Blowout jobs, tighter Fed

Non-farm payrolls for August came in far above every Wall Street forecast. The report showed an economy in no need of help, and it left little room for anyone still arguing that the Fed should ease.

The rules say higher

Standard monetary rules, including the usual Taylor Rule specifications and inertial reaction functions, give a clear answer. With headline inflation at 3.4 per cent and the labour market at full employment, they put the appropriate federal funds rate well above 4.50 per cent. At 3.50–3.75 per cent, current policy looks too loose to last and is adding fuel to domestic demand.

How the rule does its sums

John Taylor's rule, published in 1993, starts from a neutral real interest rate, adds current inflation, then adds half the gap between inflation and the 2 per cent target and half the gap between output and its potential. With the economy at full employment the output gap is close to zero, so the prescription depends mostly on inflation and the assumed neutral rate. Inflation at 3.4 per cent adds both to the nominal rate and to the gap term, which is why even conservative assumptions about the neutral rate produce a figure well above today's range. Taylor's own original assumption of a 2 per cent neutral real rate puts it higher still.

Inertial versions of the rule add the previous period's rate to the formula, so they recommend closing the gap gradually rather than in a single jump. That makes them less alarming at first sight and more telling in practice: they point to a series of increases spread over several meetings, which fits the market's shift from pricing cuts to pricing a sequence of rises.

The Fed does its own version of this exercise. Its twice-yearly Monetary Policy Report to Congress publishes the prescriptions of several simple rules, including Taylor's original and a balanced-approach variant that puts more weight on unemployment. The committee treats them as a cross-check rather than a formula, but when every variant points the same way, the burden of proof shifts to those who want to hold.

Fiscal policy strengthens the case. Large federal deficits keep money flowing to households and firms even at full employment, so monetary policy has to lean harder against demand than it would if the budget were closer to balance. A payroll surprise of this size also tends to move the two-year Treasury yield most, since that maturity is the most sensitive to the expected path of the policy rate, and to lift the dollar as traders add to bets on tighter money.

One report is not a trend

The case against acting on one number is familiar. Payroll figures are revised in each of the following two months, and an annual benchmark revision can move the level of employment by hundreds of thousands once tax records are available. The household survey, which produces the unemployment rate, sometimes tells a different story from the payroll count. A single strong month can also reflect seasonal quirks around the summer, when school staff and temporary workers enter and leave the figures.

The breadth of hiring matters as much as the total. Gains concentrated in health care, government and leisure say less about the business cycle than hiring spread across manufacturing, construction and professional services, and the share of industries adding jobs is one of the numbers officials examine closely. A strong headline driven by a narrow set of sectors would give the committee more reason to wait than one in which almost every industry is hiring. The unemployment rate and wage growth in the same report complete the picture, since a genuinely tight market should show up in pay as well as in headcount.

The neutral rate is the other soft spot. Nobody observes it directly, and estimates published by the Fed's own economists have ranged widely in recent years, so a rule's prescription can shift by a percentage point depending on which estimate is used. None of this rescues the case for easing, but it does argue for moving in small steps.

Warsh loses his excuse

For Chairman Kevin Warsh and the Federal Open Market Committee, a jobs number this strong removes most of the case for waiting. The economy does not need support from the central bank. It needs a firmer hand before an overheating labour market locks in higher inflation expectations.

There is precedent for tightening into strength. In February 1994 the Fed began raising rates with inflation still moderate, on the argument that waiting for prices to accelerate would require harsher action later, and it doubled the funds rate within a year. The bond market suffered, but the economy avoided recession and went on to one of its longest expansions. That episode is the model a hawkish committee would cite.

Who pays for a firmer hand

Borrowers on floating rates pay first, from companies with leveraged loans to households with credit-card debt and home-equity lines. Savers and money market funds gain, and the dollar tends to strengthen against currencies whose central banks are holding still. Sectors that depend on cheap finance, such as housing and commercial property, would feel the effect within months. The August consumer-price report, weekly jobless claims and the revisions to this payroll figure will show whether the strength holds. Hiring is strong and the rules point to a rate well above today's. The Fed will very likely raise rates at its next meeting, and borrowers should expect it to keep going.