Employment falls but wage news less favorable

Fed issues tightening bias, markets rally
The Federal Reserve announced that they were going to a tightening bias at the FOMC meeting this past Tuesday. In some ways, the markets were disappointed. After all, if the Fed had raised the fed funds rate target by 25 basis points, market players would have felt that the Fed was done for the year. The tightening bias puts the markets on hold - until the next FOMC meeting in mid-November. Market players didn't like the news on Tuesday and fell sharply immediately after the announcement. By the end of the day, the Dow managed to close at Monday's levels.

Luckily, other news came to the forefront later in the week that gave equity investors something bullish to grab. Indeed, earnings reports and merger announcements kept the markets hopping through most of the week. Even the soggy employment report didn't phase the stock market. All major indices were higher on Friday - and for the week.

Treasury market (still) worried about (potential) Fed rate hike
The Fed's tightening bias disappointed bond market players. They would have preferred to "get it over with" for the rest of the year. As it stands, it means that bond market investors must analyze each of the key indicator reports coming out before the FOMC meeting on November 16. Today's employment report was not friendly for the markets. Although nonfarm payrolls dropped in September, market players focused on the higher than expected wage gains. The Fed still has another employment report to digest (as well as several inflation indicators and retail sales) before the next FOMC meeting and a decision to raise rates - or not.

Nonfarm payrolls fall
Nonfarm payrolls fell 8,000 in September after a downward revised gain of 103,000 in August. The one-two punch for the two months of the quarter curtailed the quarterly gain despite a July spurt in payrolls. At 156,000, the three-month moving average in September was nearly as weak as the 144,000 three-month average for the March to May period. We have to go back to January 1996 to see anything weaker. If you will remember, January payrolls were felled by a snowstorm on the East Coast. The drop in August payrolls was attributable to the negative impact of Hurricane Floyd. However, the Bureau of Labor Statistics estimates that the hurricane depressed payrolls by 58,000. There is no question that employment gains would have been mediocre even without the hurricane effect.

In order to get such a sluggish employment report; the normally-booming service sector must have been hit hard. Indeed, payrolls in the service-producing sector dropped 9,000 for the month. In the goods-producing sector, construction employment increased, just about reversing the previous month's drop. Factory payrolls continue to bleed. It now appears that the 53,000 gain posted in July was an aberration. The weakness in manufacturing employment is at odds with the improvement in manufacturing activity - such as new orders. Factory orders are now 8 percent above year ago levels, but payrolls are down 2.1 percent from last September.

The bottom-line on payrolls? It is unusual to see such a sharp deterioration in employment when demand is still healthy. For instance, chain store sales posted robust gains on the whole in September suggesting that the consumer-spending spree isn't over. The two-month moderation in payrolls could be reflecting the high degree of tight labor markets. It is possible that employers simply can't find qualified workers. This would mean that growth is limited by supply shortages, rather than a drop in demand. After all, the civilian unemployment rate remained unchanged in September at 4.2 percent with modest gains in both employment and the labor force. If the labor market were softening, we would see an uptick in the jobless rate.

Is the wage acceleration a real concern?
Average hourly earnings rose 0.5 percent in September after smaller gains in the previous two months. The uptick frightened the bond market and curtailed the exuberant mood that could have come from the drop in payrolls. As seen in the chart below, the monthly rise pushed the year over year gain to 3.8 percent after slower increases in previous months. However, the quarterly pattern was unchanged in the third quarter from the second quarter, according to senior BLS officials.

The bottom-line on wages? Since mid-1998, average hourly earnings have fluctuated between 3.5 and 4 percent on a year-over-year basis. Fed officials were not entirely worried about these annual wage gains because they were offset by healthy productivity gains. The difference between now and then is that the Fed is not so sure that productivity will continue to rise at the same heady pace of the past couple of years. When wage increases are offset by productivity increases, then companies don't need to raise their prices for the goods or services they are selling. As world demand picks up steam after two soggy years, Fed officials worry that the U.S. won't find the same competitive pressures curtailing prices as in the past couple of years. After all is said and done, though, it is too early to view the September rise in wages as the big bad wolf of inflation.

Auto sales weaken but chain store sales healthy
Motor vehicle sales dropped off in September after reaching new highs for the cycle last month. Truck sales actually increased for the month, but auto sales decreased and overwhelmed the total. There is no question, though, that overall motor vehicle sales are still at high levels. The chart below depicts domestic and imported motor vehicle sales in millions of units at seasonally adjusted annual rates.

Chain stores reported monthly sales results this week with mostly favorable results from a year ago. The data suggest that retail sales could be robust in September. The sales reports were somewhat surprising, however, in light of the weekly chain store sales from the LJR Redbook and the BTM/Schroders series. These have shown marked declines over the summer months. It will be interesting to see how these figures translate into retail sales (reported next week).

THE BOTTOM LINE
The September employment report did nothing to soothe the fears of anxious investors. The equity market seemingly ignored the figures as earnings reports and merger activity gave investors something else to watch besides the economy.

The employment report was negative for the bond market because the focus on wages was stronger than the interest in the downdraft in employment. Hurricane Floyd affected the data and made it more difficult for market players to interpret the report.

It really is too soon to determine whether the Fed will raise rates at the next FOMC meeting. Today's news makes it a toss-up. But never fear - the Fed and market players will have several more economic indicators to help them determine the direction of the economy and inflation.

Looking Ahead: Week of October 11 to 15
We use the Market News Service survey of forecasts to describe the market consensus.

Thursday
Market participants are expecting new jobless claims to decrease 7,000 in the week ended October 9 from last week's 312,000. The data could still be skewed by the aftermath of Hurricane Floyd.

Economists are predicting that retail sales will edge up 0.2 percent in September after gaining 1.2 percent in August. Motor vehicle sales dropped during the month and will put downward pressure on the total. Excluding autos, sales are expected to rise 0.4 percent for the month, in line with the past couple of months.

Friday
Market participants are looking for the producer price index to jumped 0.4 percent in September after more moderate gains in previous months. Some of this expected gain is due to higher energy prices. Excluding food and energy, the PPI should also post a 0.4 percent hike due in part to higher tobacco prices.

Business inventories are expected to rise 0.2 percent in August, higher than the previous two months. However, sales are expected to jump 1.4 percent and this will keep down the inventory to sales ratio.

The consensus forecast for the index of industrial production is up 0.1 percent after a modest 0.3 percent gain in August. Several manufacturing indicators including the NAPM point to a pickup, but soggy employment will curtail the gain. At the same time, the capacity utilization rate should decrease to 80.7 percent from 80.8 percent in August.