US Slowdown ?

Although the 250k jobs gain in October probably benefited from a net positive hurricane effect—we think the rebound from Florence was bigger than the hit from Michael—the underlying trend looks to be in the 200-225k range, more than twice the longer-term breakeven rate of around 100k. The household survey sent a similarly robust message. Although the unemployment rate edged up to 3.74% on an unrounded basis, this was entirely due to a rebound in labor force participation that masked the impact of another large rise in household employment. Underneath the month-to-month fluctuations, participation continues to trend sideways as the positive cyclical impact of stronger labor demand and the negative structural trends broadly cancel out. So we expect the unemployment rate to resume its decline in coming months, ultimately to 3% by early 2020. This is probably well below the level consistent with the Fed’s inflation target.

The 3.1% year-on-year gain in average hourly earnings in employment report reinforces that view because it suggests that the wage Phillips curve is indeed steeper beyond full employment, just as our city-level approach would imply in a sub-4% unemployment environment. Although the latest wage number did benefit from an easy year-on-year comparison, it came on the heels of a 3.0% year-on-year rise in the Q3 employment cost index for private-sector wages and salaries excluding incentive-paid occupations, probably the single best indicator of US wage growth. Further increases in wage growth to the 3¼-3½% range are likely over the next year.

All this suggests that inflation is on track for a meaningful overshoot of the Fed’s 2% target. In our baseline forecast of 2.3% for core PCE by late 2019, that overshoot remains within the Fed’s likely comfort zone. But we see the risks to this forecast as tilted to a bigger increase. Part of this is because core goods inflation looks set to move into positive territory on the back of higher tariffs and stronger upstream inflation readings; i.e., the core PPIs for finished and intermediate goods have moved up significantly over the past year, but this has yet to show up in the core goods CPI and PCE. But the deeper reason is that labor market tightness is moving to levels rarely seen in postwar history at the national level, and it suggests that such extreme readings typically push inflation notably, not just slightly, higher.

So the economy really needs to slow to avoid a dangerous overheating. And some signs of deceleration are emerging. Our fourth-quarter GDP estimate is at 2.6%, well below the prior two quarters, and our current activity indicator (CAI) fell to 3.0% in October, after readings in the 3½-4% range for several months. The fundamentals are also pointing to gradually slower growth in 2019, as fiscal support is likely to diminishand we expect the boost from financial conditions to turn into a moderate drag, even if the equity market continues to rebound from October.

If unemployment is below 3½% and inflation above 2%, we think Fed officials will need to be quite confident that growth will stay at or below trend to sound an all-clear on further rate increases, which could translate into a large easing in financial conditions and a return to growth rates well above trend. That point could arrive in the second half of 2019, but we think early 2020 is more likely. Moreover, given the self-sustaining momentum in the economy seen for most of 2018, there is still a meaningful risk that the slowdown we forecast proves insufficient to stabilize the unemployment rate until well into 2020, or that inflation overshoots by more than we expect. So we view the risks around our forecast of five more 25bp hikes from here—roughly two more than market pricing—as broadly balanced, if not a little tilted to the upside.

Last, it is harder to say how the other key economic policy issue—the trade war—relates to the outcome of the election because the White House largely controls trade policy without Congressional input. For now, our working assumption remains that the escalation versus China will continue, with an increase in the tariff rate on the last $200bn of imports to 25%, and ultimately some tariffs on all US imports from China. we suggests that this would only have a limited impact on US growth, and might even reinforce our hawkish rate views by boosting core inflation. Admittedly, however, the risks to this view are tilted to the downside, especially if China broadens its retaliatory measures beyond tariffs, e.g. by restricting the activities of US multinationals or letting the currency depreciate more sharply.