Twenty fifteen was a good year for the U.S. economy, and 2016 should be even better. The economy is on track to return to full employment by midyear. It will have been almost a decade since the economy was last operating at full tilt. Deep Dive: Why a Recession Is Not Around the Corner
Full employment is consistent with a 5% unemployment rate, which has already been achieved, and a 9% underemployment rate. Underemployment includes the unemployed, part-timers who want more hours, and potential workers that have stepped out of the workforce and thus are not counted as unemployed but say they want a job. This is the so-called U-6 unemployment rate, which currently stands at 9.8%. On a full-time equivalent basis -- translating the part-timers into full-timers -- it is about 9.6%. Deep Dive: U.S. Employment Situation
At the current pace of job growth of more than 200,000 per month, if sustained, the economy will be back to full employment by next summer. To be even more precise, given that the working-age population is growing by only 100,000 per month, the underemployment or U-6 unemployment rate should stand at 9% by August. There is clearly much uncertainty around this estimate, but there is little doubt that full employment is approaching fast.
Businesses are adding jobs at a consistent and prodigious rate. Payrolls will expand by almost 3 million in 2015, about the same as the year before and the year before that. The last time job growth was as consistently strong was during the technology boom of the late 1990s.
The oil price collapse and resulting rationalization in the energy industry, and the stronger U.S. dollar and weakening in trade-sensitive manufacturing have slowed job growth a notch in recent months. But these constraints should fade by the spring. Moreover, job creation in the rest of the economy shows no signs of slowing. Deep Dive: How Long Will Oil Prices Stay Low?
Most encouraging is that job openings are about as plentiful as they have ever been. There are now less than three underemployed for every open job position.
For context, at the worst of the recession, there were closer to one open position for every 11 underemployed. Openings are widespread across most industries, but particularly in healthcare and professional services; two industries adding aggressively to their roles. Layoffs also remain extraordinarily low, with nearly record low numbers filing for unemployment insurance. Deep Dive: Why Employment Is on the Upswing
The tightening job market is evident from the recent firming in wage growth. According to the Bureau of Labor Statistics, average hourly earnings and wages as measured by the employment cost index have picked up meaningfully over the past year. After abstracting from the short-term ups and downs in these measures, wage growth is up nearly half a percentage point over the past year, well over the near 2% year-over-year growth that had prevailed since the recession.
Wage growth is even stronger than indicated by the BLS wage data. The BLS calculates wages based on reports from establishments that average pay across all their employees. Measured wage growth is being depressed as many lower-paid millennials are coming into the workforce, while higher-paid boomers are leaving it. The tighter labor market also means that those now finding jobs are likely less productive and thus lower-paid.
The importance of these worker-mix effects is evident from wage data constructed by Moody's Analytics based on payroll records maintained by human resource company ADP.
The ADP data are derived by tracking the wages of individuals and are thus not impacted by the changing mix of workers in establishments. According to ADP, year-over-year wage growth for individuals is just more than 4%. Like the BLS data, ADP measured wage growth has accelerated by about half a percentage point over the past year.
A positive near-term leading indicator of future wage growth in the ADP data is the pickup in wages paid to workers switching jobs. Across all switchers, pay increases have risen substantially over the past year.
Part-timers switching to either another part-time job or a full-time job enjoyed the biggest improvement. Switcher wages have accelerated across all but the energy industry and are up most in the construction trades and in healthcare. All age groups are enjoying increased switcher wages, but those in their prime working years of 35 to 54 have seen the largest acceleration. Switcher wages are up in all parts of the country, but most in the South and Midwest.
Wage growth is expected to accelerate substantially as the economy attains full employment. It may take a while, but wages are ultimately expected to reach a 3.5% growth rate. This is equal to the sum of inflation, which is expected to be near the Federal Reserve's 2% target, and 1.5% trend labor productivity growth. At this pace of growth, labor's share of national income will stabilize; labor's share has been shrinking more or less since the early 1980s.
