United States
Will the Real Employment Data Please Stand Up?
July 02, 2007

By Richard Berner | New York

The verdict is in: Job growth has slowed significantly, and more is coming.  But there are still important questions about the real underlying pace of job growth, because in 2007, two measures of employment have traded places.  Measured by the payroll survey, job gains have slowed by less than in the household canvass — the opposite of the 2006 results. 

Which metric is correct? And does it matter?  After all, it appears that the dichotomy between weak growth and relatively firm labor markets that we dubbed the employment conundrum only a few months ago is ending (see “The Employment Conundrum,” Global Economic Forum, April 9, 2007).  As expected, the economic slowdown is stabilizing while the deceleration in both hours and employment persists, so that productivity growth may be bottoming out. 

Assessing the underlying pace of job growth still matters, however.  If job and thus income gains are actually weaker and productivity growth stronger than official data portray, it could tilt expectations for both real growth and inflation below current expectations and again stir hopes for the Fed to ease monetary policy. 

Don’t count on it.  There is some evidence that the payroll survey may overstate job gains, but it is hardly conclusive.  I think the payroll survey, with all its flaws, is still more accurate than the door-to-door household canvass, primarily because it covers about one-third of all US establishments and is ultimately based on employment insurance records.  In contrast, the household survey covers about 60,000 individual responses.

Moreover, higher productivity growth won’t be a sufficient trigger for monetary ease.  Most Fed officials believe that the trend in productivity is considerably higher than the 1.6% gain in 2006 and higher even than the 2.1% rise in 2005.  Judging by their forecasts, they, like we, have been anticipating a return to higher productivity growth over the balance of this year and next.  And while productivity growth has important implications for slack in both product and labor markets, the near-term link between them and inflation has loosened.  So policymakers’ inflation outlook likely will depend on a broad array of factors, as it has over the recent past. 

What do the two measures of job growth indicate? Nonfarm payroll employment has decelerated to monthly average gains of 133,000 (1.2% annualized) in the first five months of 2007, compared with gains averaging 189,000 (1.7%) in all of 2006.  Those results have closely tracked our expectations.  In contrast, gains measured by the household employment yardstick (the one estimated from the survey used to calculate the unemployment rate), and which outpaced the payroll measure in 2006, have surprisingly stalled this year.  Thus far in 2007, household employment gains have averaged merely 3,000 monthly, versus 319,000 (2.1%) in 2006.  And even a version of the household measure in which statisticians smooth for gaps in population and adjust for the conceptual differences between the household and payroll surveys has averaged just 43,000 (0.4% annualized) in 2007, compared with 311,000 in 2006. 

Productivity growth, meanwhile, is beginning to stabilize.  Measured by officially-published data, we estimate that over the year ended in the second quarter, nonfarm business output rose by 2.4%, and the gain in hours steadied at 1.1%.  Consequently, we think labor productivity rose by 1.3% over that period, compared with 1% in the year ended in the first quarter.  Using the year-over-year change in the household data as a proxy would actually produce slower year-over-year gains in productivity, but they would result in first half gains at least half a point higher, or close to 2%. 

What explains the difference between the two employment readings?  Mismeasurement could be a culprit, but in my view neither labor hoarding nor an undercount of laid-off illegal construction workers seems large enough to explain the gap.  Many have noted that construction employment has held up remarkably well, considering the downturn in housing.  Construction payrolls associated with residential building have declined by a monthly average of 7,800 in 2007 (2.8% annualized).  That does seem out of line with the 31,000 monthly average decline in housing starts this year (21% annualized), but homebuilders are finishing projects started six months ago, so employment may decline when the pipeline empties.  Builders also may have held out for a housing upturn that isn't coming, at least not soon, and hoarded skilled workers.  As lending standards tighten for subprime and Alt-A borrowers, and the spring selling pace remains tepid, construction jobs are due to decline. 

Over a longer time horizon, however, statisticians may also have inaccurately measured labor inputs.  Indeed, the latest theory argues that there really has been a sharp downdraft in construction employment, but that it just hasn’t shown up in the data.  The reasoning is that the drop has occurred among specialty trade workers (e.g., plumbers and electricians; such residential construction jobs outnumber those in 'construction of buildings' by 2 to 1).  Many such specialty workers are probably loosely attached to the workforce and often work for very small proprietors.  An undetermined number of these are immigrants, some legal, some not, so the statisticians’ surveys miss them in the overall tally. 

