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Cover image by: Sylvia Chang
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Instead, what we got was an almost unbelievably strong jobs report with more than 500,000 jobs created in January (the most since July) and a decline in the unemployment rate to 3.4%. This came after five consecutive months of decelerating job growth. Is this the start of a rebound or simply a statistical outlier? It is too early to say. In any event, here are the details.
The US government issues one employment report that includes two surveys: one is a survey of establishments; the other is a survey of households. The establishment survey reports that 517,000 new jobs were created in January with gains across a range of industries. Recall that, in the period between August and December, job growth ranged from 260,000 to 352,000—an extraordinary and unexpected number. This means that economic growth in the first quarter of this year is off to a strong start.
By industry, there were strong job gains in both construction and manufacturing. The lion’s share of construction jobs was in nonresidential, although residential construction saw an increase. Within the broad services sector, there were strong gains in retail (up 30,100), transportation and warehousing (up 22,900), professional and business services (up 82,000), private education services (up 25,800), health care services (up 79,200), leisure and hospitality (up 128,000 including 98,600 for restaurants and bars), and government (up 74,000). The latter included 39,000 for state governments and 30,000 for local governments. Even when job growth was much stronger early in the postpandemic period, job growth was mostly concentrated in leisure and hospitality. This report signals a more widespread creation of jobs.
The establishment survey also reported on wages. With strong job growth in a tight labor market, one would expect accelerating wages. Instead, the opposite happened. In January, average hourly earnings increased only 4.4% from a year earlier, the slowest rate of wage increases since August 2021. Earnings were up a modest 0.3% from the previous month. Thus, as inflation is receding, so are wage gains. This means that the labor market is not contributing to inflation. It also means that workers are experiencing a loss of real purchasing power. Meanwhile, there continued to be relatively strong wage gains in the leisure and hospitality sector, with average earnings up 7% from a year earlier.
The separate survey of households found a modest increase in the participation rate in January. It also found that the number of employed grew faster than the number of labor market participants. The result was a decline in the unemployment rate from 3.5% in December to 3.4% in January. These numbers also reflect a strong labor market.
The general zeitgeist had been that the Federal Reserve needs to see a weakening of the labor market before it is willing to slow or reverse the pace of monetary tightening. This reflects the belief that the job market remains sufficiently robust and that it might prevent inflation from easing to the 2% target. Thus, the most recent report was interpreted to mean that the Fed is likely to tighten more than previously expected. As such, equity prices fell while bond yields increased on expectations of further rate hikes amid underlying inflationary pressure. The dollar strengthened.
However, some investors worry about a tight labor market because it could exacerbate inflation. And yet even with accelerating employment, wages are decelerating. It makes little sense. This part of the equation appears to be irrelevant to investors, at least for now. Often, investors react to news based on what they think other investors will do. That might explain their failure to consider the surprising wage environment.
The data on job vacancies suggests a slight increase in the tightness of the job market. After several months of declining vacancies, the job vacancy rate increased to the highest level in five months, suggesting the possibility that the job market is not yet weakening in the way that the Federal Reserve would like to see. The employment cost index, meanwhile, saw a further easing of wage and benefit inflation, suggesting that the labor market, despite tightness, is still not contributing to inflation and that wage behavior is moving in the direction sought by the Fed.
Of the 20 member countries in the Eurozone, 14 had positive growth from the third to the fourth quarter while six experienced a decline in real GDP. Those six included Germany (down 0.2%) and Italy (down 0.1%). The others were Czechia, Lithuania, Austria, and Sweden.
The fact that the Eurozone temporarily averted recession is likely due to several factors. These include a mild winter, which reduced the impact of the energy shock. Indeed, gas prices in Europe are down substantially, which helped to ease the loss of consumer purchasing power. In addition, several governments in Europe have provided subsidies to consumers and businesses to offset the impact of high energy prices. This is the equivalent of a fiscal stimulus and helped to offset the impact of a tighter monetary policy. Going forward, however, the European Central Bank (ECB) is still expected to tighten monetary policy further. As this happens, interest-sensitive sectors of the economy are expected to suffer negative consequences, potentially pushing the region into recession.
