Investors may have become inured to the continuous decline in US unemployment since 2010, but the recent drop has been truly remarkable by postwar historic standards. Last month, unemployment fell to 3.5 per cent of the labour force, a level not seen since 1969.
Furthermore, employment has been rising at an average rate of 170,000 a month in the past year. Goldman Sachs economists calculate that the American economy needs to create only 100,000 extra jobs a month to match the rise in the labour force, and thus leave unemployment unchanged.
If job creation continues at this pace, the unemployment rate will fall further, reaching 3.3 per cent by the end of 2020. This would be the lowest level since the Korean war.
By far the most important cause of ultra-low unemployment has been the recovery of aggregate demand in the economy, which has resulted in gross domestic product growth persistently higher than the growth of labour productivity. Consequently, unemployment from lack of demand has fallen by about 6 percentage points since 2009 (see box).
A second, and less significant, reason has been a decline in the natural rate of unemployment, which is the equilibrium rate that is consistent with stable inflation at any point in time. This rate, determined by the supply side of the labour market, is estimated by the Congressional Budget Office to have fallen by 0.3 percentage points since the trough of the economic cycle in 2009.
In past cycles, a decline in unemployment below its natural rate has often been a signal that wage pressures are rising, quickly leading to higher price inflation and tighter monetary policy. This should worry both the Federal Reserve and the financial markets.
A year ago, with unemployment dropping below the natural rate, Fed chairman Jay Powell seemed concerned that this pattern might reassert itself. In June 2018, he said:
If central banks were instead to try to exploit the nonresponsiveness of inflation to low unemployment and push resource utilization significantly and persistently past sustainable levels, the public might begin to question our commitment to low inflation, and expectations could come under upward pressure.
Fed chairman Jay Powell, June 2018
These concerns seem to have disappeared almost completely in recent months. A series of dovish speeches on the labour market by Mr Powell and vice-chairman Richard Clarida culminated in Mr Powell saying two weeks ago:
Recent years’ data paint a hopeful picture of more people in their prime years in the workforce and wages rising for low- and middle-income workers . . . This is just a start: there is still plenty of room for building on these gains.
Fed chairman Jay Powell, November 2019
Instead of worrying about the possible inflationary consequences of excess resource utilisation in the labour market, as he did a year ago, the chairman is now embracing a further tightening in the jobs market and welcoming the consequences, including higher wage inflation for low paid workers.
This important shift in Mr Powell’s perception of the balance of risk has stemmed from several factors.
- Consumer price inflation, the Fed’s targeted variable, seems stuck at low levels, with little indication that the tightening in the labour market is having any adverse impact, although wage inflation is now clearly rising.
- Fringe workers, especially of prime age in disadvantaged groups, are being drawn back into employment by the buoyancy of labour demand. Mr Powell has hinted that falling unemployment among black, Hispanic, disabled and less educated people is reducing the overall level of inequality in the economy, and has said that wage disparities among employed workers are narrowing after two decades of widening.
- The tightness in the labour market may be inducing employers to find new ways of increasing staff efficiency, thus permanently boosting productivity growth and potential GDP. This rise in productivity is analogous to what happened near the peak of the 1990s economic upswing, when Alan Greenspan as Fed chairman allowed the labour market to “run hot” for several years. He correctly believed that inflation would remain under control.
These social and economic reasons for following Mr Greenspan now seem compelling to a large majority on the Federal Open Market Committee. Hence, the risk that markets will face a hostile Fed in 2020 has been sharply curtailed.
However, this story has not always ended well. Ultra-low unemployment in the late 1960s eventually led to much higher inflation, when Fed chairman Arthur Burns was pressured by the presidential re-election campaign in 1972. That turned out to be a major, inflationary mistake.
Chairman Jay Powell will not want to let President Donald Trump lead him down the same dangerous path.
Why US unemployment is nearing all-time post war lows
Since the US unemployment rate peaked at 10.0 per cent in October 2009, it has fallen by 6.5 percentage points. Over the same period, the natural rate of unemployment (estimated by the Congressional Budget Office) has dropped from 4.9 per cent in 2009 Q4 to 4.6 per cent today.
The natural rate of unemployment, less the actual rate, provides an estimate of demand-deficient unemployment, or the “unemployment gap”. This gap has shrunk from minus 5.1 per cent at the trough of the recession to plus 1.1 per cent now.
The unemployment gap measures the degree of excess utilisation of resources in the labour market. It is usually closely related to the output gap, which is an indicator of resource utilisation in the whole economy.
At present, both the unemployment gap and the output gap are positive, suggesting that inflation pressures should be rising throughout the economy. So far, these pressures are not becoming apparent, either in price inflation data or in inflation expectations. However, based on the behaviour of the US economy in past cycles, the Fed is taking a calculated gamble that inflation will remain subdued for longer than usual.