The August Employment Report and Fed Tapering

The stock market's rally should not be dented by this week's August Employment Report, even if it as strong as consensus expects.  This is because a strong Report may not be enough to trigger a Fed decision to start tapering.  In contrast, a soft Employment Report could push the market's view of the start of tapering into next year.

Both Fed Chair Powell and Fed Vice Chair Clarida highlighted the need to see further progress in labor market improvement, particularly a significant decline in the Unemployment Rate -- which is not likely to be fully realized in the August Employment Report.  The Rate has a long way to fall before reaching pre-pandemic levels.  The Total as well as almost all its sub-components were about 2 percentage points above these earlier levels in July.  It could take several months to make a sufficient dent in this spread to warrant saying "substantial progress has been made."  That may be why Powell and Clarida both seemed to indicate a late-Q421 start to tapering. 

Consensus looks for +728k m/m Nonfarm Payrolls, a strong gain even though less than the +943k in July.  Some evidence supports the idea of an even larger gain than July's.  /1/ The Claims data argue for a speedup, as Continuing Claims fell much more sharply between July and August than between June and July.  /2/ State & Local Education jobs could jump even more than in July as the school year began in parts of the country.  

But, there is other evidence suggesting a smaller gain in August than in July.  /1/ The Claims data missed the speedup in July Payrolls, so they may not be a reliable indicator in August.  August Payrolls could see payback for the surge in July Payrolls, making the 2-month change more consistent with the Claims data.  /2/ In 5 of 7 months so far this year, Payrolls sped up when the ADP Estimate was larger than the (first-print) Payroll print in the prior month and slowed when the ADP Estimate was smaller than the Payroll print in the prior month.  ADP was 330k in July while Private Payrolls was 703k.  If the relationship holds, August Payrolls should slow relative to July.  Consensus for August Private Payrolls is +610k, consistent with this evidence.

Consensus expects the Civilian Unemployment Rate to fall to 5.2% from 5.4%.  The Insured Unemployment Rate, calculated from the Claims data, supports this estimate.  The Insured rate fell 0.3 percentage point between the July and August Employment Survey Weeks.  This is only suggestive, however, since there is no exact relationship between the Insured and Civilian Unemployment Rates (see table below).  One reason for the inexactness is that the Civilian Rate is based in part on the Labor Force while the Insured Rate is not.  Note that even if the consensus estimate is correct, the Civilian Unemployment Rate still would be well above its pre-pandemic low of 3.5%.

                         Level in Survey Week (percent)
    Insured Unemployment Rate            Civilian Unemployment Rate 

Jan21          3.4                                            6.3
Feb             3.1                                            6.2
Mar            2.7                                            6.0
Apr             2.6                                           6.1
May            2.6                                           5.8
June            2.5                                           5.9
July            2.4                                           5.4
Aug            2.1                                           na        

Consensus also looks for a dip in the Mfg ISM -- the other key data this week -- to 58.5 in August from 59.5 in July.  Most other mfg surveys fell in August, although some could be catch-up after missing the decline in the July Mfg ISM.  A near-consensus print would still be a strong level, but the pullback could underscore problems in the supply chain.  A modest decline would not likely be enough to dissuade the Fed from beginning tapering later this year.

Tapering Here We Come?

The stock market could trade cautiously ahead of Fed Chair Powell's speech at the August 26-28 Kansas City Fed conference at Jackson Hole.  But, there is reason to think the recovery from the initial sell-off on the release of the July FOMC Minutes will continue.  

Initially, the market sold off on news headlines highlighting the Minutes' sentence that "many participants" could see the appropriateness of beginning to taper by year end.  But, a near-term start is not a given.  The news reports did not emphasize the conditionality of this view nor the lack of unanimity among the participants regarding the timing.   (One of the "hawks," Dallas Fed President Kaplan, already has said he may have to adjust his position on beginning tapering in October if the Delta variant significantly impacts the economy.)  Moreover, Biden's decision whether to re-appoint Powell as Fed Chair -- a decision expected to made this autumn -- conceivably could play a role in the timing of the tapering. 

There were 3 key sentences in the Minutes:

1. "Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee's 'substantial further progress' criterion as satisfied with respect to the price-stability goal and close to being satisfied with respect to the maximum-employment goal."

    a.  This is the sentence cited in news stories.

But, this was followed by sentences indicating differences of opinions among participants:

2. "Various participants commented that economic and financial conditions would likely warrant a reduction in coming months."

 3. "Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee's 'substantial further progress' standard or because of uncertainty about the degree of progress toward the price-stability goal." 

Given the lack of unanimity in the FOMC, Powell's speech is unlikely to be precise about when tapering will begin.   It could discuss the conditionality of the decision, but again not in a precise way (as he has done in is post-meeting news conferences).  He will probably emphasize the Fed's intent to maintain the funds rate at its currently low level for a long time.  Indeed, the need for a low interest rate as a catalyst to economic growth takes on more importance if tapering begins.  The markets' view of tapering could soften if this idea takes hold.  Stocks could have a relief rally after the speech.

