A little late here with some labor report highlights. It’s just not a good sign when it’s only Tuesday and you already feel as if you are falling behind for the week! If the broad outlines of this report hold going forward, the Fed will face a few interesting questions this year.

The headline number revealed a strong payroll gain of 263k for April. The three-month moving average dipped due to the weak February report, but the twelve- month moving average remains above 200k. That’s the number to watch right now, and it doesn’t show signs of slowing.

The forward-looking temporary services sector rebounded, alleviating concerns of an emerging broader trend toward slower job growth:

It seems likely that recent hiccups in this data were largely attributable to weakness in manufacturing.

Overall, I don’t think there is much evidence here that the anticipated economic slowdown this year is having much of an impact on hiring yet. In fact, the unemployment rate fell as labor force growth slowed:

The unemployment rate of 3.6% is below the Fed’s 3.7% median projection for year end 2019. A drop in labor force participation is of particular note:

At least as far as the overall participation rate is concerned, there is little evidence of a sustained rise. It has held near 63% since 2014. Assuming this continues, the Fed will once again question the limits of strong job growth and start thinking the unemployment rate might fall more dramatically than they anticipate. Remember, the demographics always lurk in the background. The Fed anticipates that labor force participation will slide as the population ages. At that point, the unemployment rate can be stabilized with job growth around 100k, or less than half the current rate.

That said, it is not clear when unemployment falls low enough that we should be concerned about capacity constraints. The unemployment rate has been at or below Fed estimates of the natural rate of unemployment for, well, literally years without any disconcerting inflationary pressures:

The Fed’s explanation for low inflation is that inflation shocks are always conveniently one-sided, so the years of suboptimal inflation outcomes don’t really mean the Fed has missed its target or overestimated the natural rate of unemployment. Despite this convenient framing, the Fed will have a hard time holding the line on this position if the inflation data continues to disappoint. The Fed will have to again consider lowering it estimates of the natural rate.  Such a dovish shift would help offset any hawkish lowering of unemployment projections for 2019.

Wage growth looks to be decelerating:

Still, real wage growth remains on an upward trajectory, rising as unemployment falls:

In real terms, wage growth has rebounded to its pre-recession pace, an under-appreciated event in my opinion. Assuming this continues, the Fed will start to wonder if this implies costs pressures on firms will soon rise to a level in which they can no longer avoid pushing through higher costs to consumers.

Separately, Federal Reserve Vice Chair Richard Clarida backed up Chair Jerome Powell’s claim that the recent inflation shortfall is transitory. He also threw cold water on the idea that the Fed would make substantial changes to its operation procedure. Via Bloomberg:

He noted that while some of the proposals look great in theory, “there are some important implementation challenges that we would have to look at seriously before we would move away from our existing framework, which has served us well.”

If you want to see some really crazy stuff, watch this interview with Dallas Federal Reserve President Robert Kaplan. He repeats the story that the inflation shortfall is transitory and reiterates his position that structural factors are weighing on inflation. The reporter rightly challenges him by pointing out that the structural factors story means that the inflation shortfall is in fact persistent not transitory. Kaplan responds that the Fed can’t do anything about disinflation caused by structural factors:

“We are just going to have to monitor this very carefully but I am not inclined at this point to lower the Fed funds rate to address it,” said Kaplan, who doesn’t vote on monetary policy this year. “I think that is more effective dealing with the cyclical elements of inflation, I am less convinced that it deals that effectively with the structural elements.”

This is  just classic. The inflation story is evolving from “we have a symmetric inflation target” to “any shortfalls of inflation relative to target are transitory” to “we can’t do anything about inflation shortfalls because although they are persistent, they are structural in nature.”

Here’s the problem. Suppose the Fed ignores low inflation as structural as Kaplan suggests. Then, within the Fed’s framework, they will essentially be accepting a drop of inflation expectations because they are proving they do not intend to lean against weak inflation. By extension then the Fed undermines its position going into the next recession both because they face lower inflation expectations and any plan to raise inflation is automatically deemed lacking any credibility.

Bottom Line: Below target inflation when unemployment is low and job growth is strong puts the Fed in an uncomfortable position. If the situation continues, by the end of the year Fed will need to pull together a more coherent policy framework.