As I’ve noted previously, however, such workers don’t completely escape the job canvasses (see “The Employment Conundrum: Construction Doesn’t Nail It Down,” Global Economic Forum, April 27, 2007).  The Pew Hispanic Center estimates that there are 7.2 million unauthorized workers in the United States, and that about 35% of them arrived between 2000 and 2005.  Short-term (here less than five years) unauthorized migrants number about 2.8 million, with many working in construction and services.  The construction industry employs about 1.4 million unauthorized workers, with 550,000 short-term workers, according to Pew (their estimates are based on the Current Population Survey — the household survey — which counts 12 million construction workers.  The payroll or establishment survey counts 7.7 million construction workers; the difference is largely self-employed). 

I don’t believe that the effect of illegals who escape both surveys is big enough to affect the payroll job count.  After all, there is no evidence that construction employment as measured and construction activity were way out of line in the housing boom.  And the existence of duplicate or phony Social Security numbers confirms that even if such workers are illegal, the establishment survey does not miss them. 

I do think, however, that the Bureau of Labor Statistics has a problem with the payroll survey.  The massive upward revision (810,000) to the March 2006 payroll benchmark announced this year does suggest that the so-called ‘birth/death’ model that BLS uses to blow the payroll survey up into job totals is flawed.  That model for construction employment has been very stable recently — maybe too stable.  Perhaps now the revisions will go the other way as some small firms go out of business, so it could be that the construction job tally is overstated.  The construction industry is fragmented with many small firms, so a downward revision to construction in the March 2007 benchmark would not be a surprise; statisticians will publish a preliminary estimate of that benchmark in October.  The 30,000 monthly average decline in the tally of nonfarm workers in the household survey who are self-employed supports the idea that some small proprietors — perhaps in construction — are struggling.   And although the household count by industry is quite volatile, construction employment in that canvass has plunged by a monthly average 141,000 so far in 2007.

Resolving this tale of two employment measures matters for policymakers and investors.  I would not be surprised to see household job gains pick back up to be more in line with the payroll tally.  That could keep the unemployment rate from rising and would reinforce policymakers’ concerns that ‘high resource utilization’ would point to upside inflation risks.  In contrast, significant payroll weakness would raise concerns of economic fragility.  Either way, we think that the yield curve may steepen a bit further as uncertainty over the outlook and monetary policy increases term premiums and thus nominal yields. 

I see risks evenly balanced around our baseline.  Two-tier labor markets will increasingly reflect the bifurcated economy, netting to ongoing debate about the outlook.  Complacency, credit events, and rising threats of protectionism remain the biggest challenges to risky assets.

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United States
Review and Preview
July 02, 2007

By Ted Wieseman/David Greenlaw | New York

Treasuries posted strong long-end led gains over the past week, keeping the market rebounding from its mid-June lows but reversing most of the curve steepening that had been seen in the prior week’s flight-to-safety rally.   Investor focus moved from area to area over the course of the week, contributing to some significant volatility. First, continued subprime problems and some signs of incipient contagion across other markets gave Treasuries a big lift through early Wednesday, but this flight to safety bid eased back significantly over the course of the day Wednesday as various other markets calmed down, even as subprime remained under pressure. Then, on Thursday, attention belatedly shifted to the FOMC meeting -- which had been mostly ignored during the subprime driven fear trade earlier in the week -- and the FOMC statement kept the focus on upside inflation risks, which hit the front-end particularly hard and swung futures pricing back towards expecting a Fed on hold indefinitely.

Finally, the week’s economic data eventually came more into focus Friday, helping give the market a big lift -- with month and quarter-end adjustments, terrorism fears, and renewed subprime contagion concerns also providing significant support -- and swinging Fed pricing back again to expecting one rate cut next year. Both growth and inflation data released through the week were market friendly. On the growth front, we cut our Q2 GDP forecast to +3.8% from +4.2% on weaker estimates for business investment in equipment and software and consumption in response to the durable goods and personal income reports. Meanwhile, core PCE inflation in May fell to +1.9%, the first sub-2% reading since March 2004. If Fed officials were confident that core inflation would hold a bit below 2%, we expect that most of them would probably find this acceptable, but as the FOMC statement stressed, and we agree, upside risks continue to predominate notwithstanding the recent run of benign results, likely keeping the Fed firmly on hold for a further sustained period.

On the week, benchmark yields fell 4-14 bp, with the long end leading, leading to a reversal of most of the prior week’s big steepening move, as 2’s-30’s flattened 9 bp on the week after steepening 12 bp the prior week, and 2’s-10’s flattened 7 bp after steepening 9 bp.

