Is the Labor Market Cooling or Not?

The financial markets are increasingly communicating that interest rates will be higher for longer. As recently as March, the Fed Funds futures market was pricing in a Fed Funds rate of just 3.75% by the end of this year. That figure is now over 5.0%. Over the same time frame, the yield on the 2-year Treasury bond has increased from this year’s low of about 3.74% to the current 4.59%. These markets are telling us in no uncertain terms that 1) inflation is more pervasive than previously thought, and 2) the Fed will maintain rates in elevated territory until their job is done. 

The Fed’s primary concern has become the red-hot labor market and the effect it’s having on consumer spending, particular on services like travel and entertainment. So I thought today I’d review the state of the labor market and see if we can determine if any progress has been made in reducing the imbalance between labor supply and demand.      According to the Labor Department, the total number of people employed in the US as of May, 2023 was up to 160.7 million – about 1.9 million above the pre-COVID high of 158.8 million in December, 2019. 

However, if we take into consideration the growth in the population, it becomes clear that the labor market is somewhat less robust than it had been. In fact, there would be 2.3 million more people working right now if the employment-to-population ratio were to increase from its current 60.3% to the pre-pandemic high of 61.1%. Some of the factors that have been cited for the decline in labor participation include long COVID or fear of contracting COVID; the aging of the population; an increased propensity to retire early due to rising asset prices; skills mismatches; a lack of affordable child care; and the extended unemployment and other government benefits associated with the pandemic. Lower immigration rates, which had been a drag on the total number of people working, have returned to pre-pandemic trend. Even so, the reduction in the supply of available workers has contributed to the tightness in the labor market. 

One way of comparing the supply of jobs to the demand for jobs is by tracking the ratio of job openings to the number of people counted as officially “unemployed.” To be counted as unemployed, you must 1) be unemployed; 2) have actively looked for work in the prior for weeks; and 3) be available for work. This definition obviously excludes all individuals who have dropped out of the labor force for one reason or another. You can see in the chart below that the ratio of job openings to unemployed has dropped from a high of around 2.0x to the current 1.8x. However, that ratio is still well above the average of about 1.2x prior to COVID’s arrival. The translation: the demand for labor still far exceeds the supply. 

The Fed closely tracks the comparison between the supply of and demand for labor because if demand far exceeds available supply, that could potentially put upward pressure on wages. And outsized wage gains can lead to more widespread inflationary pressures in the economy, a situation which economists refer to as the “wage/price spiral.” In the chart below you can see that wage growth has dropped from about 6% in early 2022 to a little over 4% in the most recent month (May). However, that rate is still significantly above the 3% average in the months leading up to COVID’s arrival. The Fed would like the see wage gains continue to moderate. 

Weekly initial jobless claims are also watched pretty closely by the Fed because they are as close to a “real-time” read on the state of the labor market as we can get. You can see below that initial claims for unemployment insurance did rise a bit early this year before trending back down again over the past few weeks. The most recent reading, though, showed a surprising spike in claims to 261,000 – well above recent readings. Is this the start of a new trend higher?

To be sure, the Fed is not specifically targeting increased job losses. However, most economists believe that unemployment will have to increase from the current rate of 3.7% in order to bring inflation down closer to the Fed’s target of 2%. 

Finally we arrive at last Friday’s employment report. On the first Friday of each month, the Labor Department provides us with employment data from two distinct surveys, the Household Survey and the Payroll Survey. The Household Survey is used to calculate the unemployment rate. That survey said that in the month of May, the total labor force grew by 130,000, consisting of a 440,000 increase in the number of unemployed and a 310,000 decrease in the number of employed. These changes resulted in the unemployment rate rising to 3.7% in May from 3.4% in April. Could it be that the Fed’s interest-rate increases are finally having the desired effect of cooling the labor market?

Not so fast. The other survey seemed to contradict that conclusion. According to the Payroll survey, which polls businesses rather than households, US companies increased, not decreased, payrolls by 339,000 during May. If we compare that jobs gain with the 310,000 decrease in the number of employed reported in the Household survey, the difference comes to a rather large 649,000. Monthly variances like this do happen, as the chart below shows, but they’re not all that common. 

Where does that leave us? With a lot of ambiguity. There is clearly still a sizeable mismatch between the demand for and supply of labor, and that mismatch is driving wage gains that are probably inconsistent with the Fed’s goal of reaching 2% inflation. This is why the markets keep pushing out the dates of the last interest-rate hike and the first interest-rate cuts. And most economists believe that the longer it takes to start cutting interest rates, the higher the chances of a Fed policy error that thrusts the economy into a recession. However, the arrival of any economic recession has also been pushed out due, in large part, to the sustained strength in the labor market. If that sounds like circular reasoning, then you’re reading it right. 

Higher interest rates for longer would seem to argue for a more modest allocation to the mega-cap stocks that have led the markets higher this year. As we mentioned in last week’s Market Commentary, the S&P 500 would be down on the year if not for the contribution from just ten of these mega-cap names. As for your humble author, I’ll be looking for opportunities outside those handful of names.