The Harmony of the Spheres

With Its Dual Mandates Aligned, the Fed Hears a Sweet Music

All together now

The Pre-Socratic Greek Philosopher Pythagoras,

we learn from Aristotle, believed that the movement of the heavenly bodies creates a sound, inaudible to our ears because we have never not heard it and can't distinguish it from silence. The music of this cosmic dance was supposed to be a harmony.

We've written before about the Federal Reserve's "Dual Mandate" to promote full employment and price stability (the unofficial third mandate, the stability of the financial system, is here left to the side). Sometimes these two principles are in tension with each other: it is something of an economic orthodoxy that to put downward pressure on prices, especially the price of labor known as the wage rate, it is necessary to create unemployment (known as the "Phillips Curve".) Similarly, to increase employment, it is necessary to give prices full rein. Unusually, what we seem to be seeing now is something of a puzzle in which prices are continuing to fall even while unemployment remains quite low. The two mandates are in harmony, at least for the meantime, which is nonetheless sweet music to the Fed's ears.

The Labor Market Shows Its Strength

The monthly Total Nonfarm Payrolls data from the US Bureau of Labor Statistics released last Friday was somewhat shocking in its strength and breadth. The economy added 353,000 jobs in January, twice what forecasters had expected. The already strong report from December was revised upward, giving us two months of very solid job growth. Ordinarily, 200,000 new jobs per month is consistent with a healthy economy.

The unemployment rate was more or less unchanged at 3.7%. The non-accelerating inflation rate of unemployment has been estimated to be around 5-6%. Given this criterion, the economy is at--or even beyond--full employment.

Wages continue to rise, indicative of a tight labor market, or the ability of workers to negotiate higher wages, and employers' willingness to grant them.

When we look at the number of jobs that are open but unfilled, we continue to see that employers are operating below capacity. Though openings have fallen from their peak Pandemic levels...

...there are still 1.5 jobs available for every unemployed worker. This suggests that workers will continue to enjoy negotiating leverage in setting the price at which the labor market clears.

The decline in the number of workers who voluntarily leave their jobs suggests that workers are either happy to work, or are uncertain that their employment prospects will be as good or better if they leave the workforce.

The increase in wages hasn't been enough either to dissuade workers from retiring, or to entice retired workers to re-enter the labor force. The Labor Force Participation Rate fell a bit in November, and remained steady in January. The wage rate will likely have to continue to rise to convince these workers to come off the sidelines.

This is a tight labor market. Workers remain scarce, wages are rising, the pool of labor is contracting, and demand for labor is increasing. The question of where all these workers are going to come from is an increasingly pressing one for policymakers and employers.

Manufacturing Recovers Some Lost Ground

One of the areas of weakness in the American economy has been the manufacturing sector. It's been in contractionary territory for some time, and after one earlier false recovery, perhaps now shows signs of making a full recovery. The Institute for Supply Management's Purchasing Managers Index shows that the rate of contraction in Manufacturing fell again this past month, and is inching its way toward stasis or even expansion.

The same index for Non-Manufacturers continues to show strength. The strength in services is especially important for the United States since its economy is so heavily tilted toward services.

The outlook for prices paid, however, paints a less sanguine picture.

Prices have risen, and employment continues to decline slightly. Manufacturers have to get more done with less, and they are probably compensating by reducing their workforce.

Housing Construction Positive

Spending on Construction continues to increase. High interest rates increased mortgage rates and made consumers reluctant to buy, and builders reluctant to build new housing stock. Still, the supply of housing stock is still far too low to accommodate all the new households that have been formed since 2007. In a sign of confidence in the economy, new houses are getting built, which should support housing sales and relieve some pressure on home prices.

Inflation Cools and Approaches Fed's Targets

Real Personal Consumption Expenditures, the Fed's preferred measure of inflation, continued to drift lower. It's now expected to arrive at or below target by the end of the year.

We see the same cooling in inflation whether we use nominal or core inflation. They both tell the same story, that prices are reverting to their pre-Pandemic rates of increase.

Whether prices resume their journey below the 2% target rate is a topic of much consternation in economic circles. While we don't know whether we are in a new inflation regime marked by higher inflation rates than experienced during the Great Moderation, we can say that they will trend lower as rates of shelter inflation, which are on a lag, have trended lower and are a large component--40%--of household spending. That is music worth playing loud.