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Jobs growth steady but slow

November's jobs report shed no new light on the labor market situation. November's 147K new private sector jobs was in line with what we've been seeing on average for the year to date and for the past three years. It's slightly more than the 130K new jobs per month that need to be created just to keep up with the long-term average growth of the labor force, which is about 1% a year, so if things continue at the same pace the unemployment rate can decline very slowly from here. It's only declined faster because the labor force has grown very little for the past four years, which in turn is a function of many people deciding to "drop out." The current 1.5% per year pace of jobs growth is unlikely to translate into anything more than 3.5% real economic growth, assuming productivity growth continues to run at the 1-2% per year pace we've seen in recent years. That's OK, but it still adds up to the weakest recovery ever.

Note the relatively steady growth of private sector jobs as measured by the Establishment Survey (blue line). Both surveys show that the economy has created about 5 million jobs over the past two years. Also note that there is absolutely no sign here of anything like a recession. Jobs growth may be disappointing, but it is still definitely positive.

After declining from 2008 through early 2011, the labor force has resumed a 1% annual pace of growth over the past year. But it is still more than 5 million below where it could have been if long-term trends were still in place.

The November report provided more confirmation that the public sector workforce is no longer shrinking. Despite declining jobs in the past few years, public sector employees have not suffered nearly as much as their private sector counterparts over the past decade: private sector jobs are only now back to where they were in early 2002, whereas public sector jobs have risen on net by 1 million (almost 5%). It's still the case that  the best job security and the best pay and benefits can be found in the public sector.

Thanks to below-trend growth in the labor force and the relatively tepid growth of jobs, the economy has fallen farther behind its long-term growth trend than at any time in modern history. This is the weakest recovery ever. Fewer people working means the tax base is a lot smaller than it could be, and that is main source of a shortfall in tax revenues. Faster economic growth, powered by faster job creation, is the key to shrinking the fiscal deficit from the revenue side. Raising tax rates will only risk retarding the rate of growth. Are you listening, Mr. Obama?

The Fed is doing all it can to promote faster growth, by purchasing on net about $1.5 trillion worth of MBS and Treasuries in the past four years. So far, however, there is no sign that they have managed to increase the pace of jobs growth. Their main accomplishment has been to satisfy the world's almost insatiable demand for risk-free short-term securities, which in turn has been driven by fear of sovereign defaults, a double-dip recession, the expectation that massive federal deficits will inevitably result in a huge increase in tax burdens, and concerns that monetary stimulus could prove to be very inflationary. As the chart above shows, the market's current expectation for inflation over the next 10 years is 2.5%, which is pretty much average. But it's nowhere near the deflationary levels that most Keynesian models have been predicting given the economy's weak recovery and the unprecedented output gap that currently exists.

The chart above is a more sensitive measure of inflation expectations. The blue line shows that the bond market expects inflation to average a little over 3% during the period 2018-2023. That's not very frightening, but it does suggest that what's driving the rise in equity prices over the past year or so is inflation expectations rather than growth expectations. The Fed has absolutely succeeded in snuffing out any deflationary threat, but instead of boosting jobs growth, they have merely boosted the market's confidence that future cash flows to U.S. businesses will be rising by at least 2.5-3% per year, even if the economy posts very weak growth.

The negative real yields on TIPS, which are at or close to all-time lows, are a clear sign that the market expects future economic growth to be dismal. At the same time, the inflation expectations built into TIPS and Treasury prices say that the market expects inflation to be at least as high in the future as it has been in the past. Growth expectations are falling, while inflation expectations and equities are rising. Translation: equities are behaving more like inflation hedges these days, than like barometers of real growth expectations.

UPDATE: Nobel prizewinner Edward Prescott comes to a similar conclusion regarding the current 13% "output gap" that I show in the fourth chart of this post. See his op-ed in the 12/12/12 edition of the WSJ: "Taxes Are Much Higher than You Think." Increased tax and regulatory burdens, coupled with increased income redistribution schemes, likely explain why the gap is so large.

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