US is still at accommodative

Underneath the distortions, the September jobs report was firm. Based on the weakness in weather-sensitive sectors such as retail and leisure/hospitality as well as commentary from the Labor Department, we estimate that Hurricane Florence shaved 50-60k from the headline number. If we add back this hit to the reported 134k gain, underlying payrolls seem to have grown at a pace close to the 200k average over the prior twelve months, and the summer months were revised up even more sharply than we had expected. The household survey was also strong, with a big increase in employment.

Broader US growth remains just above 3½%, based on  September current activity and our Q3 GDP tracking estimate of 3.3%. We expect this pace to slow gradually over the next 1-2 years as the fiscal impulse diminishes from its current ¾-1pp contribution to about ¼pp by the end of 2019 and the financial conditions impulse turns negative. But even under that forecast, growth will likely be strong enough to push the unemployment rate down to a 65-year low of 3% by early 2020. This would almost certainly represent a sizable undershoot of the rate consistent with 2% inflation over the medium term.

Although average hourly earnings growth moderated slightly to 2.75% year-on-year in September, this was entirely due to a tough year-on-year comparison which masked the third 0.3% monthly increase in a row. Over the next couple of months, we expect both AHE and the employment cost index for private-sector wages and salaries excluding incentive-paid occupations—our single favorite measure of wage growth—to move to a 3%+ year-on-year pace, for the first time in nearly a decade. This corresponds to our estimate of the full-employment pace of wage growth, calculated as the sum of the Fed’s 2% inflation target and our estimate of the underlying whole-economy productivity trend of just over 1%.

Unlike wage growth, core price inflation has undershot expectations in recent months on a sequential basis. But the downside surprises have mostly come in the noisiest parts of the goods price indices, especially apparel. We think core goods prices will rebound in coming months, partly because the apparel CPI now looks low relative to apparel import prices and partly because the newly imposed tariffs on $200bn in imports from China will start to show up in areas such as household furnishings. More broadly, we continue to expect a gradual move of core PCE inflation to the 2¼% range by the end of 2019, with significant risks in both directions but mostly skewed to the high side.

Our perspective on the short-run macro effects of higher trade barriers on the US economy has been sanguine. This was an easy call earlier this year, when the tariff announcements were tiny relative to US and global GDP. But is the further escalation of the trade war—we now expect tariffs on all US imports from China has limited relation. Higher tariffs will boost inflation, which will weigh on private-sector real income and  reinforce the trend toward tighter Fed policy. But these effects look relatively small, and they are likely to be partly offset via market share gains by import-competing US producers. All told, we expect a negligible hit to US GDP of 0.1% or less.

Although the financial markets have largely bought into the view that tariffs are a sideshow in the US macro story, many economists are instinctively more pessimistic. This is probably because we have all learned that tariffs weigh on our standard of living by preventing us from fully exploiting comparative advantage, i.e., by diverting scarce resources into the production of goods we should be importing. And it is tempting to equate a lower long-term living standard with weaker near-term cyclical performance. But this is a fallacy, in our view, because long-term resource allocation and short-term resource utilization are two very different things. In fact, devoting more resources to sectors in which we have no comparative advantage can be quite consistent with a cyclical expansion in the short term, even though it is likely to make us poorer in the long term.

Fed Chairman Powell made it clear in the FOMC press conference that the committee removed the term “accommodative” from the statement because of growing discomfort with its binary nature, and thought that September was a good time for such a shift precisely because it is so clear that policy is still accommodative. In fact, Powell noted that Fed may go past neutral, but still are a long way from neutral at this point, probably. This seems like a strong endorsement of the median longer-term dot of 3% and the median terminal dot of 3¼-3½% .

The bond market has responded to the strong data and hawkish Fedspeak by pushing up its estimate of the terminal funds rate to 3%, a move of nearly 35bp since late August. On the back of this repricing, US financial conditions have tightened by about 25bp, with most of the move coming in the past week. Based on our analysis of the impact of monetary policy shocks on financial conditions, this response looks quite typical. But we think it is still incomplete, as we continue to forecast a terminal funds rate of 3¼-3½% by the end of 2019, with risks tilted to the upside.