How the US Labor Market Affects Inflation and Interest Rates

　　Ever since the beginning of the year, the market has continuously raised interest rate expectations, and U.S. bond yields have experienced wide fluctuations. In early May, markets overlooked structural pressures in the labor market and wagered on rate cuts in the second half of the year. However, the higher-than-expected PCE reading in April attested to the resilience of the labor market. The market’s expectations for the Fed’s policy stance have been reversed once more, and interest rate hike expectations have been revived. As of May 31, CME interest rate futures implied fed funds target rate expectations showed that the probability of the Fed stopping raising interest rates in June was 77.3%, while the weighted average interest rate expected at the December interest rate meeting was 4.95%, and the rate cut expectations weakened. The labor market is the biggest uncertain factor affecting the trend of US inflation and the path of interest rate hikes by the Federal Reserve. The pressure on the structure of the labor market cannot be ignored.
U.S. labor market remains resilient

　　Although the U.S. labor market marginally slowed down in May, it remained resilient. On the one hand, the unemployment rate has risen more than expected, and the labor supply has marginally improved. According to the Household Survey, total employment fell by 310,000 in May and the unemployed rose by 440,000, causing the unemployment rate to rebound to 3.7%, surpassing market expectations of 3.5%, but the average hourly wage growth rate fell only slightly to 4.3 % (the previous value was 4.35%), and the “wage-inflation” spiral pressure is still relatively large. On the other hand, new non-agricultural employment exceeded expectations, and labor demand remained strong. According to the establishment survey data (Establishment Survey), the number of non-agricultural employment increased by 339,000 in May, far surpassing the market expectation of 195,000.
Looking back, the U.S. job market will remain tense, and it will take time for the demand side to cool down. First, the number of people employed in “temporary support services” has turned positive, and labor demand has remained resilient. In the non-farm payrolls data, “temporary-help” (Temporary-help) can be used as a leading indicator of the overall employment situation. The number of temporary support service employment in May turned from negative to positive, and the data in March and April were revised upwards, which pointed to the labor market’s resilience after a brief period of weakness since February. Second, the labor market condition index (LMCI) remains high, and the labor market is still in a relatively tense state. LMCI is a measure of the Kansas City Fed’s comprehensive 24 indicators to measure the state of the labor market. Among them, the LMCI activity level index reflects the tightness of the labor market compared with the historical average level, that is, greater than zero indicates a tense state, and less than zero indicates relaxation; the LMCI momentum index reflects marginal changes in the labor market. The latest readings in April show that the LMCI activity level index rebounded slightly and remained at a historically high level, and the labor market is still in a high state of tension; the LMCI momentum index has been negative for six consecutive months, indicating that the labor market tension has marginally weakened.

Third, the turnover rate in industries such as manufacturing, education and medical care is still higher than before the epidemic, and workers still have some bargaining power. To a certain extent, the turnover rate can measure the confidence in the labor market and the tightness of the labor market. Since the middle of 2022, the turnover rate has continued to decline. The overall turnover rate in the labor market in April has been close to the pre-epidemic level, but the turnover rate in some industries such as manufacturing, education and medical care is still higher than the pre-epidemic level, and workers still have some bargaining power.

