The Fed has raised interest rates sharply and quickly to slow growth to contain inflation, but has it done enough? Although we expect February data to show some moderation in growth, we agree with Fed statements that they are not yet close to done.
The supercharged reports for January have been widely disparaged as distorted by seasonal adjustment problems, implying that growth is actually weaker than reported. We agree. But we strongly disagree that growth has moderated sufficiently to soon enable the Fed to pause its string of rate increases. Let’s focus on employment. No doubt, the huge 517,000 January increase in payrolls was elevated excessively by the seasonal factors, which expected a “normal” decline in January of the underlying raw, unadjusted data of 3 million workers, but reported the huge gain because the actual raw data saw a loss of “only” 2.5 million. So, yes, January hiring was overstated.
But, where was the corresponding understatement? Seasonal factors move hiring from one month to a different month, but do not add or subtract from annual growth. Moreover, there’s a critical reason why underlying employment falls sharply in January. Hundreds of thousands of extra workers are routinely hired in all three months of Q4 to meet the needs of holiday spending. January layoffs are directly related to Q4 hiring. Fewer layoffs occur whenever there is less hiring. So, if Q4 hiring is below normal, fewer people will come off employment rolls in January. This would imply artificial weakness reported for Q4 and excessive growth in January. So, it is really significant that the average level of monthly hiring in Q4 was 291,000, which is actually not weak; it was merely a bit slower than in prior months. On an absolute basis, it would be considered quite strong. Job growth over the latest four months, October through January, slowed modestly to 347,000 on average per month from a 376,000 pace in the second and third quarters, hardly enough to satisfy the Fed or to relieve wage inflation pressures. It seems hard to escape the conclusion that job growth remains too strong for the Fed.
Nonetheless, plenty of people noted the slower pace of hiring in Q4 growth, which they chose to take as a harbinger of weakness ahead. Q4 should have been stronger than it was reported on a seasonally adjusted basis. Economic bears prefer to accept the weakness of the Q4 data as significant, while they dismiss the strength of January as a statistical anomaly. In fact, both are statistical anomalies and they offset each other. A more accurate reading of the data is that job growth remains well above sustainable levels for the entire period of October through January. I expect some of the strength reported for January eventually will be displaced into Q4 with the next update to the estimated seasonal factors.
What about labor supply, which limits how fast the economy can grow? The hiring rate remains dramatically above the labor force growth rate. The Bureau of Labor Statistics estimates labor supply as having grown by 219,000 monthly in 2022, including re-entrants. That appears to be awfully high. Most analysts believe that the underlying trend in labor supply is less than 100,000 monthly. But whichever estimate you believe, job growth remains high and well above sustainable levels, which is why the unemployment rate is at the cyclical low of 3.4%.
Turning to the outlook, prospects for economic growth in 2023 continue to be revised higher. Housing was a sizable drag on the economy in 2023, but it appears to be bottoming (for now). Auto and aircraft production are ramping higher, as supply disruptions ameliorate and chips supplies increase, to make up for significant production shortfalls over the past two years. China reopened suddenly only two months ago and its economy is already surging, with spillover effects on all its trading partners. Global production of military equipment and munitions simply cannot keep up with demand because of the invasion of Ukraine. At some unknown point, a massive rebuilding program will kick in for Ukraine, with a sharp rise in demand for goods imported from Western countries. All these considerations have unleashed a hypothesized “no landing” scenario, i.e., no recession and also no soft landing. But a no landing scenario is not a real outcome. Rather, it is a deferral of whatever must occur to contain inflation.
We conclude that an imminent recession is unlikely, because there are too many tailwinds to support growth and interest rates have not risen enough to offset those positives. Hiring (and economic growth) will slow in 2023, if only because the pool of unemployed is already below 5.7 million. However, the effort to hire puts upward pressure on wage rates and inflation. The Fed badly needs the demand for labor to moderate considerably to relieve that pressure. (One area of contentious debate is whether the large number of Job Openings is accurate, since private sector measures, as produced by Indeed and ZipRecruiter, suggest that job postings have fallen considerably.) So, the Fed is likely to raise its policy rate two or three more times over the next few meetings and then leave those rates at the higher level for the balance of the year in its effort to contain inflation. But more may need to be done.