Nevertheless, with the Claims data suggesting another strong Payroll gain in August, the next Employment Report will probably support the "hawks" at the September FOMC Meeting.   But, a large jobs gain may not be enough to satisfy the "doves."  They could still be concerned about the large shortfall in jobs relative to the pre-pandemic peak (5.7 Mn in July) and the 2% pt spread between the current Unemployment Rate and the pre-pandemic low (total as well as sub-groups).  The latter could be particularly important from a political perspective, given that Powell has committed the Fed to lowering the Unemployment Rate for Blacks and Hispanics.   So, while the September FOMC Statement will likely open the door for a tapering, it could leave the starting date dependent on further improvement in the labor market. 

The choice of the next Fed chair could influence the timing of tapering.  News reports suggest that Biden already is being pressured by progressive Democrats not to re-nominate Powell because he is not pushing the Fed hard enough in the direction of bank regulation, income inequality, and climate change.  Fed Governor Brainard is said to be the progressives' choice.  Biden may be forced to show his hand in September, since he could nominate Brainard for Fed Vice Chair, which will be vacant in October.  If Brainard is chosen to be Fed Chair instead, Powell could join the "doves" in pushing for a start to tapering in Q421, if only to make it easier for his successor.  If he is chosen, he could hold out against tapering until the Unemployment Rate spread shrinks by more -- avoiding a problem with Democrats in his confirmation hearings.

Besides the discussion on tapering, the FOMC Minutes contained an insightful summary of the Fed staff's economic outlook.  Fed staff said that "in the second half of 2021, an easing of the surge in demand seen over the first part of the year was expected to be largely offset by a reduction in the effects of supply constraints on production, thereby allowing real GDP growth to continue at a rapid pace."  Last week's US economic data fit this scenario -- July Retail Sales pointed to a flattening in their trend and housing data suggested a softening trend beginning in the 1-Family sector, but Industrial Production showed an upturn in the chip-constrained motor vehicle production.  This compositional shift has a curious implication for the inflation outlook -- slower demand will put downward pressure on prices, but so will an increase in supply as shortages ease.  The economy could be moving into a period of moderate, but uneven, growth and slowing inflation.  Ironically, this scenario could make it difficult for the Fed to justify tapering.

Bracing for the Fed

The stock market will likely trade cautiously ahead of the Kansas City Fed's Jackson Hole Conference on August 26-28.  The Fed Chair's speech at this annual conference sometimes announces intentions to change monetary policy.  So, the markets will probably brace for an announcement about an intention to taper in the near term.  They will be looking for hints to this effect in this Wednesday's release of the July FOMC Meeting Minutes -- although they are not likely to find much, given that Fed Chair Powell's post-meeting conference did not provide any new insights.  In the background, concern about the negative effects of the Delta virus variant could weigh on stocks.  But, this concern should be mitigated if upcoming US economic data continue to point to strong growth.

This week's US economic data releases will touch on the consumer, manufacturing and construction sectors.  Consensus looks for -0.3% m/m Total and +0.2% Ex Auto Retail Sales for July.  A small decline or increase is typical after a strong Sales gain as in June (+0.6%Total, +1.3% Ex Auto).  So, any commentary attributing a soft print to the virus should be viewed dubiously.  The July Employment Report showed job gains in most Retail categories, suggesting Retail Sales remain in an uptrend.  

Consensus looks for a +0.5% m/m increase in July Industrial Production and, within it, Manufacturing Output.  The risk is for an even larger gain in the latter, as the consensus estimate does not appear to take account of a productivity gain this month -- the expected Output increase equals the increase in Total Hours Worked in manufacturing.  What could be important for the stock market if this report suggests the chip shortage is ending in the motor vehicle sector.  The clue will be whether Motor Vehicle Assemblies increase m/m.

Consensus expects a dip in July Housing Starts but an increase in Permits.  A dip in Starts could be just a lagged reflection of the decline in Permits in June.  So, if Permits rebound in July, the decline in Starts should be dismissed as temporary. That said, the housing sector has a problem.  The Affordability Index (based in part on Existing Home Prices) has been declining all year because of the surge in home prices.  Since March, the Index has dropped to its lowest  level since 2018 despite the benefit of lower mortgage rates.  The risk is for a shift to rentals from 1-Family purchases, which could hurt construction activity.  Higher rents will eventually show up in the CPI, while home prices could soon be coming down.

Door Open for Fed Tapering

The strong July Employment Report increases the risk of the Fed cutting back its bond buying program before year-end.   Economic growth and the labor market are on solidly positive paths, allowing Fed officials to say they're seeing "substantial further progress" toward their "maximum employment" goal.  Officials will have many speech opportunities to inform the markets of a policy shift in coming weeks, as the next FOMC meeting is on September 21-22.  But, with the Unemployment Rate still well above pre-pandemic lows and inflation looking as if it will soon come off its extraordinary high pace, a Fed rate hike is likely a long way off.  Indeed, the increased chances of tapering could put additional downward pressure on commodity prices.  The markets' reactions to tapering will likely be muted as a result.

