For all the warnings in the latest US employment report that the Federal Reserve should think twice about raising interest rates, the labour market’s most important health measure is signaling that it should do just that. Official figures on Friday showed a surprise fall in the number of jobs in the economy and slowing wage growth in July.
But the unemployment rate fell to 4.1%, the lowest in over a year, and continued its downward drift from November’s recent peak of 4.5%. An unemployment rate of 4.1% is, by any measure, reflective of an economy at, or close to, full employment.
Moreover, it is now slipping below what many observers, including Federal Reserve officials, would consider the long-term "natural” rate of unemployment that neither fuels nor cools inflation. This theoretical number is sometimes referred to as the non-accelerating inflation rate of unemployment (NAIRU). The median estimate of the long-run unemployment rate in the Fed’s quarterly Summary of Economic Projections has been 4.2% for the past two years.
The unemployment rate is now back below that long-run projection for the first time in over a year.
Torsten Slok, chief economist at Apollo Global Management, zooms out a little further and notes that unemployment has been at or below 4.5% - the upper end of the Fed’s long-run NAIRU estimate range - for 58 consecutive months. That’s the longest stretch on record, showing that the labor market has been in "excess-demand territory” for an unusually long time, Slok says. Surprisingly low unemployment certainly helps explain why inflation has been above target for so long.
Lower NAIRU estimates mean unemployment would need to be even lower to exert upward pressure on inflation. A Kansas City Fed model estimate of the long-term natural unemployment rate - or U-star - was 4.3% in July, the lowest in nearly two years.
These are theoretical measures. Among the plethora of real-world US labour market indicators, from "JOLTS” job openings to jobless claims, and from nonfarm payrolls to wage growth, the unemployment rate is the first among equals. Or as Slok puts it, "the best guidepost.”
This view is generally shared across the Fed’s interest rate-setting Federal Open Market Committee. Richmond Fed President Thomas Barkin said so after the July figures were released. Governor Christopher Waller said something similar last month, and Cleveland Fed President Beth Hammack said the same in June.
Former Fed Chair Jerome Powell repeatedly nodded to the unemployment rate’s weight over the years. You can see why. It is well-known, easy to understand and updated regularly. Despite methodological and calculation differences, it is also generally comparable with other countries.
This makes it a pretty decent measure of the US labour market’s relative strength globally.
As the unemployment rate is considered a good proxy for broad slack - or otherwise - in the economy, it is often a key input into economic models like the "Taylor Rule,” which estimates the level of interest rates that gives the Fed the best chance of delivering on its dual inflation and employment goals.
Of course, it’s dangerous to put too much weight on one indicator, and Powell also repeatedly said the FOMC looks at the "totality” of the data. And rightly so. It’s well-documented by now that the jobs market is being heavily distorted by the shrinking supply of workers.
The labour force participation rate (LFPR), excluding pandemic-related distortions in 2020-21, is the lowest in more than 50 years.
This trend has accelerated in the last couple of years, with post-pandemic societal issues thought to be discouraging people from looking for work. Many baby boomers with a nice stock-market-boosted retirement cushion may have dropped out of the labor force too.
But most analysts say President Donald Trump’s aggressive anti-immigration policies are the chief reason the supply of workers has fallen off a cliff. This would suggest the unemployment rate is being kept artificially low for the "wrong” reasons. So much so, break-even job growth - the pace of hiring needed to prevent the unemployment rate from rising - is now close to or perhaps below zero, as July’s data indicated.
Not one of the 68 respondents in a Reuters survey predicted a net decline in jobs in July, and hefty downward revisions to previous months mean the three-month moving average of nonfarm payrolls growth has sunk to just 20,000 from 142,000 in May.
Meanwhile, wage growth cooled in July as well, with monthly and annual average earnings growth rates of 0.1% and 3.2%, respectively, both below every forecast in a Reuters poll of dozens of respondents. When it comes to Fed thinking on interest rates, this softness will probably not be enough to offset historically low unemployment, and five years - and counting - of inflation above the Fed’s 2% target. At least not yet. If unemployment stays low, even for the "wrong” reasons, upward pressure on rates will likely persist.
n Jamie McGeever is a columnist for Reuters. The opinions expressed here are those of the author.