Friday's US employment report was undoubtedly good news. After months of disappointment, the Bureau of Labor Statistics was, at long last, able to publish a report that contained genuine upside surprises.
The gain of 308,000 in non-farm payrolls in March was well ahead of market expectations. Doubtless it will be seized upon as evidence that the US economy is finally beginning to respond in a proper fashion to the doses of monetary and fiscal medicine handed out to all and sundry by the Federal Reserve and the Treasury Department.
Certainly, the Bush Administration will want to take March's job numbers as a clear sign that the economy is back to normal. With a presidential record on job destruction beaten only by Herbert Hoover during the Great Depression, George Bush will at last have some favourable economic ammunition to fire at John Kerry ahead of November's presidential election.
Financial markets, though, may be a little less sanguine. No one is suggesting that jobs growth is unwelcome, but a whole series of other concerns may now develop, tugged along in the wake of an improving jobs market. The most obvious of these is a worry about higher interest rates. I have argued in this column before that the Federal Reserve is probably divided into three groups: those who focus on economic growth, those who focus on the labour market and those, finally, who spend their days gazing at the inflation figures. I have also argued that the risk of higher interest rates is more likely to come about when there is evidence in favour of both faster growth and an improving labour market. It now looks that both are coming through together - at least for the time being.
Does this mean that an interest rate increase is now just around the corner? If so, it would reveal a certain fickleness in financial markets. Only a month ago, when the employment report was a lot weaker than expected, futures markets began to think that maybe interest rates would not have to go up at all this year. A month later, the risks look rather different (see table).
How should we judge this debate? One way is to look back at previous turning points in US interest rates and see what was happening to the labour market at the time. I have dug out data going back more than 30 years and have highlighted each of the occasions when interest rates began to rise on a sustained basis from an earlier trough. I have then simply looked at the health of the labour market in the six months, 12 months and 24 months before the first of these rate increases, totting up the total cumulative change over each of these periods.
As the table shows, there have been five main periods of monetary tightening since 1970. The first began in 1971 and the last began in 1994. There have been odd blips and reversals on the way, but I think the periods I have picked represent the major shifts between worlds of falling or low interest rates and worlds of rising or high rates.
The remarkable thing about most of these periods is that they have been associated with extraordinarily strong jobs growth in the months and years running up to monetary tightening. At the end of the 1970s, as an extreme, rates started to rise after two years in which more than 6 million jobs were created. In the mid-1990s, interest rates started to rise only after two years in which more than 4 million jobs had been created.
So although it is true to say that the Fed does indeed raise interest rates after there is clear evidence of a recovery in the labour market, we need to say more than that. Interest rates are likely to rise only after a huge number of jobs are created, and we are still a very long way from that state of affairs. In the two years that ended last month, only 101,000 jobs had been created, making this a very strange recovery indeed (see chart).
There is one exception, 1971. In the six months prior to this batch of monetary tightening, the US economy had created only about 450,000 jobs and, over the previous year, had managed only 261,000. Why were rates heading up so quickly? The most obvious factor was inflation. Price pressures had begun to build in the late 1960s and, by 1970, inflation was approaching 6 per cent, enough to give any central banker a bit of a headache.
This time around, price pressures are a lot less obvious. Yes, commodity prices have been buoyant over the past few months but, at the same time, labour costs have been remarkably weak, driven down by a combination of low wage growth and rapid productivity gains. As a result, underlying inflation in the US is not much more than 1 per cent which, by most central banks' standards, is an inflation rate that is too low, not too high.
So I am really not convinced that this first month of jobs growth marks the start of a move towards monetary tightening. The Fed needs to see not just one month of job gains, but many months of gains, of sufficient size to suggest that interest rates can rise without throwing the recovery off course. And it may be that, as we go into the second half of the year, renewed doubts will emerge over the longer-term health of the US economic expansion.
The US has demonstrated a remarkable dichotomy over the past two years. Americans have lived through the biggest economic stimulus in the past 50 years, a combination of very low interest rates and expansionary fiscal policy. Yet they've seen the worst jobs record since the 1930s. And the problem for policymakers in the second half of 2004 is a likely loss of influence: taxes can't be cut easily and interest rates can't fall easily, yet these are the things that have, so far, kept the US economy's head above water.
For example, I reckon that the policy changes seen to date have been sufficient to boost US consumer spending growth by about 2 per cent a year in each of the past three years. These policy changes have done two things: first, they have supported post-tax incomes at a time when pre-tax incomes have been very weak; and, second, they have kept consumers borrowing despite the big declines in stock prices in 2001 and 2002. However, if tax cuts are running out and interest rates cannot fall any more, consumers suddenly look more vulnerable.
And that means that jobs growth really does have to come through on a sustained basis. Without it, the US consumer - and, hence, the US economy - is in trouble. So why rush? The Fed can afford to bide its time. Inflation is low, the jobs gains seen so far are very small, and the consumer is not yet on safe ground. Rates may eventually go up but the case for tightening monetary policy now does not seem to be terribly strong.Reuse content