Upside surprise to US payrolls not enough to save the dollar

US employment data last week delivered an economic boost for the reelected President Bush. Non farm payrolls for October beat the market's expectations by more than 150k, with the report showing a net total of 337k jobs being created. The release brings the average monthly increase for 2004 to 198k from 188k in September. The unemployment rate rose by a tenth to 5.5% as more people entered the labor force. Insofar as that represents workers who were previously out of the labor force but now consider their hiring prospects to be better, that is a 'good' reason for a higher unemployment rate.

Also noteworthy were the upward revisions to the payroll data for August (by 70k to 198k) and September (by 43k to 139k). The labor market is surely stronger than recent data suggested. As for hurricane related effects, construction employment rose 71k in October, probably reflecting a post-hurricane building/repair boom in some states. In fact, that was the highest monthly gain in construction jobs since the 74k in March 2000. But even excluding all those construction sector jobs, the resulting 266k figure was still strong and well above expectations. Indeed, the hiring was broad based across sectors. Manufacturing employment fell 5k in October and is up 69k in the year to date.

The average workweek was unchanged at 33.8 hours. Average earnings rose five cents in the month to $15.83, seasonally adjusted. That represents a 2.6% y/y increase in average hourly earnings and a year to date gain of 3.0%. One important result of the payrolls figure is that it will support consumption going forward.

The market reaction was telling. Interest rates and the US dollar rose. However the move in the latter was brief and the dollar closed the trading day at a seventh month low against the euro of 1.2920. Expect the USD to trend weaker, especially against the Asian currencies. Even though it is not a stated US policy, a weakening USD is consistent with a rebalancing of the global economy. Kickstarting growth with a weaker currency to help the export sector is a logical step with corporate America still reluctant to invest and consumers likely to cut back on spending. Inflation pressures are mild and so this makes a weaker USD easier for policymakers to accept.

The payrolls data has cemented our, and the markets, expectation that the Fed will raise rates 25bps (to 2.0%) on Wednesday. For December, our view has been that there would be another 25bps, with the fed funds target rate ending the year at 2.25%. After the October payrolls number, the market has come closer to our call with the futures tilting toward about a 70% probability from 50% before the payrolls data were released. There are two more payrolls releases before the December FOMC.

The improvement in the labor market does not mean that Fed is on the defensive regarding inflation. The reason is that the recent inflation data have been very much under control. For example, the Q3 unit labor cost data released Thursday was tamer than expected at 1.6% q/q. Fed Chair Greenspan has said many times that labor market tightness in the form of higher ULC provides the pressure behind broad-based inflation. But note that ULC did rise 0.6% y/y - the first y/y increase since Q1-03. Nevertheless, fed funds are not 1.0% anymore, and next week will be up 100bps from the lows. That means that come 2005, the Fed will have removed significant monetary accommodation and may choose to slow the pace of rate increases, depending on the data. We continue to see fed funds at 3.0% by mid-2005.

Doug Smith, Chief US economist, with additional comments from Daniel Hanna