Monday, 8 October 2007

US employment data still point to rate cuts

The United States economy is looking a little better now than it did a month ago, thanks to the latest employment report from the Labor Department. Nevertheless, the report still points to slow growth and the possibility of interest rate cuts by the Federal Reserve in the near future, if not in October.

On Friday, the Labor Department reported that nonfarm payroll employment in the US rose by 110,000 in September. In addition, the economy added 89,000 jobs in August, reversing the decline of 4,000 that had initially been reported early last month.

The report, together with signs of stability returning to financial markets, reduced expectations of a rate cut by the Federal Reserve later this month. The rate of increase in employment now appears fully consistent with a slow-growing economy and not with one in recession.

It also corroborates the reports from the Institute for Supply Management earlier in the week. These reports had shown that the ISM's manufacturing PMI dipped to 52.0 in September from 52.9 in August while the non-manufacturing business activity index fell to 54.8 in September from 55.8 in August. Both indices show slowing growth but no recession, at least not at the moment.

Economists cited by the mainstream media also generally took the employment data relatively positively.

"It certainly doesn't look like an economy that's losing momentum," John Ryding, chief US economist at Bear Stearns, was quoted in a Bloomberg article as saying. The same article quoted Michael Feroli, an economist at JPMorgan Chase, as saying: "The labor market is bending, but not breaking."

Not everyone is sanguine though. "We may be headed for trouble as it is," Robert Dederick, president of RGD Economics, was quoted in the article as saying. "Remember, economists are saying there's a 35 percent chance of a recession, which is about as far as they ever go until we're actually in the recession."

And the Labor Department's employment report for September did provide a reason for concern. According to the report, the unemployment rate ticked up to 4.7 percent in September, moving back towards levels last seen around the middle of last year. On a chart, the upturn in the unemployment trend is now clearly discernible.

History shows that when the unemployment rate turns up, it often continues to surge, leading to a recession. As James Hamilton, Professor of Economics at the University of California, San Diego, said at his Econbrowser blog over the weekend, "the dynamics that produce this tend to kick in fairly quickly once they set in". So what looks like merely slow growth now could quickly turn into a recession.

At the moment, though, it is still too early to say conclusively that this will happen.

As for interest rates, if there is a perception of a recession threat, the Federal Reserve is likely to cut them. This is especially if inflation is not a threat at the same time.

And indeed, inflation is at a level that would probably not pose a big concern to Federal Reserve officials at the moment. The common measures of inflation in the US mostly show that consumer prices are rising at a rate that is within the Fed's comfort zone of 1-2 percent.

In August, the consumer price index rose at a year-on-year rate of 2.0 percent while the consumer price index excluding food and energy rose at a rate of 2.1 percent. The personal consumption expenditures price index, more closely followed by the Federal Reserve, rose at a rate of 1.8 percent with and without food and energy.

While these are not levels of inflation at which Federal Reserve officials would want to cut interest rates under conditions of normal growth, in their minds, they are also not impediments to rate cuts if a real threat of recession is perceived.

Having said all that, the Labor Department's employment report did provide a hint of inflation. Average hourly earnings grew 0.4 percent in September, up from 0.3 percent in August. The latest rise takes the year-on-year increase up to 4.1 percent.

However, if the pickup in unemployment is sustained, an acceleration in inflation is unlikely to take hold. In fact, rising unemployment is likely to lead to a decline in inflation.

In any case, history certainly shows that in periods when the unemployment rate is rising, the federal funds rate has usually fallen.

So on balance, the latest employment data makes a rate cut by the Federal Reserve this month no longer a high probability event, but they nevertheless also show that the Fed is still likely to lean towards further cuts in the coming months.

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