Viewpoint
February 07, 2025 | 15:09
February 7, 2025
Economics
Economics
Economics
Economics
Economics
Economics
Economics
Economics
The U.S. Hits a Labor Market Sweet Spot |
| The January nonfarm payroll data and annual benchmark revisions did little to alter our view of a resilient labor market, despite a net downward revision of 610k jobs in December 2024. The moderation in job growth to an average 166k jobs/month over the past year will be welcome news for the Fed that is patiently waiting for its monetary policy medicine to cool consumer inflation before resuming rate cuts. |
| But lingering strength in earnings and a drop in the jobless rate will likely keep the Fed on the sidelines for the foreseeable future. Average hourly earnings increased 0.5% in January and are rising at a ‘hot’ 4.5% a.r. over the past three months, while the unemployment rate dropped to 4.0% from 4.2% in November (Chart 1). We still expect the next rate cut to come at the June meeting, at the earliest. If a trade war erupts with Canada, Mexico, and the EU between now and then, the Fed will likely have to wait even longer before cutting interest rates again. Still, the labor market does appear to be in a ‘sweet spot’ right now, not too hot and not too cold. Zooming out to see the bigger picture: the evidence of labor market rebalancing continues to pile up even as fears of faltering continue to fade. Nowhere is this more prominent than the recently released Job Openings and Labor Turnover Survey (JOLTS) data for December. Openings slipped to 7.6 million, essentially back to pre-pandemic levels. The job openings rate, at 4.5%, is exactly where it was in January 2020. At the same time, the appetite for employers to hire and for workers to leave for greener pastures remains lower than normal. The run rate on hiring and separations is still anemic compared to our recent past. The hiring rate (at 3.4%) and the separation rate (3.3%) in December have fallen well below their January 2020 levels of 3.9% and 3.8% respectively (Chart 2). Moreover, the ratio of job openings to unemployed people fell to 1.1 in December, far below the pandemic peak of 2.0, and the pre-pandemic level of around 1.3 (Chart 3). Employers’ appetite for new workers has clearly waned from the overheated days of 2022 and there are more unemployed people competing for those open slots. For now, at least, the Fed appears to be in a sweet spot with the economy and labor market. Still modestly-restrictive monetary policy makes a job-growth resurgence in the months ahead a relatively low probability event even as further labor market deterioration is expected to progress at only a glacial pace. Initial jobless claims remain historically low and January’s unemployment rate was well below last summer’s peak, which had scared the FOMC into a bigger-than-normal 50 basis point rate cut in September. This recently solid data gave the FOMC the confidence to describe the labor market as “stabilized” in its January post-meeting statement. Our baseline forecast is that job growth will moderate a bit further in the months ahead, but only enough for the unemployment rate to creep up to around a 4.3% peak in the second half of 2025 before stabilizing. The economy still appears on track to create around 1.68 million net new jobs Q4/Q4 in 2025, just a modest deterioration from last year’s 1.93 million jobs. |
Productivity and Price Stability Could Be a Victim of Trade War |
| Though moderating, the increase in productivity achieved by American workers and businesses remains solid. Labor productivity rose 2.3% last year, above the quarter-century median of 1.7%. Whether due to AI adoption, strong new business formation, or reorganized processes to address worker shortages, the improvement is welcomed by a central bank still trying to fully tame inflation. Barring a trade war, there’s every reason to believe productivity growth will remain firm this year, helping the Fed achieve its dual mandate, first by raising productive capacity and boosting employment, and second by limiting overheating and restraining inflation. |
| Where the Fed could use a hand, however, is on the fruits of higher productivity: wages. Hourly compensation rose last year by 5.0%, more than warranted by the gain in productivity. While labor market conditions have loosened, the jobless rate remains low at 4.0%, modestly below the Fed’s neutral estimate. Consequently, unit labor costs—the difference between growth in compensation and productivity—rose 2.6% last year. Though not terribly high, it’s a problem for the Fed because unit labor costs tend to mirror core PCE inflation and vice versa. It’s no coincidence that the current year-over-year rates for both are similar at 2.7% and 2.8%, respectively. It’s also no coincidence that core inflation swam below the 2% water-line between the financial crisis and the pandemic when labor costs were also soggy. While compensation growth has moderated more recently, the current 4.3% y/y run rate—relative to 1.6% for productivity—is inconsistent with achieving price stability. Either wage growth will need to cool or productivity will have to speed up. |
