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Getting Tight: What Does the Strong Jobs Market Mean for Inflation?

The jobs market isn’t just making headlines. It’s making history.

The recently released employment report for May marked the 92nd straight month of payrolls growth—the longest stretch in the history of the data. Now at 3.8%, the official U3 unemployment rate hasn’t been this low since 2000. The broader U6 unemployment rate—which includes “marginally attached” workers and part-time workers who would rather be working full time1—is at a 17-year low. In fact, there is now roughly one job out there for every job-seeker.

The better-than-expected report included much to cheer the economic bulls out there. Indeed, the jobs data appear to have given the stock market a fillip just as it was getting over concerns about the political situation in Italy.

But the jobs report is about more than just the headline number. And the strength of the labor market raises some questions about inflation and interest rates that could have implications for the market later in the year.

Inflation watch

While the headline jobs numbers are generally looking strong, they haven’t triggered an inflation scare yet. Why?

One reason is that while wage growth perked up, it isn’t exactly off to the races. Wages were up 2.7% in May from a year earlier, slightly faster than the 2.6% increase the month before. But that’s not unprecedented in recent history. Average wage growth has been at or above 2.7% six times since January 2016.  

For context, the last time the unemployment rate was this low, hourly earnings were growing at an average pace of 4% (although that was around the end of the dot-com bubble).

“Part of the problem is that a growing percentage of the new jobs being created are in lower-wage industries, like education/health services and retail,” says Liz Ann Sonders, chief investment strategist at Schwab. “It’s also worth noting that average hourly earnings data are biased lower because younger new workers enter the job market at lower wages, while older, higher-paid workers are retiring.”

Businesses may also be struggling to find qualified workers for some jobs.

“In fact, ‘quality of labor’ is now the top concern among the companies surveyed by the National Federation of Independent Business,” Liz Ann says. “When the economy started expanding back in 2009, finding qualified workers ranked far below problems such as weak sales, taxes and red tape in terms of importance among businesses.”

“So even though it looks like there are enough jobs to go around, the mismatch in skills is one reason they aren’t being filled right away,” she says. “The skills gap is an ‘ocean liner’ problem rather than a ‘speed boat’ problem—it’s going to take some time to turn it around.”

Finally, labor force participation, which looks at the potential size of the workforce relative to the working-age population, appears to be stuck in a rut. The labor force participation rate has been bouncing around between 62% and 63% since the end of 2013. In the five or so years prior to the financial crisis it hovered around 66%.

Combined, these factors suggest unemployment and average wage growth could both remain low for the foreseeable future, taking some of the pressure off inflation.

In sum

“All things considered, the data remains more than strong enough to keep downward pressure on the unemployment rate—and upward pressure on the trend in short-term interest rates.” Liz Ann says. “In fact, in the immediate aftermath of the May jobs report, expectations for four total rate hikes this year by the Federal Reserve jumped from less than 15% to nearly 30%.”

That would mean three more increases this year, in addition to the rate hike in March. At its last meeting, the Fed said it expected just three hikes in total this year, though individual Fed governors have suggested four hikes is possible.

“The likelihood of a June rate hike is a virtual certainty,” Liz Ann says. “Markets have already been choppy this year, and additional rate hikes could add to the volatility in the stock market, so as we’ve been saying for months now, investors need to stay disciplined and focused on their goals.”

1The Bureau of Labor Statistics defines marginally attached workers as “Persons not in the labor force who want and are available for work, and who have looked for a job sometime in the prior 12 months (or since the end of their last job if they held one within the past 12 months), but were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey. Discouraged workers are a subset of the marginally attached.”

What You Can Do Next

  • Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
  • Watch Schwab experts discuss other market and economic topics in the Stock Market Report.
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