The 2-year yield fell 4 bp to 4.875%, the 3-year 7 bp to 4.90%, the 5-year 9 bp to 4.93%, the 10-year 11 bp to 5.03%, and the 30-year 14 bp to 5.12%. TIPS underperformed, with the 5-year TIPS yield down 3 bp to 2.66% and the 10-year 4 bp to 2.65%. After some big back and forth swings, the futures market ultimately ended up pricing in a more dovish Fed path on a medium-term basis. In the nearer term, there wasn’t much movement, with the November fed funds contract flat at 5.21% and the December and January contracts each gaining a half bp to 5.19% and 5.175%, putting the odds of a rate cut by year end at about 30%. There was a more significant move looking into 2008, with the low rate June 08 eurodollar futures contract rallying 6 bp on the week to 5.175%, putting the odds of a 25 bp rate cut next at around 75%. The reds (Sep 08 to June 09) rallied 7 to 8 bp on the week, with somewhat bigger gains in longer dated contracts in line with the Treasury curve flattening.

Various markets that interest rate investors had been focused on as flight to safety flows came and went through the week continued moving in the wrong direction. The deterioration eased up for a while after contagion fears initially peaked early Wednesday, but concerns intensified again Friday. The subprime market remained under significant pressure, with the ABX BBB- index falling to a record low 54.54 from 57.95. On Friday the weakness in this lowest rated part of the mortgage market started to more significantly infect higher quality segments, with the ABX A index posting a particularly sharp drop on the day to 84.27 from 87.44. Even as mortgage market fears remained a key market worry, attention appeared to be shifting to some extent through the week away from subprime and onto other markets. Leveraged loans seemed to be a particular area of concern as the LCDX index steadily deteriorated through the week to end at 97.73, down from 98.60 at the close of the prior week. Meanwhile, credit spreads widened modestly further after the big move seen the prior week, with the current series Hi-Vol CDX index closing Thursday at 100.8 bp and trading near 102 bp midday Friday after having widened more than 10 bp the prior week to 99.3 bp. Swap spreads moved significantly wider, with the benchmark 10-year spread rising to 63.75 bp from 62 bp.

Economic data released over the course of the week were market friendly, both for growth and inflation. On growth, incorporating the results of the durable goods, personal income, and construction spending reports, we cut our Q2 GDP forecast to +3.8% from +4.2%.   The durable goods report was significantly weaker than expected, though it is possible that seasonal adjustment problems might have played a role and could be reversed next month.   We’ll see, but in May results were weak, with overall durable goods orders down 2.8%. While a significant drop in civilian aircraft bookings (-23%) weighed on the headline, underlying details were just as soft, with the key core gauge -- nondefense capital goods ex aircraft orders -- falling 3.0% after having surged 7.0% over the prior two months. Downside in capital goods orders in May was led by machinery (-1.6%) and electrical equipment (-3.9%); high tech orders (+1.8%) posted a decent gain. Nondefense capital goods shipments dipped 0.2% after having jumped 2.5% over the prior two months, pointing to slower growth in investment spending in the second quarter. Based on this result, we initially cut our estimate for Q2 equipment and software investment to +4.6% from +7.3%. Subsequently, unpublished details on the business/consumer breakdown of May motor vehicle sales made available after the personal income report was released led us to further reduce this to +4.2%.

On top of this downward adjustment, we lowered our Q2 consumption forecast to +1.9% from +2.2%. Even though real spending in May (+0.1%) was as expected and there was no revision to April (+0.2%), the pattern of the revision to Q1 provided a more negative ramp for Q2.   Given that the savings rate sank to a nine-month low in May and that nominal consumption is on track to post a sharp advance in the second quarter (we project a 6.3% rise at this point), it seems clear that this sharp deceleration in real spending is being driven by the hit to spending power from the surge in gasoline prices through mid-May rather than a negative wealth effect.

Real disposable income increased at a 5.6% annual rate in Q4 and Q1 as real consumption jumped 4.2% annualized. It now appears likely that real DPI will decline slightly in Q2, driving the moderation in spending, though the accompanying drop in the savings rate in recent months indicates that consumers are still willing to dip into savings to some extent to defend their lifestyles in the face of surging energy prices despite the ongoing moderation in housing wealth gains.

A much better than expected construction spending report for May (though tempered somewhat by downward revisions to prior months) provided a modest positive offset to the negative impacts of the lower Q2 trajectories for equipment investment and consumer spending. Overall construction spending jumped 0.9% in May, the largest rise in fifteen months, on better results from all the key components -- residential new homebuilding, private nonresidential, and state and local government.

