Another month, another strong US jobs report. Nonfarm payrolls grew 215k in March, again far above our 85k estimate of the pace consistent with a stable unemployment rate over the medium term. Other indicators—including household employment and jobless claims—also suggest continued strong growth in labor demand. Based on the labor market indicators as well as most business and consumer surveys, our current activity indicator (CAI) for March stands at a preliminary 2.3%, up from 1.4% in February.
The job gains over the past six months would have pushed the headline unemployment rate down to only about 4%, had it not been for the 0.6-point gain in labor force participation. While this gain is highly welcome, we think it is unlikely to extend much further as the share of non-participants who say they want a job is now near previous cycle lows. More broadly, our recent analysis using household survey micro data found that the “participation gap” has now nearly closed so that the room for further non-inflationary gains is probably limited.
Thus, we think the headline unemployment rate is a much more representative indicator of overall labor market conditions than it was during most of the recovery. At 5.0%, it stands only about ¼pp above both our and the FOMC’s estimate of its structural rate. There is some additional slack in the still-elevated number of involuntary part-timers, but we continue to think that the economy will hit full employment by yearend.
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...Whatever the precise weighting of explanations for the dovish shift in the FOMC’s message—a weaker central economic forecast, greater risk aversion, or a desire to stabilize the FX markets by limiting monetary policy divergence—we expect a shift back in the opposite direction before too long. Our central economic forecast is now a bit stronger than the committee median, we are less worried than the committee about the downside risks to that forecast, and we think that the divergence in economic fundamentals between the US and most other countries will make it difficult to avoid greater monetary policy divergence.
Effectively, we believe that US employment growth will need to slow in order to keep the labor market from overheating in 2017-2018, that slower employment growth will require tighter financial conditions, and that tighter financial conditions will probably require a significantly higher funds rate than the market is pricing. Of course, it is possible that financial conditions will tighten spontaneously, which would reduce the need for tighter policy. But the opposite is equally possible; after all, today’s FCI is approximately equal to the market’s best guess of tomorrow’s FCI, and we don’t see strong reasons to believe that the markets are overly optimistic about the future on net (except for the monetary policy path).
For these reasons, we have not changed our forecast that the FOMC will hike three times this year. We are well aware of the risks, given that the FOMC itself is now projecting just two hikes and the “dot plot” has overestimated the funds rate for several years running. But we think the fundamental backdrop is now very different from the pre-liftoff era, when the dot plot often looked like it was driven by a desire to “just get off zero” at a time when the economic fundamentals did not really support tighter policy. Now, the mandate is within striking distance, growth is picking back up, and we think the time for gradual—but not too gradual—policy normalization has come.