Tariffs won’t help. In fact, they would lift inflation directly when passed on to consumers, and indirectly by curbing productivity. Tariffs impede productivity by disrupting supply chains and diverting managers from running their business to mitigating the effects of import duties. Furthermore, productivity would decline in the one sector, manufacturing, in which it is already quite weak (up just 0.3% last year, resulting in a 3.1% rise in unit labor costs). The sector is also vulnerable to tariffs as import exposure is relatively large in some industries, including motor vehicles, clothing, computers, and electrical equipment. If productivity slows, growth in unit labor costs would likely hold near current levels or even rise further. In this event, what would normally be a one-time lift in inflation from tariffs could become more persistent. If businesses can’t absorb the rise in unit labor costs, they will try to pass the levy to customers. Unless the jobless rate rose materially to slow wage growth, consumers would likely stomach some of the price increase. Bottom Line: Whether tariffs have a short-lived or longer-lasting effect on inflation will depend, at least partly, on the starting point for unit labor cost growth. For now, it’s telling the Fed to proceed with caution. |
Can the U.S. and China Strike a Trade Deal? |
| There is growing speculation that Trump and Xi may be setting the stage to strike a new trade agreement. The key reasons for such optimism revolve around the relatively modest size of newly imposed tariffs and comments made by some Trump officials (i.e., that tariffs can be important bargaining chips). On the former, Trump’s decision to raise tariffs on all Chinese goods by 10 ppts seems meek compared to the prior threat of a 60 ppt hike. Meanwhile, Beijing’s response, mainly implementing tariffs of 10%-to-15% on a limited number of export items to the U.S. (around 80), is largely viewed as symbolic. Adding further fuel to the prospect of a deal is the relative stability of China’s yuan against the U.S. dollar. Nevertheless, we remain more skeptical that trade/economic relations between the two superpowers will improve. This is not to say that a new trade deal cannot be negotiated. We can envision a revamped form of the ‘Phase One’ trade agreement, signed in early 2020, incorporating more stringent targets and timelines. Recall that this agreement required China to purchase US$200 bln of goods and services within a two-year timeframe and included commitments to improve intellectual property rights, remove technology transfer requirements, stop currency manipulation etc. The deal failed because China was not able to make good on buying US$200 bln of U.S. exports, which was largely undermined by the subsequent outbreak of the pandemic. On the flip side, hammering out a similar Phase One deal may be more difficult as a lot has changed since Trump 1.0. Of prominence, China has moved beyond the mantle of the world’s factory for cheap manufactured goods and has become a major competitor in many advanced technologies, notably in the clean energy space and artificial intelligence. This explains why President Biden made extensive efforts to cut China off from high-end semiconductors, including chipmaking equipment and people employed in this industry. Meanwhile, Trump’s desire to reduce the U.S. bilateral/overall trade deficit can’t simply be solved by asking China to buy more of America’s goods and services (agricultural, oil and gas, nuclear reactors, financial services, etc.). As many U.S. economic experts have repeatedly stated, the country needs to alter its savings/investment behaviour, namely by reducing its yawning budget deficits. Meanwhile, there is widespread belief that China has already concluded that appeasing the U.S. is virtually impossible, particularly given its political regime, and economic decoupling between the two cannot be prevented. Thus, Beijing will continue to focus on shoring up its weakened economy (e.g., fixing the housing market and tackling deflation) and diversifying its export markets. According to IMF statistics, the U.S. share of China’s total merchandise exports fell to 14.6% in the first three quarters of 2024 (vs. 19.0% in 2017). Though it’s true that a large or significant part of the decline was due to rerouting via third party countries, it’s equally true that China is still reducing its dependency on final U.S. demand. This declining importance can be better gauged by viewing exports to the U.S. as a share of China’s GDP, which slipped to 2.4% (vs. 4.0% in 2017). This stands in sharp contrast to Canada and Mexico, where exports to the U.S. amounted to 18.6% and 26.7% of GDP, respectively, in the first three quarters of 2024. Key Takeaway: We would be pleasantly surprised if Trump and Xi struck a new trade deal. Nevertheless, we continue to hold the view that relations between the two economic giants are likely to remain extremely volatile under Trump 2.0. |
