Why Haven’t Low Unemployment Rates Led to Rising Inflation?

Last week we received the latest Canadian and U.S. employment reports and they continued to confound market watchers.

The unemployment rates in both countries are at levels that should be pushing average incomes higher as the demand for labour outstrips its supply. When that happens, employers are typically compelled to raise compensation in order to attract workers – and since the cost of labour has a pervasive impact on prices across the economy, this increases overall inflation.

But that isn’t happening. Instead, low unemployment levels in both countries have corresponded with wage increases that are hovering close to the overall level of price inflation, and this leaves policy makers with a conundrum.

If low unemployment is a signal that wage inflation is imminent, then they should start raising interest rates soon to avoid falling behind the curve and having to increase them more sharply later (which risks tipping an economy into a recession). But if the unemployment rate is no longer a reliable indicator of the labour market’s health, then policy-rate increases will be premature and could stifle hard-won economic momentum.

Before we examine this question in more detail, let’s take a quick look at the highlights from the latest employment data:

U.S Non-Farm Employment Report (March)

• Overall U.S. employment rose by 98,000 jobs last month, which was well below the 175,000 new jobs the consensus was expecting. The initial non-farm payroll estimates for January and February were revised down by another 38,000 jobs as well.
• Overall unemployment fell from 4.7% to 4.5%, marking its lowest level in nearly ten years, but average wages only rose by 0.2% for the month and average hours worked rose by only 0.1% over the same period.
• On a year-over-year basis, average wages have risen by 2.7% but this is well below the level that would have historically corresponded with a sub-5% unemployment rate.

Canadian Labour Force Survey (March)

• Overall Canadian employment rose by 19,400 jobs last month, which was well above the 6,000 new jobs the consensus was expecting. Despite this, our unemployment rate rose from 6.6% to 6.7%, but only because more Canadians came off the sidelines and began looking for work.
• While the headline number was impressive, most of the gain was in the self-employed sector, which added 18,400 new workers in March. Our policy makers take a sharp rise in self-employment with a grain of salt because it often includes workers who are in the midst of job transitions and prefer to categorize themselves as self-employed instead of as unemployed.
• Manufacturing employment rose by 24,400, which Statistics Canada noted was “the largest one-month increase in manufacturing since August 2002”. Despite this, the rest of the data showed job losses in higher-paying jobs and gains in lower-paying forms of employment. Not surprisingly in light of that, average wages did not rise in March and have now grown by only 1.1% on a year-over-year basis, which is well below our overall inflation rate of 2% and marks our lowest rate of wage growth in nearly two decades.

While the degrees of difference vary, the fundamental disconnect between U.S. and Canadian unemployment rates and the growth rates of average incomes in the economies of both countries continue to confound experts.

Here are a couple of points that help explain why this is occurring:

• Both countries still have participation rates that are below their long-term averages. (As a reminder, the participation rate measures the percentage of working-age citizens who are either employed or who are actively looking for work.) Today, a surprising number of able-bodied workers have given up looking for work, and as such, they are not officially counted as unemployed. But if the demand for labour increases to the point where these people see new economic opportunities, they will re-enter the workforce (as we saw in Canada last month when higher-than-expected job growth corresponded with a rise in our unemployment rate as previously disenfranchised workers re-entered the workforce). Given that, today’s low unemployment rates are not truly representative indicators of the tightness of our labour markets because of the larger-than-normal pool of potential workers that aren’t officially counted as unemployed.
• Both the U.S. and Canadian economies have seen a slow but steady trend of higher-paying jobs being exchanged for lower-paying jobs (which some have described as “the hallowing out of the middle class”). So while overall employment has risen, average incomes have not. In some cases, workers who used to have one steady, full-time job now have two or more part-time jobs. (This is especially true in the U.S., where companies have moved to part-time employment as a way to circumvent increased health-insurance expenses associated with the Affordable Care Act.) Against this backdrop, a rise in the total number of jobs correlates with falling incomes.

The U.S. Federal Reserve recently decided that overall unemployment has fallen to a level where the risk of higher inflation now outweighs the risk that monetary-policy tightening will stifle U.S. economic momentum, and it has now raised its policy rate twice in response.

Meanwhile, the Bank of Canada (BoC) has remained more cautious and is looking for more convincing economic data before following the Fed’s lead. That said, Canada’s broader economic data have been on an impressive run of late, and if that continues it may force the BoC to raise its overnight rate more quickly than planned.

Five-year Government of Canada bond yields held steady last week, closing at 1.12% again on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.44% for high-ratio buyers, and at rates as low as 2.49% for low-ratio buyers. If you are looking to refinance, you should be able to find five-year fixed rates in the 2.64% to 2.79% range, depending on the terms and conditions that are important to you.

Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.60% (2.10% today) for low-ratio buyers. If you are looking to refinance, you should be able to find five-year variable rates in the prime minus 0.45% range (2.25% today), depending on the terms and conditions that are important to you.

The Bottom Line: Our recent run of stronger-than-expected economic data makes it perfect timing for the release of the BoC’s latest Monetary Policy Report (MPR), which is due out this Wednesday. The MPR gives us the Bank’s comprehensive view on the state of our economy, and we’ll be reading that for any signs that the BoC might be contemplating an acceleration of its rate-hike timetable. Stay tuned.