In our December cyclical outlook, we offered a baseline view that the next phase of the business cycle in the U.S. would see a delicate handoff from job growth to wage growth. As we reach full employment, job growth should converge toward labor force growth (meaning a slowdown from 200,000 jobs per month toward 100,000–150,000), but this convergence should come along with an increase in wages. This is textbook macroeconomics: Job supply tends to be increasingly constrained by demographics and labor force growth. As the supply of unemployed labor dries up, the price of labor (i.e., wages) will go up to reduce demand and balance the market. This is the textbook second half of the business cycle expansion.
The least we can say is that Friday’s U.S. jobs numbers validate this representation of forces at play in the U.S. labor market. The change in nonfarm payrolls dropped to 151,000 from the recent pace of around 225,000 per month while average hourly earnings jumped to 2.5% year-over-year, a welcome acceleration from the recent 2.0% pace.
A functioning Phillips curve (in economic theory, the relationship between employment and inflation) is a cornerstone of our investment framework. With the U.S. economy reaching full employment, we expect to see higher wages and higher inflation in services ex shelter (think healthcare, education, hospitality, etc.). This source of domestic inflation is essential for the Federal Reserve to reach its inflation target, especially since we’re still facing global disinflationary headwinds.
U.S. inflation will remain driven by opposing forces. On the domestic front, our base case for inflationary tailwinds is being validated: Modestly slower job growth but higher wages should be sufficient to get services on an uptick. Continued headwinds include global disinflationary forces – mainly coming from Asia and also Europe – and a stronger U.S. dollar. As a result, we expect U.S. core CPI to remain steady at around 2% in 2016.
Again that handoff from job growth to wage growth is delicate; higher labor costs combined with lower import prices and a stronger dollar put pressure on corporate earnings and this could suppress willingness to hire. Interest rates and inflation break-evens marking new all-time lows should be a clear message to the Fed that the “delicate handoff” should be handled with care.