UBS: US economy: From doom and gloom to optimism

What a difference a day makes. It took just one strong labor market report to shift the mood of the market from doom and gloom to optimism about the US economy. As if the change in the Federal Reserve's language in October was not enough, this pretty much put the seal on expectations that interest rates will rise in December. And this was not just due to the fact that this labor market report was outright strong, it was also because the previous report was seen as unusually weak. 

But was the previous report really that weak? The monthly change in the crucial nonfarm payrolls (nfp) number was a revised 137k; certainly down from the 200k+ pace seen earlier in the year but was it actually low? How many jobs does the US economy have to generate to keep the unemployment rate steady? According to a convenient little tool provided by the Atlanta Fed, under some reasonable assumptions it really only takes just over 100k jobs a month to keep the unemployment rate steady.

In short, even the weaker numbers of the prior report would still mean an ever tighter labor market. The NFP number is notoriously volatile, but consider what would happen to the unemployment rate if the US economy kept adding jobs at the same average pace as the last three months (187k). Within a year the unemployment rate would drop to just 4.4% (chart 1). And if jobs continue to be created at the same pace that they have averaged over the last year, the unemployment rate would hit 4% before Christmas next year.

Clearly this pace of growth cannot continue, otherwise the unemployment rate would reach zero within five years. There has to be some unemployment in the system: some people have just quit or been laid off but have yet to start a new job; others have recently left education or just re-joined the labormarket. Not even an old school classical economist would believe that the labor market can clear that quickly. Does that mean that the pace of NFP growth has to slow down? Not necessarily, because some other things could change too, most importantly the participation rate (and, of course, wages). If lots of people decide to re-join the labor force, more jobs will need to be created to absorb them. But the participation rate has continued to fall. Perhaps a stronger labor market will encourage people to look for work again. If the participation rate reverses the decline of the last year (just under half a percentage point), then the pace of job gains over the last three months would still be enough to keep the unemployment rate steady.

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