Structural supply-demand mismatch is the root cause

　　The overall supply and demand situation in the labor market has deteriorated, and structural pressures still exist. The job vacancy rate rebounded to 4.6% in April, an increase of 0.8 percentage points from the previous value; job vacancies increased by 358,000, reaching the high water mark of 10 million. At the same time, the gap in the labor market also increased by 540,000 to 4.45 million, indicating continued strength in the labor market. From a structural point of view, the labor demand side is still resilient. In May, the U.S. ISM manufacturing PMI employment rate rose significantly (51.4), and remained above the boom-bust line; the ISM service industry PMI employment rate fell below the boom-bust line (49.2). As a result, labor demand has marginally weakened, but remains resilient.
　　From the perspective of the employment population, under the impact of the epidemic in 2020, the service industry will be limited, and the proportion of manufacturing employment will jump in the short term. However, as the epidemic is released, the labor market will gradually return to normal, and the manufacturing employment population will continue to decline. . Except for the slight decline in the number of manufacturing employment in May, all new employment in other industries was positive, and services such as education and medical care were the main contributors to the new non-agricultural employment. Combined with the vacancy rate corresponding to service industries such as education and medical care, it has rebounded and remained at a relatively high level in history, and there is still a high demand for labor in the service industry.
　　Labor supply is inelastic. In terms of age, the participation rate of the elderly population (over 55 years old) is relatively low. Since the beginning of the year, the participation rates of the 16-19 and 20-54 age groups have remained above 36.8% and 82.7% respectively, returning to pre-epidemic levels; the participation rate of the elderly population over the age of 55 is around 38.5%. About 1.5 percentage points lower than before the epidemic. Considering that the elderly are greatly affected by the epidemic, it is more difficult to return to the labor market, the supply of labor is close to saturation, and its elasticity is relatively low. In terms of ethnic groups, a low unemployment rate is common among all ethnic groups. Except for the unemployment rate of Hispanics or Latinos that continued to decline in May, the unemployment rates of other ethnic groups have risen, but they are still at a relatively low level.

Breaking the “wage-price” spiral requires re-anchoring inflation expectations

　　Inflation expectations are on the rise again, and the labor market continues to be strong, supporting wage growth and exacerbating the “wage-price” spiral to a certain extent. Since April, long-term inflation expectations have risen again. Inflation expectations are self-fulfilling and self-reinforcing. Inflation risks may have a second half. Specifically, the transmission path of inflation expectations mainly includes two paths: first, inflation expectations encourage the smoothing of future consumption by the real sector, and the increase in current consumption directly affects inflation, that is, “inflation driving factors→inflation degree↑→inflation expectations↑→current consumption ↑→core inflation degree↑→inflation expectations↑”; second, inflation expectations lead to wage inflation through the “wage-inflation” spiral, that is, “inflation drivers→inflation degree↑→inflation expectations↑→wage inflation↑→core inflation degree ↑→Inflation expectations ↑”.

　　Under the sticky expectation of inflation, the labor market is the biggest uncertainty factor affecting the trend of core CPI in the United States. On the one hand, the Beveridge curve has moved up after the epidemic. Since April 2020, the Beveridge curve has risen upwards, indicating that the matching efficiency between job vacancies and unemployment has deteriorated, and the labor market has remained tight. On the other hand, in the post-epidemic era, the slope of the Phillips curve in the United States has risen significantly. Under the impact of the new crown epidemic, the shortage of global supply chains, the tension in the U.S. labor market and the rise of deglobalization, the slope of the Phillips curve from the perspective of the unemployment gap has risen significantly, which shows that core inflation will show an upward trend under the same degree of labor market tension. One of the reasons for the high stickiness of core inflation in this round.
　　Currently, cyclical factors support core PCE inflation to remain high. The San Francisco Fed splits inflation into cyclical and non-cyclical components based on the correlation between the inflation rate and the unemployment gap. Among them, the cyclical component includes all sub-items that are significantly negatively correlated with the unemployment gap, and this type of inflation is often more sensitive to the overall economic situation; the remaining is non-cyclical components, and this type of inflation is more sensitive to specific industry factors, such as healthcare services. From August 2022 to March 2023, the decline in core PCE in the United States is almost entirely contributed by non-cyclical factors, while cyclical components continue to rise, supporting the high viscosity of core PCE.
　　From the perspective of inflation, wage growth remains high, and rents and services other than rents are still highly sticky. In terms of rent, the unemployment rate has a clear lead on rent inflation, leading by about 2 quarters. Since the outbreak of the epidemic in the United States in 2020, the labor market has continued to be strong, and the unemployment rate has gradually dropped to historical lows, strengthening the stickiness of rent inflation. In terms of services excluding rent, the service industry is a labor-intensive industry, and the price of core services other than rent depends on labor costs. In the cost structure of the service industry, labor costs account for a relatively high proportion. The current labor market remains strong, wage growth remains high, and core services remain highly sticky.