The effect of the job market on the economy

The U.S. job market continued its recent monthly trend of slower growth, reflecting the economy’s modest expansion pace. August nonfarm payrolls grew by 187,000, slightly exceeding analyst expectations. However, the unemployment rate moved higher, from 3.5% in July to 3.8% in August, though it remains near 50-year lows.¹

The U.S. labor market is a key focus of the Federal Reserve (Fed) in its effort to combat persistent inflation. Fed officials have clarified that one objective for achieving lower inflation is tempering wage growth. A strong jobs market is more likely to push wages higher, which could contribute to higher inflation.

The job market’s resiliency, highlighted by consistently low unemployment and solid job growth, is considered one of the key drivers of a surprisingly steady economy. Some market analysts anticipated a recession in 2023. But led by solid consumer spending, fueled in part by the strong employment picture, modest economic growth continues.

What do recent trends tell us about the direction of the job market? How might the Fed react to these trends as it calibrates monetary policy to lower inflation? Does today’s job market provide any guidance for investors as they set expectations for the rest of the year?

Job growth – solid but slowing

Rapid job growth was a feature of the economy throughout 2021 and 2022. The U.S. Bureau of Labor Statistics reported that for all of 2022, non-farm payrolls grew by an average of 399,000 jobs per month. This represented a slower pace than 2021’s rapid job growth, which topped 605,000 per month.² In 2023, the pace of new job growth is even slower, though it continues to demonstrate stability.

Source: U.S. Bureau of Labor Statistics.

The monthly average for 2023 is skewed somewhat higher by an unusually strong jobs report in January (472,000 new jobs created). For the seven-month period from February through August 2023, the monthly average is just under 202,000 new jobs created.²

August’s 3.8% unemployment rate is the highest reading since February 2022 but represents only a modest change from its most recent low of 3.4% reached in April 2023. The job market’s surprising strength in the face of the Fed’s efforts to slow economic growth has helped avoid what many industry analysts thought was the high likelihood of a recession in 2023. Gross Domestic Product (GDP), a measure of the nation’s economic output, grew by 2.1% in the second quarter of 2023, in line with the first quarter’s 2.0% annualized growth rate and consistent with 2022’s annual GDP growth rate of 2.1%.³

Job openings fell to 8.8 million in July 2023, still considered to be an elevated level, but down from a peak of 11.2 million job openings at the end of 2022. At the same time, 6.2 million Americans are looking for work. That means there are still 1.4 jobs for every unemployed person seeking work.⁴ Notably, the ratio of jobs-to-available workers has leveled off in recent months, another sign of modest job market weakening.

The most recent numbers come with a note of caution, according to Matt Schoeppner, a senior economist at U.S. Bank. “The August data summarizes one of the most volatile months of the year for the jobs market. It can be subject to sharp revisions.” Schoeppner says for that reason the Fed may not put much stock in the most recent data as it considers monetary policy going forward.

The labor force participation rate is considered a key employment measure. It represents the percentage of the population currently in the workforce. This number is considered by some analysts to be lower than desired. It showed modest improvement in December 2022, and again in February and March of this year. The labor force participation rate bumped up slightly to 62.8% in August, an increase from the level that held for five consecutive months prior to that, at 62.6%.¹ “Improving labor participation is one way to address tightness in the labor market that’s propping up wage gains,” says Schoeppner.

Continuing job market strength may seem surprising given the Fed's efforts to slow the economy. Yet this may reflect the impact of the economy bouncing back from the unusual circumstances of recent years, says Tom Hainlin, national investment strategist for U.S. Bank Wealth Management. “The workforce has undergone a number of changes since COVID-19, and adjustments are still being made.” Notably, the total number of working Americans (based on Bureau of Labor Statistics data) only recently recovered to the peak level it reached before COVID-19 began in early 2020. “What’s lacking is the total growth in jobs we would normally have experienced if the pandemic had not occurred,” notes Hainlin.

Additionally, some industries still face a worker shortage after a number of employees left their positions or were laid off during the height of the pandemic. “Some jobs haven’t come back as quickly as we hoped,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. This is evident in several industries, particularly in the services and healthcare sectors, where many jobs remain unfilled. Notably in August, unfilled jobs in health care increased by 71,000, and employers added 40,000 leisure and hospitality positions.¹

What does the job market tell the Fed?

The Fed raised its short-term fed funds target rate from near 0% before March 2022 to a range of 5.25% to 5.50% by July 2023. The major questions now are whether the Fed will feel compelled to hike rates further, and how long it will maintain rates above 5%. The tightrope the Fed is walking is whether it can maintain its policy stance, designed to dampen inflation, without triggering a recession.

One reason the Fed moved so aggressively to raise interest rates, according to Schoeppner, is that the central bank was “late to the game in addressing the inflation issue, which first flared in early 2021. Despite significant interest rate hikes, we’ve only seen the tip of the iceberg in terms of how the Fed’s actions impact business and consumer spending.” In other words, it takes time for Fed policies to work their way through the economy to create real impact.

Challenges in the labor market

The Fed faces a conundrum due to job market’s continued strength, according to Haworth. “The Fed’s focus is on how much wages will grow. Can the Fed meet its objective of full employment while bringing inflation down?” asks Haworth. Wage growth slowed from the levels of the previous three years but seem to have stabilized. Wages grew at a rate of 4.4% for three consecutive 12-month periods ending in May, June and July 2023. In August, wage growth measured 4.3% for the previous year.¹ That’s still considered elevated, particularly compared to pre-pandemic levels.

Source: U.S. Bureau of Labor Statistics.

Schoeppner notes that the Fed’s target annual wage growth rate is in the 3.5% range. One key to achieving that could be improvement in the labor participation rate. “There’s still a need to lure more workers back to the job market,” notes Schoeppner. Given the recent pace of job creation and the number of available jobs outpacing the number of workers, Schoeppner says labor costs remain elevated, which is likely a consideration as the Fed weighs its fed funds rate decisions.

A longer-term concern is productivity, which measures the level of output in comparison to input, such as capital or labor. The onset of the information age resulted in huge advancements in productivity, but the environment has changed. “We still see improvements in productivity,” says Hainlin. “But the advancements aren’t creating as much of an impact in generating jobs and economic growth as they once did.” Hainlin says it raises questions about expectations for future economic growth if both productivity rates and the size of the labor force advance more slowly.

What to expect going forward

Haworth notes that because rate hikes take time to work their way through the economy, we may continue to see a slower pace of new job creation in the coming months. Investors will keep a close eye on the unemployment rate, which has remained below 4% since early 2022. Another frequent data point to watch is the weekly report on initial jobless claims. “After edging lower in January, initial jobless claims briefly trended meaningfully higher,” says Schoeppner. Initial jobless claims, which were below 200,000 a week in January, peaked at 265,000 in June, but are now back down below 230,000.⁵

Slower job growth, a reduction in the ratio of open positions to available workers and an uptick in the unemployment rate may actually be looked upon favorably by the markets, according to Haworth. “Somewhat softer employment data is easing investor concerns for future Federal Reserve interest rate hikes.”

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