The July Employment Report was strong.  The +943k m/m surge in Nonfarm Payrolls is mostly attributable to Leisure & Hospitality (+380k) and State & Local Education Jobs (+231k).  But, even without these post-pandemic bounce-backs, Payrolls rose a strong 332k.  Moreover, June and May Payrolls were revised up.  The surge in jobs was also seen in the 1.0 Mn jump in Civilian Employment.  This swamped the moderate increase in Labor Force, so the Unemployment Rate dropped to 5.4% from 5.8%.  Total Hours Worked in July stand 4.3% (annualized) above the Q221 average, pointing to another strong Real GDP Growth in Q321.  The Atlanta Fed model's latest projection is 6.0% (q/q, saar), similar to the 6.5% growth rate in Q221.

While it is too soon to draw a conclusion about the risks to the August Employment Report, the early evidence from the Claims data suggests another strong report.  Specifically, the -366k w/w drop in Continuing Claims to 2.930 Mn, a new low for the move down, suggests a speedup in hiring.

Despite the strong growth, inflation may be moving down toward the Fed's target of 2%.  Consensus looks for +0.4% m/m Total and +0.5% Core in this week's July CPI report.  They are about half the June pace (+0.9% each).  Some of the culprits for the recent large increases -- used car prices, gasoline prices -- have begun to flatten.  The July report may be too soon to see the full extent of the flattening, however.  So a further deceleration in coming months is a good possibility.

Labor Costs are moving up, but they too may be starting to moderate.  Although Average Hourly Earnings were higher than expected in July, +0.4% m/m after an upward-revised 0.4% in June (was +0.3%), they were slower than the 0.5-0.7% seen in April and May.  Wages rose the most in sectors with labor shortages -- Leisure & Hospitality and Transportation/Warehousing sectors.  Wage pressures in these sectors may begin to ease in September when the ending of supplemental Unemployment Benefits may induce an increase in labor supply.  This week's report on Q221 Unit Labor Costs will show whether Productivity Gains are offsetting the higher wage inflation.  Consensus looks for a slowdown in ULC to 1.2% (q/q, saar) from 1.7% in Q121, which is in the right direction from an inflation perspective.

Risks in This Week's Key US Economic Data

The stock market will be focusing on key US macroeconomic data this week -- the July Mfg ISM and Employment Report.  The risk is for both to come in softer than consensus.  Such prints could be a positive for stocks, as they would argue against an early start to Fed tapering.  Away from the data, the market needs to see Congress hike the debt ceiling by the end of Monday.  A short-term moderate-sized hike would seem to be a likely outcome, as the two "infrastructure" proposals appear to be far from approval.

Consensus looks for a speedup in July Nonfarm Payrolls to +900k m/m from +850k in June.  The Claims data, however, don't suggest a jobs speedup.  The 4-week average of Initial going into the July Payroll Survey Week was about the same as it was going into the June Survey Week -- 387k versus 396k.  This suggests the pace of layoffs did not change much.  It is possible that some of the chip-shortage vehicle plant shutdowns could subtract from Payrolls this month.  And, the decline in Continuing Claims between Survey Weeks was smaller in July than in June, suggesting not as many people returned to work in July as in June. 

Consensus also looks for a 0.2% pt m/m decline in the Civilian Unemployment Rate to 5.8% in July from 5.9% in June.  The Insured Unemployment Rate, which is based on Continuing Claims, does not rule this out.  The Insured Rate edged down 0.1% pt for the 2nd month in a row.  There could be catchup by the Civilian Unemployment Rate after it rose in June, contrary to the Insured Rate.  But, there is a lot of uncertainty regarding the Labor Force Participation Rate.  If many people are encouraged to re-enter the labor market, the Participation Rate would increase and work to lift the Civilian Unemployment Rate if the re-entrants don't have jobs yet.

Consensus expects a moderate 0.3% m/m in July Average Hourly Earnings.  While the y/y would rise to 3.9% from 3.6% in June, this m/m pace would suggest the speedup in labor costs is not excessive yet.  The slowdown in the Q221 Employment Cost Index, reported last week, was encouraging in this regard.

Consensus sees a uptick in the Mfg ISM to 60.9 in July from 60.6 in June.  Evidence from other surveys is mixed.  Markit Mfg PMI, Empire State Mfg,  and Chicago PM rose, but Phil Fed Mfg Index fell.  None of these has tracked the m/m direction of the Mfg ISM reliably.  So, a decline cannot be ruled out.  The chip shortage problem could weigh on this Index, although the latter doe not tend to be dominated by the motor vehicle industry.