The Employment Picture: “Things are seldom what they seem. Skim milk masquerades as cream.”
As Tom Hanks, the conductor on the Polar Express aptly concluded, “Sometimes the most real things in this world are the things we can't see.” Signs of a percolating job market were indeed lacking in visibility until last Friday’s post-election employment situation report. Against an expected addition to non-farm payroll of 150,000 – 175,000, employers added 337,000 workers during October. Moreover, employment growth during August and September was revised upward, such that the average monthly payroll growth has been 225,000 over the past three months and 198,000 year-to-date. As more formerly discouraged workers re-emerged into the search mode, the unemployment rate paradoxically increased from 5.4% to 5.5%.

Why the brightening of the employment picture? For starters, labor productivity (i.e., per capita goods and services produced) is growing at the slowest rate in over two years, a 1.9% increase during the third quarter. During 2003, labor productivity increases were approaching 6%. The Bureau of Labor Statistic’s Employment Cost Index, a barometer of average wages and salaries, increased 3.5% during the third quarter, the largest quarterly increase in over a year. Hiring in the financial services, retail, and construction sectors has been particularly strong. Hurricane-related clean-up work is believed to have generated approximately 50,000 new construction jobs during October.

The By-Product: Contracting Corporate Profits?
As labor productivity wanes and employment costs increase, it’s not too difficult to infer that, absent pricing power, corporate profits could be under some pressure. There is scant evidence of widespread pricing power, given that core finished goods prices have increased by only 1.9% over the past year. That’s only about one-quarter of the increase in core producer prices for intermediate goods. The response from the business sector: cautious capital spending. For the first time in decades, business cash flows have exceeded total capital investment.

Another Day Older and Deeper in Debt
Total outstanding marketable U.S. Treasury securities finished the September 30 fiscal year in the amount of $3.85 trillion, an annual rate of increase in excess of 10%. That’s about $385 billion in additional securities needing ready, willing, and able buyers—an increasing number of whom are foreign-domiciled. In spite of last week’s back-up in bond prices, the 10-year note remains roughly 20 basis points below levels of one year ago (although the yield on the two-year note is 80 basis points higher than its level of a year ago). Moreover, the U.S. dollar continues to trade at record low levels against the Euro, as it approaches an exchange rate of 1.30. In spite of the fact that oil prices sustained a 10% decrease from the high of $55 per barrel, the U.S. Dollar also declined. Assuming that lower oil prices usually imply lower trade deficits, this does not bode well for the greenback.

At $427 billion, the budget deficit now comprises 3.7% of GDP, still below the proportional deficit levels sustained during the 1980s. Nevertheless, the current account deficit, exacerbated by higher energy prices, is fast approaching 6% of GDP—clearly an unsustainable level. As such, there are limited alternatives for reducing this shortfall:

	Higher rates of interest or a cheaper U.S. currency to attract foreign investment
	Increased U.S. exports from a depreciating currency
	Increased U.S. household savings to counter increased reliance on investment flows from abroad

On the latter score, the U.S. savings rate has been notoriously low, perhaps because consumers are disinclined to boost savings in the wake of continued housing appreciation. It remains to be seen how the consumer would react to any moderation in housing prices vis-à-vis increasing savings and reducing personal spending.

In recent weeks, yields on mortgage-backed securities have increased at a slower rate than treasuries. While the U.S. Treasury is in the throes of record debt issuance, there is some speculation that rising interest rates could lead to a disproportionately slower rate of growth in the supply of mortgage-backed securities. This phenomenon could be caused by a combination of a slower housing market and reduced levels of refinancing activity.

You’re a Mean One, Mr. Grinch
In the past 20 years, the Fed has increased its funds rate during the month of December on only two occasions—once in 1986 and again in 1988. Nonetheless, odds are increasing that the Fed will be placed in the curmudgeonly position of ratcheting up the funds rate at the December 14 meeting. In the wake of last week’s strong employment situation report and based upon the current level of Fed funds futures trading, the market has assigned roughly an 80% probability of another round of tightening in December. Reflecting this estimation, the two-year treasury, which was trading at a yield of 2.59% prior to release of the employment report, is now trading approximately 22 basis points higher. Still, against a possible year-end funds rate of 2.25%, a spread of only 55 basis points would hardly represent a tightening cycle. With the spread between the two-year and 10-year treasuries of approximately 140 basis points—the narrowest level in over three years—the yield curve currently expects a more aggressive Fed to contain inflationary fears.

Fed officials have reiterated their policy of a measured rate of increase to a more neutral, less accommodative monetary position and will likely continue monitoring the stimulating effect of the improving job market. They will also review the possibilities of flatter consumer spending (caused by no recurrence of last year’s tax cuts and the possibility of decelerating home prices) and capital spending (caused by the slowing of productivity increases and requisite hiring increases). Does the Fed have “cause for pause” in its march toward neutrality? On the basis of core inflation that appears to be contained and a labor market that does not appear to be slowing down, financial markets seem to be casting a “no” vote.

John Biestman is assistant vice president, IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.

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