The Street Gets Inflation Threat Backwards

Kasriel notes:

There has never been an expansion cycle in the past 45 years in which the participation rate (those actually in the labor force as a percent of those that could be in the labor force) trended lower save for the current one. Had the labor participation rate risen in a normal cyclical fashion, today's unemployment rate would be considerably higher

Further, benchmark revisions to the population controls to the household survey by the Census Bureau may have also had an inadvertent impact of lowering the unemployment rate. Note that this is not an actual measure but an accounting adjustment. (See this for more details.)

The weak labor participation rate should put the Fed's mind at ease as to the slack in the labor market reason: There's plenty of it.

Non-Farm Payrolls

Non-farm payrolls (NFP) gave the Street yet another way to misread inflation.

While January's NFP number was far below consensus, it was misunderstood in several ways:

The three-month average of 229,000 is misleading. Why? Recall that the hurricanes altered NFP data in September and October. The BLS repeatedly noted that reporting the data of displaced/relocated personnel was going to be problematic. To the bureau's credit, it eventually managed to track down most of the relocated workers; hence the upwards revisions. Hence, the revised three-month average is revealing of little, other than that many displaced Gulf/New Orleans employees have settled into new jobs.

With NFP a negative 8,000 in September and a plus 56,000 in October, that makes the five-month average 147,000. When job creation barely keeps up with population growth, it's hardly inflationary.

January is one of those months when the seasonal adjustments have an enormous impact. This happens every year, as the temporary holiday workers finish their stints. But it points out that the 193,000 payroll figure, which some are fearing as a sign of inflation, needs to be taken with a grain of salt.

Measured in actual job gains (i.e., not seasonally adjusted), the economy lost 2.625 million jobs from December to January.

Year-over-year payroll growth appears to be peaking, as this chart shows. Kasriel notes that "year-over-year nonfarm payroll growth appears to be peaking out around 1.6% -- lower than any other cyclical peak in the past 45 years."

All Employees Total Nonfarm

Wage Inflation

We know that wage inflation is Public Enemy No. 1 for the Fed. Do the most recent data give it cause to act pre-emptively? Hardly.

January hourly wages rose 7 cents per hour -- that's a 3.3% increase. As you can see from the constant-dollar CES chart below, wages dove in late 2005 after the hurricanes hit. They have since snapped back to pre-hurricane levels. But they are hardly trending upwards.

Source: CES

The most recent wage increase is very likely the result of the mix of new construction jobs -- especially in the Gulf region. That's hardly emblematic of surging wage pressure.

Looking at wage improvements since 1965, we are coming off the lowest annual improvement levels in half a century. In fact, the recent wage gains are weaker than even the lows in 1986-87 period.

CES Average Hourly Earnings

In the 1970s, wages rose at a 6% to 8% annual level. Coming from below 2% annual gains, and still far below 4%, is hardly cause for concern.

Reap What You Sow

The Fed's reflation has succeeded all too well. The prices of homes, food, energy and all manner of commodities have been moving higher for several years now. Wall Street has mostly ignored this kind of inflation.

Income, on the other hand, has been fairly stagnant. I'm hard pressed to recall any union negotiating victory in recent years. Globalization and outsourcing have kept wage pressures extremely low.

I expect the economy to slow in 2006, and to possibly enter a recession in 2007. If the Fed erroneously misreads the most recent data as proof of a too-strong economy and a tight labor market, it risks turning a bad, but manageable, situation into a disaster.