The effect of the job market on the economy

Key takeaways

• Job growth remained strong throughout 2022 while the unemployment rate continued to hover near historic lows.
• In contrast to the strong job numbers, GDP, a measure of the nation’s economic growth, slowed considerably compared to 2021.
• Continued strength in the job market combined with a slowing economy are influencing how the Federal Reserve calibrates monetary policy to combat inflation.

The Federal Reserve (Fed), the nation’s central bank, has taken aggressive steps to slow U.S. economic growth as a way to combat persistent inflation this year. The Fed’s actions included aggressive upward adjustments to the target federal funds rate. These moves have not yet had a significant impact on the still robust U.S. jobs market. Although U.S. economic growth slowed as expected in 2022, the unemployment rate remains near historic lows, with higher-than-average job growth.

The contrast between a strong job market and a slowing economy may reflect the unusual, pandemic-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? What will it mean for the Fed’s monetary policy going forward. Does data about the job market 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 263,000 new jobs (non-farm payrolls, seasonally adjusted) in November 2022, outpacing the consensus estimate of 200,000 jobs by economists surveyed by Dow Jones. Over the year's first eleven months, non-farm payrolls grew by an average of 392,000 jobs per month. While slower than 2021’s rapid pace of job growth, which topped 560,000 per month, 2022’s results are still impressive. The unemployment rate in November stood at 3.7%, remaining near a historically low level.¹ The job market’s strength comes despite the economy’s much slower growth. Gross Domestic Product (GDP), a measure of the nation’s economic performance, narrowly declined in the first two quarters of 2022, then showed modest improvement in the third quarter.²

Two more factors may raise concerns for the Fed. The latest jobs report showed average hourly earnings growing at an annualized rate of 6.8% in November. That's the highest reading since January 2022, a sign that wage growth continues to exceed the Fed’s target annual range of 3.5%. In addition, data shows the civilian labor force continues to contract. This contributes to a tighter labor market, which may continue to pressure wages higher as employers must look to fill jobs from a smaller pool of candidates.

Continuing job market strength 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) only recently 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 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, particularly in the services and healthcare sectors, 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 3.75% to 4.00% by November 2022. It is expected to raise rates again in December, with more rate hikes likely in 2023. Recent strong jobs data gives the Fed impetus to remain aggressive about raising interest 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.”

One reason the Fed has moved so aggressively, according to Matt Schoeppner, a senior economist at U.S. Bank is that the Fed 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 consumer and business spending.” Schoeppner believes a bigger slowdown is coming, but the Fed remains wary that financial conditions could improve, muting the Fed’s efforts to curb inflation.

Schoeppner points to comments by Fed chairman Jerome Powell about future rate hikes. “He’s indicated the Fed may slow its pace of rate hikes (there have been four consecutive 0.75% hikes in 2022), but we’re looking at what could be a higher, top-end federal funds rate before rate hikes are finished than the peak level many analysts previously expected,” says Schoeppner.

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 close to 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. Wage growth slowed modestly in recent months but still remains elevated, at 4.7% over the previous 12 months.¹

“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.”

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

“Wage growth is still the strongest it’s been since the 1980s,” says Schoeppner. “Another concern is the labor participation rate, which is moving sideways, a trend that wasn’t expected given that employment conditions have improved since COVID-19 first became an issue.” With the labor market still creating jobs at a brisk pace and the number of available jobs outpacing the number of workers, Schoeppner says labor costs remain elevated, forcing the Fed to continue to push interest rates higher in the near-term.

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 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. “Rate hikes can take six-to-12 months to work their way throughout the economy,” says Haworth, an indication that job growth could slow in the months to come. In the fall of 2022, large layoffs at some major technology companies garnered headlines. The trend has not yet carried over into other parts of the economy. “Jobless claims across the entire workforce are trending very much sideways,” says Schoeppner. “Even laid-off workers stand a chance of quickly finding new employment given the current state of the jobs market.”

“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.”

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.

Strong jobs market data likely contributed to investment market volatility in 2022, as it indicated the Fed would likely need to raise interest rates more dramatically. Stocks fell into bear market territory (a decline of 20% or more from peak levels) earlier in the year, then reached new lows at the end of September. Hainlin believes that the still-healthy jobs market is a reason for investor caution. “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 could result in a less favorable environment for stocks in the near term.”

Talk with 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.