While we expect the housing recession will reintensify significantly in Q3, the surprising bounce in housing starts seen in the three months through April has led to at least a temporary moderation in the pace of decline. Meanwhile, nonresidential spending is on fire, surging another 2.7% in May for a 27% annualized gain over the past four months. After rising 14% in the year through Q3, real business investment in structures slowed to just +3% annualized over Q4 and Q1. The incoming monthly figures point to a sharp reacceleration in Q2, and we boosted our forecast for structures investment to +16.3% from +14.7%. The equipment component of investment is much larger than structures, however, so this adjustment did little to offset the downward revision to the former implied by the durables and motor vehicle results, so we now see overall business investment rising 7% in Q2, down from the 10% gain we estimated coming into the week. Finally, state and local government construction spending jumped a much higher than expected 2.1% in May. As a result, we boosted our estimate of Q2 state and local government spending to +3.6% from +3.0% and our forecast for overall government spending to +4.1%.

Inflation trends also were market friendly. The core PCE price index rose 0.10% in May, a bit less than the +0.15% gain we expected, leaving the year/year pace at +1.9%, the first sub-2% reading since March 2004. This level of core inflation, if it appeared sustainable, which is highly questionable at this point, would probably be considered acceptable to most FOMC members. Indeed, the most notable shifts in the FOMC’s statement were that it stopped referring to current core inflation rates as “elevated” and half-heartedly acknowledged the recent improving trend.   Inflation expectations, while remaining somewhat elevated, also have moved a bit in the right direction recently. With gas prices coming down, both the one-year (+3.4%) and five-year (+2.9%) median inflation forecasts in the University of Michigan survey were revised down a tenth for all of June from the early month readings. And the 5-year/5-year forward inflation breakeven in the TIPS market based off the benchmark issues fell to 2.48% at Friday’s close after having ended the prior week at close to a ten-month high of 2.56%. Still, we agree with the Fed that upside risks to inflation are still significant in an economy operating near full capacity.

We continue to see the bar being very high at this point to a change in rates in either direction and expect policy to remain on hold for a further extended period. The moderation in core PCE inflation back below the Fed’s presumed 2% preferred ceiling makes an actual rate hike quite unlikely at this point even if we were to see modest renewed elevation in coming months, which we think is a reasonable possibility. On the other hand, the sharp recovery in second quarter growth, even if not as robust as it seemed coming into the week, likely precludes any consideration of a rate cut any time soon. We continue to think that there will be some room for a modest easing in policy in 2008 to bring rates down to a more neutral level if a further period of subpar growth through this year eases resource pressures somewhat and core inflation ultimately stabilizes a bit below the 2% level.

The upcoming week sees a number of key data releases, highlighted by the employment report Friday, but it will be a fragmented week, with the Independence Day holiday Wednesday, early close Tuesday, and probably a good number of market participants taking off additional days on either or both sides of this mid-week break. Key data releases due out include ISM Monday, factory orders and motor vehicle sales Tuesday, and employment Friday:

* We forecast a 55.0 reading for the June ISM. The regional surveys for June were mixed, with Empire, Philly, and Richmond showing improvement while Dallas and KC displayed some deterioration. So we now look for an unchanged result for the ISM gauge following the gains seen over the past couple of months. A pick-up in motor vehicle assemblies should help keep the orders component elevated but we may see a bit of a pullback in categories such as employment and vendor deliveries. Finally, the prices paid index is expected to hold steady at a very high level again this month.

* We look for a 1.7% decline in May factory orders. The previously reported fall-off in the volatile aircraft category, along with an expected dip in the nondurables component due to falling energy prices, should lead to a sharp drop in overall factory orders. Meanwhile, we look for inventories to be +0.2%, with the I/S ratio holding at 1.24.

* Our preliminary forecast is for a 16.4 million unit annual sales pace for motor vehicles in June, a modest rebound to a pace that matches the year-to-date average but is a bit above the 16.1 million unit result posted in May. The mix of sales in June is expected to show trucks regaining some ground. This appears to reflect heavy promotional activity as well as the recent slippage in fuel prices. We will update our estimate if the automakers offer further guidance.

* We expect to see some moderation in job growth during June and look for a 100,000 gain in nonfarm payrolls. Our estimate reflects a number of factors including the modest uptick in jobless claims posted during the survey week, a slight deceleration in the growth of federal government withheld tax collections in recent weeks, and an anticipated renewed downturn in residential construction employment, which appeared to get a boost from unusually favorable weather conditions during May.

The unemployment rate is likely to tick up slightly as a result of an expected rise in the labor force participation rate. Finally, growth in average hourly earnings appears to have actually decelerated a bit since the start of the year despite the imposition of significant minimum wage hikes in several large states. A federally mandated increase will go into effect next month but it is smaller in scale than some of the state changes and is unlikely to have a meaningful impact on overall average wage rates. Additional hikes in the federal minimum will be phased over the next couple of years.

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