There are both downside and upside risks to this outlook. On the downside is persistently weak productivity growth, which has been well below 1% per annum in recent years. Productivity is expected to pick up as businesses refocus on it. With labor costs so low since the recession, businesses have felt little pressure to invest in labor-saving technologies. This should change as businesses realize that their labor costs are rising with the tightening job market, but this is still a forecast.
On the upside is the likelihood that the job market will overshoot full employment. By the end of 2016, it will be clear that the economy's biggest problem isn't unemployment, but a lack of qualified labor. Businesses in a rising number of industries will be in bidding wars for workers. According to homebuilders, this is already an issue in the construction trades, and manufacturers are also complaining they can't find the highly skilled workers they need.
Firming wage growth is the signal that the Federal Reserve has needed to begin normalizing interest rates. Policymakers indicate that the coming rate hikes will be gradual, with the funds rate ending 2016 at just more than 1%. This is a reasonable forecast, given that inflation remains well below the Fed's target, and the Fed's desire to err on the side of too strong an economy rather than a struggling one. The Fed desperately wants to avoid backtracking on the rate hikes or, even worse, having to resume quantitative easing or adopting other nontraditional policies.
Policymakers also rightly want to see what impact the rate hikes will have on broader financial market conditions. The stock market appears vulnerable, given its currently high valuation, an even stronger U.S. dollar seems likely, and credit spreads have the potential to significantly gap out, particularly for below-investment-grade corporate bonds. The seeming lack of transactional liquidity in markets could also exacerbate the volatility in all markets.
Financial pressures on already-fragile emerging markets could also intensify. Most vulnerable are countries that rely heavily on capital inflows and whose nonfinancial businesses have issued debt in dollars.
These include Turkey, South Africa, and a number of countries in Latin America and Southeast Asia. Growth in the EMs slowed sharply this past year, and the best that can be expected in the coming year is that they stabilize.
Just where the rate hikes end depends on the equilibrium funds rate, or R* -- that funds rate consistent with an economy operating at its potential and inflation at the Fed's 2% target. There is a general consensus that R* has fallen since the Great Recession, but there is little consensus regarding by how much. The Fed's long-run forecast of the funds rate would suggest that the equilibrium funds rate is approximately 3.5%. This is equal to the sum of the Fed's 2% inflation target, the economy's potential growth rate, and the impact of various economic "headwinds."
Although not well-defined, the most significant headwind is the higher required capitalization and liquidity of the banking system post-crisis.
If regulators require that banks must hold more capital and be more liquid, then the banks' return on equity and assets will be lower. Thus for the system to extend the same amount of credit to the economy at the same lending rates, the system's cost of funds needs to fall by a like amount as its returns. That is, banks' lending margins -- loan rates less cost of funds -- must be maintained. This can be achieved if the Fed adopts a lower R*, and thus lower banks' cost of funds.
Like the Fed, we also estimate R* to be 3.5%, equal to 2% inflation, plus 2.2% potential real GDP growth, less 0.7% to account for the economic headwinds. The actual federal funds rate is expected to reach our 3.5% R* by spring 2018.
The Fed's path to R* is rife with risk. The equilibrium funds rate could be much lower than we are estimating, either because potential growth is lower or the headwinds are blowing harder. Financial markets seemingly believe this, as the futures market for fed funds puts the funds rate at closer to 2% by early 2018.
However, there is also the risk that the economy will overshoot full employment, generating significant wage and prices pressures and forcing the Fed to ultimately play catch-up in raising rates. Indeed, the more gradual the rate hikes are in 2016, the more likely the Fed will have to increase rates more aggressively in 2017 and 2018 to forestall an overheating economy.
Certainly a lot could go wrong between now and 2018. But that should be a worry for another day. We should enjoy 2016 and a full-employment economy. Deep Dive: Why a Recession Is Not Around the Corner
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.