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The Fed is running out of time

Michael Knox

The US employment release for June 2017 published on 7 July, appeared to be the best of all possible worlds. Employment accelerated to 222,000 in the month of June. Yet in spite of this increase in employment, unemployment also rose to 4.4%. This seemed to indicate that the US economy could continue growing at a faster rate for longer than anyone expected.

Employment rose in healthcare, social assistance, financial activities and mining. In the US employment data, extra jobs drilling for shale oil are described as mining jobs. In June, healthcare added 37,000 jobs. Healthcare has added an average of 24,000 jobs per month in the first half of 2017. A closer examination begins to reveal the problem. The monthly average of new jobs in healthcare in 2016 was 32,000.

Still, there were other numbers that looked good in June 2017. Employment in social assistance rose by 23,000 in June. Employment in financial activities rose by 17,000 in June. In spite of this increase in employment, average hourly earnings rose by only 2.5% for the year to June. This appeared to indicate that the US could have strong employment growth and low unemployment but still retain a comfortably low level of wages growth and inflation.

This was comforting and it was an illusion. We can see part of the problem by looking at Figure 1 below. This shows us the year-on-year growth rate of US payroll employment for the period since the beginning of 2004. We see that the year-on-year growth rate of employment moved up slightly in June to a level of 1.55%.

Chart showing the annual growth in US Payroll Employment

The problem is that employment was growing at 2% annual rate back in March 2016. This means that the year-on-year growth rate of employment is still slowing down. 

Why is this happening? It is happening because the US is running out of people to give jobs to. We can also see this problem by looking at Figure 2 below. Here we see the level of US unemployment since January 2004. We have also provided a projection of where this data is going in coming months:

Chart showing US unemployment from 2004

At 4.4% unemployment, the US is now down below the natural rate. The Fed tells us that the natural rate of unemployment is 4.9%. This is the level below which wages growth begins to accelerate and add to core inflation. Well, you ask, doesn't that mean that inflation should be picking up now? How come this is not happening? Well, like many things in life, inflation takes time to occur. Our examination of the data tells us that core inflation starts to accelerate around six months after unemployment falls below the natural rate. Six months ago, US employment was still at the natural rate. This means right now we should be enjoying relatively stable inflation around the long term Fed target. This is pretty much what is happening.

But right now unemployment is significantly below the natural rate. That tells us that by year end, we should start to see inflation begin to significantly accelerate. Our examination of the data also tells us that the strength of this acceleration speeds up as the lag becomes longer. The current low level of unemployment means that inflation should be stronger in 12 months' time than it is in six months' time. Now we all realise that inflation is still a problem, even though it has not happened yet.

The focus on inflation in the business cycle has only been around since the second half of the 20th century. Before that, economies could go into recession without there being much inflation at all. Even if there is no surge in inflation, the US economy will reach a limit to its growth rate when it has finally run out of new people to give jobs to. We can define this point as being when unemployment is equal to the long term minimum rate. The lowest rate of unemployment that the US has seen in the past 30 years was 3.9%.

At that point, new people can only be employed when they become available to the work force by reaching employment age. In practice, it has not previously been possible to maintain economic growth at the minimum level of 3.9%. The last time this level was reached in August 2000, unemployment remained at this level for only five more months. The US economy then lurched into a shallow recession.

The Summary of Economic Projections released by the Fed after its quarterly meetings in March, June, September and December has suggested that the Fed will stop the decline of unemployment before it reaches this minimum level.

With only half a percent of unemployment between the current level and the minimum rate, we might conclude that the Fed is running out of time to stabilise unemployment above the minimum level.

Our projection suggests that unemployment will continue to drift down until it reaches the 3.9% level sometime around April next year. When that happens, we may judge that the Fed has finally run out of time.


The Fed needs to stabilise US unemployment where it is, or risk recession.

More information

View more analysis from Michael Knox by clicking on 'economic strategy' in the popular topics list to the right of this page. Alternatively, contact your Morgans adviser or nearest Morgans branch

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