The headlines numbers from the April employment report are at first blush a challenge to the Fed's low rate commitment. One doesn't have to dig much deeper into the data, however, to see that the near term implications are minimal as the Fed maintains its strong focus on measures of labor market slack. Still, the rapid drop in unemployment - if it continues - will leave policymakers increasingly anxious that their one-way bet on labor market slack will quickly turn sour.
Nonfarm payrolls grew pay 288k, well above expectations of 215k. While this numbers pushes the three-month moving average higher, the longer-term trend remains the same:
Maybe this is the month the acceleration begins. Maybe not. Either way, the report supports the dismissal of the weak first quarter growth numbers (now tracking in negative territory) as transitory. Just as has been the case for the last three years, there is nothing here to suggest a dramatic change in the pace of underlying economic activity.
The unemployment rate decline was a bit more interesting as it collapsed to 6.3% on the back of falling labor force participation:
The downward trend accelerated in the second half of 2013, pushing us ever closer to levels traditionally associated with greater inflationary pressures and with those pressures, tighter monetary policy. Policymakers, however, appear to remain content dismissing the unemployment rate in favor of a wider range of labor market indicators that suggest plenty of slack left in the economy. Federal Reserve Chair Janet Yellen's current four favorites:
The wage story is, in my opinion, the key. It is hard to argue against the labor slack story when employees can't push wages significantly higher. That alone should be enough to stay the Fed's hand. And if it isn't enough, they can always draw additional comfort from the inflation figures:
Inflation is, at best, only in the process of bottoming.
All that said, policymakers will be a little anxious that they are too quickly dismissing traditional metrics that would indicate they should be adjusting their inflation forecasts higher in light of the unemployment decline. As I am relatively confident will be much discussed this week, variants of the Taylor rule suggest that policymakers should already be raising rates:
In this environment, policymakers will increasingly worry about the policy lags. They will want to hold rates low, but the further unemployment drops, the more they will fear that they risk falling behind the curve - that by the time the pace of wages growth accelerates, inflationary pressure will already be well established. This is especially the case if they view the 2% target as a ceiling. Hence I remain concerned that the risk is that policy turns sharply tighter relative to current expectations.
I am also challenged to see why I should not expect the now-infamous dots in the summary of economic projections to be pulled forward on the basis of the falling unemployment rate. I am looking forward to the next FOMC meeting for that alone.
I emphasize, however, that any substantially tighter policy remains only a "risk," not a baseline. I anticipate that in her Congressional testimony this week, Yellen will emphasize the alternative measures of labor market slack and the Fed's expectation that policy rates will remain well below "normal" rates for a protracted period. As a general rule one report doesn't change policy.
Bottom Line: Overall, the general contours of the employment report suggest reason to (very) modestly bring forward expected rates hikes, but little to suggest any dramatic change to the Fed's reaction function overall. Policymakers, however, will worry that the current reaction function is overly dependent on dismissing the unemployment rate as an indicator of inflationary pressure. And there is a risk that they will move quicker than expected if that bet starts to sour. Risk, not baseline.