Slower job growth not an obstacle for the Fed

Job growth has been running at an impressive pace since early last year, pushing the unemployment rate from 6.6% to 5.1% - very close to the assumed level of NAIRU (around 5.0%). The rapid job growth has been helped along by a combination of solid GDP growth and slow labour productivity growth. Over the past three months, the US economy has added on average 221,000 jobs per month. This is an unsustainable pace in an economy where potential labour force growth, under a positive assumption about a rebound in the labour participation rate, is around 150,000 per month and even lower if the participation rate fails to increase.

"If we assume that the current pace of decline in unemployment continues over the coming six months, the unemployment rate would be 4.6% by spring. This significantly undershoots the FOMC's projected 4.9-5.0% NAIRU. In other words, we think that a slightly slower pace of job growth will not scare the Fed off hiking rates. We believe that employment gains will need to drop consistently below the 160,000 mark before the Fed will see it as an obstacle to starting the tightening cycle later this year", says Danske Bank.

Over the past two weeks, FOMC chair Janet Yellen has on several occasions stated that she sees more labour market slack in the economy than captured by the level of the unemployment rate. In particular, Yellen is of the view that running a 'hot' labour market for some time will push some people back into the labour force. The lack of upward pressure on wage inflation is clearly supportive of that view.

"However, we do not share this optimism on the labour participation rate and we expect wage inflation to accelerate as we move closer to year-end. This is a key reason why we think the Fed will initiate its tightening cycle in December this year and proceed at a faster pace than the two hikes in 2016 that the market is currently factoring in",added Danske Bank.