The decline in real GDP in Germany is important. It reflects the disproportionate impact of the energy shock on Germany’s industry-intensive economy. Although gas prices have fallen, they remain elevated. This had a negative impact on output in heavy industry such as chemicals. In addition, despite government support, the energy shock evidently led to a decline in real consumer spending. Moreover, Germany’s weak performance in the fourth quarter was part of a longer-term trend. Real GDP remains only 0.2% larger than just prior to the pandemic, a much worse performance than in the rest of Europe. On the other hand, the fourth quarter performance was not as bad as might have been absent the mild winter weather.
When volatile food and energy prices are excluded, core prices were up 5.2% in January versus a year earlier, the same as in December, which was the highest on record. Core prices fell 0.8% from December to January, suggesting that core inflation has peaked.
Annual inflation varied by country. Inflation was very high in the three Baltic countries, ranging from 18.4% to 21.6%. The EU did not report inflation for Germany. In the other big Eurozone economies, inflation was 10.9% in Italy, 7% in France, and 5.8% in Spain, which was the lowest inflation rate in the Eurozone.
With respect to Spain, inflation rebounded in January, surprising and worrying investors. Consumer prices, measured on a harmonized basis for the Eurozone, were up 5.8% in January versus a year earlier, higher than the 5.5% in December. It was the first acceleration in inflation since July of 2022. Prices were down 0.5% from the previous month, due to continued declines in energy prices. That, in turn, likely reflected the impact of a mild winter. Yet, when volatile food and energy prices are excluded, core inflation continued to accelerate, hitting a record level of 7.5% (it was 7% in December). Thus, underlying inflation is getting worse.
The inflation report for Spain was a big surprise given that Spain has seen a steady and sharp decline in inflation in recent months, putting Spanish inflation well below that of several other Eurozone economies. The sudden rebound could be seen as a red flag, especially given the continued acceleration of core inflation. It was likely easy for businesses to pass on cost increases to their customers given the relative strength of the economy, which grew 0.2%in the fourth quarter.
Despite the decline in headline inflation in the Eurozone, the ECB is expected to raise its benchmark interest rate by 50 bps at its upcoming meeting this month. The ECB is likely paying closer attention to core inflation, which has not yet decelerated but has likely peaked. The ECB is probably concerned that the Eurozone economy continues to exhibit strength as evidenced by positive purchasing managers’ indices, growing GDP in the fourth quarter, and a relatively robust job market. These factors make it difficult to suppress underlying inflation.
The principal reason that the European central banks are doing this is that inflation in Europe remains far higher than in the United States and does not show signs of abating. Although headline inflation in the Eurozone has fallen due to a drop in energy prices, core inflation has not started to decline. Moreover, it is likely that, in the coming months, the ECB and possibly the BOE will continue to tighten more than the US Federal Reserve. Indeed, the benchmark rates in the United Kingdom and Eurozone are currently significantly below that of the United States.
Regarding the action of the ECB, President Christine Lagarde was adamant that monetary policy is not close to reversing. She noted that the situation in Europe is different from that of the United States in several ways. First, Europe has had fiscal stimulus in the form of energy subsidies while the United States is in the midst of a fiscal contraction. She urged that European stimulus end soon. Second, she noted that, although wages in the United States are decelerating, that is not happening in Europe. Thus, there is greater risk in Europe that the tight labor market will contribute to inflation. Finally, with the opening of China and the possibility of a surge in commodity prices, she feels that this will influence prices in Europe more than in the United States. Yet despite Lagarde’s hawkish comments, many investors appear to be more sanguine about the outlook for Europe.
Meanwhile, the BOE is in an interesting situation. Its latest forecast is that inflation will fall below the 2% target by the end of the year. Yet that is due to the assumption that monetary tightening will stifle economic activity sufficiently to suppress inflation. As such, the BOE has chosen to continue on a path of severe tightening, knowing that this means very weak economic prospects. On the other hand, with the benchmark rate now at a 15 year high of 4%, the BOE hinted that it might now pause. Moreover, the BOE’s forecast of economic growth is not as bad as previously. Still, the policy committee said that “if there were to be evidence of more persistent inflationary pressure, then further tightening in monetary policy would be required.”
Finally, investors reacted very positively to the news emanating from both central banks. Equity prices increased and bond yields fell sharply across Europe. They likely expect a rapid decline in inflation and a less onerous economic downturn than previously anticipated.
Cover image by: Sylvia Chang