The effect of the job market on the economy

Key takeaways

• Over the first eight months of the year, non-farm payroll growth grew by an average of 451,000 per month. The unemployment rate in August stood at 3.7%, near historic lows.
• In contrast to the strong job numbers, GDP, a measure of the nation’s economic growth, declined 1.6% in the first quarter and 0.9% in the second quarter.
• A surging job market combined with a slowing economy are influencing how the Federal Reserve calibrates monetary policy to combat inflation.

U.S. economic growth is slower in 2022 after 18 months of rapid recovery from the COVID-19 pandemic. This slowdown coincides with the Federal Reserve’s dramatic monetary policy shift designed to temper inflation’s rapid rise. The Fed’s actions included aggressive upward adjustments to the target federal funds rate. Despite a slowing economy and tightening monetary policy, unemployment remains near historic lows, with higher-than-average job growth.

The contrast between a surging job market and a slowing economy may reflect the unusual, COVID-19-altered environment. Various issues, from supply chain shortages to the increasing preference to work-from-home rather than going to the office, contribute to an economy that still looks different from its pre-COVID state.

What do recent trends tell us about the direction of the job market? What does the recent jobs data, with employment growing much faster than analysts forecast, signal about the broader economy and will it provide any guidance for investors as they set expectations for the coming months?

Dramatic job growth in 2022

According to data released by the U.S. Bureau of Labor Statistics, the U.S. economy created 315,000 new jobs (non-farm payrolls, seasonally adjusted) in August 2022. Over the first eight months of the year, non-farm payroll growth grew by an average of 451,000 per month. The unemployment rate in August stood at 3.7%, a historically low level.¹ In contrast to the strong jobs numbers, Gross Domestic Product (GDP), a measure of the nation’s economic growth, declined 1.6% in the first quarter and 0.9% in the second quarter (third quarter data will be released near the end of October).²

Recent jobs data may seem surprising given the Fed’s efforts to try to slow the economy. “While the Fed is taking aggressive action, it doesn’t necessarily have an immediate impact across the broader economy,” says Tom Hainlin, national investment strategist for U.S. Bank. “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) has just recovered to the peak level it reached before COVID-19 began in early 2020. “What’s lacking is the growth in jobs we would normally have experienced over the past two-and-a-half years,” notes Hainlin.

Additionally, some industries still face a shortfall of workers 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 once hoped,” says Rob Haworth, senior investment strategy director for U.S. Bank. “The economy remains under unique constraints at this time, and there are still areas where we are not yet back to normal.” This is evident in several industries, such as travel, tourism and healthcare, where many jobs remain unfilled, relative to pre-pandemic highs.

What does the job market tell the Fed?

The Fed raised its short-term fed funds target rate from near 0% before March to a range of 2.25% to 2.50% by July. It meets again in September, with market-based measures forecasting another rate hike. Recent strong jobs data (both on jobs growth and wage increases) gives the Fed impetus to remain aggressive about raising rates and taking other actions to slow demand. Does that increase the risk that the Fed might go too far and trigger a recession?

“All indications are the Fed will do what it believes it needs to do to trim inflation,” says Hainlin. “That points to a continuation of rate hikes until it’s gone far enough to contain the rapid rise in living costs.” Hainlin says the Fed will know it has bumped rates far enough when slowing demand becomes more evident.

While speculation in some quarters is that a recession already began this year, Hainlin believes signals are mixed regarding the economy’s current condition. “Consumers still have elevated checking and savings accounts and are earning higher wages. That raises a question about what it will take to drive them to slow their spending.”

Haworth notes that corporations may also be less sensitive to the Fed’s attempt to slow the economy through interest rate increases. “Many corporations are already well financed as they took advantage of previously low interest rates to issue debt,” says Haworth. “Just at a time when you’d think, with interest rates rising, it would be more expensive for businesses to get financing, many of them don’t really need it.”

Haworth believes that with consumers and businesses in a solid financial position, the Fed has more breathing room to drive interest rates higher. “In a normal economic cycle, you might expect that we’d be working off excess credit in the system, but that just isn’t the case right now.” If a recession occurs, Haworth anticipates it will be only a modest contraction.

Challenges in the labor market

While strong job growth is favorable on many fronts, recent data does include some areas of concern, according to Haworth. “Average hourly earnings are growing at a rate of more than 5% on an annualized basis. That’s good for workers, but it means the Fed has more work to do in its effort to curb inflation by slowing demand.” Haworth points out that with rising incomes, workers are in a better position to maintain spending, which in turn could extend the period of elevated inflation. He says the Fed is likely more focused on the pace of wage gains, rather than the job numbers, to determine the future direction of interest rates.

“All indications are the Fed will do what it believes it needs to do to trim inflation. That points to a continuation of rate hikes until it’s gone far enough to contain the rapid rise in living costs.”

- Tom Hainlin, senior investment strategy director, U.S. Bank Wealth Management

“In addition, labor-force participation is ticking lower,” says Haworth. “We need more people in the labor force to help offset the current supply-demand imbalance. More workers generating more supply will help stem the tide of higher inflation.”

Productivity, which measures the level of output in comparison to input, such as capital or labor, is also raising concerns. 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 as impactful in generating jobs and economic growth as they used to be. Today, productivity growth is experiencing a secular decline.” 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

If the economy continues to slow, the jobs market is likely to eventually follow suit. That raises the question of whether more layoffs will occur. “Earnings remain reasonably strong, so that could temper future layoffs,” says Haworth. “This economic cycle feels different than one where we might typically be heading into a recession and experiencing significant cutbacks in workers.” Haworth is closely watching the government’s weekly new jobless claims report. Numbers of newly laid off rose modestly during the summer, but Haworth notes that “continuing claims for those already laid off are not rising. That tells us that those making jobless claims are quickly finding new work.”

The different nature of today’s economy may impact how companies approach layoffs. “Many firms worked hard to attract and retain the employees they already have,” says Hainlin. “There may be a reluctance to let people go, even if business slows.” Construction is one area that could see cutbacks in hiring or potential layoffs, as higher interest rates typically result in a slowdown in residential and commercial building activity.

Recent favorable news about job growth and a modest decline in the inflation rate seemed to help offset the predominantly negative sentiment that prevailed in the stock market for much of 2022. After the Standard & Poor’s 500 retreated into a bear market in June (a decline of more than 20% from its peak), July saw equity markets enjoy a strong rebound. Markets lost ground again in August, but began to bounce back after the positive jobs report released in early September. Nevertheless, Hainlin believes investors should remain cautious. “The strong jobs data adds to our view that the Fed will continue to raise rates, perhaps higher and for longer than market expectations currently reflect. That could result in slower corporate profit growth than analysts currently forecast, which creates a less favorable environment for stocks in the near term.”

Talk to your wealth planning professional if you have questions about your personal financial circumstances or how your portfolio can be positioned most effectively in the current environment.