general economic growth, especially growth without inflation. I realize some stocks are addicted to ultra-low rates and are therefore cheering this middling jobs release, but that's very short-sighted, in my opinion. Doubly so given that this really just makes Fed policy more uncertain, it doesn't actually ensure that policy will remain accommodative for longer than we figured on Thursday. For bond yields, on the net this jobs report makes me more nervous about inflation, not less nervous. The closer we are to capacity in the economy, the more proximate risk inflation becomes. As I've said many times, I could be wrong about inflation, but at the very least the risk has gone up.

The Labor Shortage Is Real: Here's What That Means for the Fed and the Market

Powell can no longer assume there will be many months of strong labor gains before wage pressure becomes a serious challenge.

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