Modest payrolls, patient Fed

Another modest month of payroll gains. The September payroll report was on the soft side, with nonfarm payrolls rising 148k and private payrolls rising only 126k. These numbers were below our (200k) and consensus (180k) expectations for headline payroll growth, and minor revisions to the previous two months of data that added 9k to payrolls was not enough to alter the flavor of the report. As was the case in August, goods-producing sectors were stronger, with manufacturing payrolls rising 2k and construction payrolls adding 20k, consistent with the recent trends in regional and national manufacturing indices and our view that the recovery in housing will prove durable to the recent rise in mortgage rates.

Private sector services continued to be softer than previous trends, adding only 100k jobs on the month, bringing the three-month average to only 118k. The weakness in services payrolls has come mainly from leisure and hospitality, which fell 13k on the month and the three-month average increase of 2k is well below the 49k average recorded between April and June. The remaining service sectors posted modest gains, with trade and transport adding 60k to payrolls, retail trade adding 21k, and education and health adding 14k. Government payrolls rose by 22k, driven by increases in state and local payrolls, while federal payrolls were reduced by 6k.

Average hourly earnings were up 0.1% in September, a bit below our and consensus forecasts (both 0.2%), and August was revised higher to show an increase of 0.3%. This leaves average hourly earnings up 2.1% y/y and indicative of only modest wage pressures. Average weekly hours held steady at 34.5 in September and the index of aggregate hours worked was up 1.2% annualized in Q3, versus the 2.1% in Q2 and the 3.6% in Q1. The payroll proxy (average hours worked times average hourly earnings) shows a similar pattern, up 3.2% annualized in Q3, versus 4.1% in Q2 and 6.2% in Q1.

The unemployment rate in the household survey fell one-tenth to 7.2% (7.235% unrounded, versus 7.278% in August), in line with our forecast. Household employment rose by 133k and the three-month average change now stands at 82k, somewhat softer than the 143k average for payrolls. The participation rate held steady at 63.2%, suggesting the decline in the unemployment rate was driven by modest job gains.

Our view remains that the pace of employment growth in recent months, although modest, will be sufficient to keep the unemployment rate in a downward trajectory, as long-term demographic trends will continue to offset any cyclically driven rebound in labor force. This is the same dilemma that the FOMC has faced throughout the recovery; moderate GDP growth and modest payroll growth are likely to keep the unemployment rate in a gradual downward trend. The main question has been how the Fed would respond to this mix. Our estimates, incorporating our views on demographics and structural trends in labor force participation, indicate that payroll growth of 75-100k per month is sufficient to keep the unemployment rate steady and job gains above this level will push the unemployment rate lower.

The recent pace of payroll growth, however, is unlikely to satisfy FOMC policymakers. Based on the chairman’s comments after the September FOMC meeting, we believe many on the committee are willing to view the decline in the unemployment rate as overstating the pace of improvement in labor markets. Consequently, we see this job report as leaving policymakers unsatisfied with the pace of improvement and reduces the likelihood the Fed tapers asset purchases in the near future.

We now expect Fed tapering in March 2014. In light of the moderate tone of the September employment report, we have pushed out our expectation for the first Fed tapering in the pace of asset purchases to March 2014 from December 2013. We now expect the Fed to finish the asset purchase program in September 2014, later than our previous expectation of June 2014. We have not changed our expected timing of the first Fed rate hike in June 2015.

This returns our outlook for Fed policy to where we were in March of this year after sequestration was allowed to proceed. At that time we expected sequester, and higher payroll and income taxes from the deal to avert the “fiscal cliff”, to weigh heavily on growth in 2013. We subsequently altered our outlook for Fed policy due to the persistent taper talk from FOMC policymakers and the loose linking of the path of asset purchases to the unemployment rate. Now that the Fed has backed away from that guidance, we expect that the Fed will want to see both stronger payroll growth and evidence that the fiscal policy drag and associated uncertainty emanating from budget negotiations has diminished before reducing the pace of its purchases. In our view, the drag from fiscal policy should begin to fade early next year, assuming that further brinksmanship does not lead to more fiscal restraint than we have in our baseline forecast, and we now expect the FOMC to wait at least until March to begin the tapering process.