The U.S. economy enjoyed a pick-up in productivity growth in 2018, as well as a pick-up in labor force growth. As a result, the unemployment rate has essentially been flat for almost a year, even with employment growth remaining strong. Meanwhile, inflation remains “muted,” as Fed officials keep emphasizing.
Fed officials would be very happy to see stronger-than-expected growth because of a pick-up in the long-term trend in either productivity or labor force growth. They remain focused on labor market constraints, however, with the unemployment rate currently 0.4 points below the median Fed official estimate of the “longer-run normal” level. That estimated level has been coming down, and it could be clipped again, although the uptrend in wage gains suggests that the labor market is genuinely tight now.
We believe the flattening in the unemployment rate has been an important contributor to Fed officials becoming dovish. In turn, we believe the trajectory of the unemployment rate will be key to whether tightening resumes. Fed officials have increasingly been emphasizing the role of inflation expectations in determining inflation, but most officials also still believe tightness in the labor market is a key determinant of price pressures over time.
However, we remain skeptical that the surge in labor force growth will be sustained, and we are not convinced that the economic backdrop has changed enough yet to generate a sharp slowing in employment growth. As a result, we expect the unemployment rate to resume its downtrend. We expect wages to keep accelerating, at least gradually. In turn, we continue to forecast another Fed rate hike this year, albeit not until September.