The U.S. economy added 216,000 nonfarm jobs in December, well above consensus expectations of 150,000. Large downward revisions (of 71,000 in total) to prior two months, however, kept labor demand on a cooling trend. On a three-month average basis, 165,000 jobs were added in December, down from 180,000 in November and 284,000 a year ago (see chart 1).

Chart 1

For full-year 2023, the economy ended up adding a respectable 2.7 million jobs (225,000 average per month), which translates to 1.7% growth in payrolls. To be sure, the pace of jobs added in the economy slowed to 1.3% (annualized) per month on average in the last three months of the year, which is materially lower than the 1.9% pace in the first nine months and slightly below the 1.4% during the two years leading up to the pandemic (2018 and 2019).

At the current pace of monthly job gains, payroll employment will catch up to our pre-pandemic full employment forecast path by the end of this year (see chart 2). That said, we expect monthly payroll growth will gradually slow toward 0.7%-0.8% (or about 100,000) in the coming months, which would be consistent with the most recent working-age population growth projection by the Bureau of Labor Statistics (BLS).

Chart 2

The jobs market is more or less back to its pre-pandemic trend. This is harder to achieve than just recovering to the pre-COVID-19 peak, and not bad for a recovery from a pandemic shock that many feared would lead to massive permanent job losses.

Contributions To Employment Growth Has Increasingly Come From Acyclical Sectors

The private sector added 164,000 jobs altogether in December, but it was the public sector's huge 52,000 jobs added--led by state and local governments--that put the overall net jobs gain over 200,000 (see chart 3). Private-sector job growth has slowed materially in the last 12 months to 1.0% (annualized) per month on average in the fourth quarter, now clearly below the 2018-2019 average of 1.5%.

Chart 3

Chart 4

In 2023, the sectoral composition of job gains became more uneven as the year went by. Of the 2.7 million jobs created during the year, almost three-fifths were from typically acyclical (not cyclically sensitive) government, and health care and social assistance sectors (see chart 4). There is a risk that employment growth in those two outperforming sectors will slow to a more normal pace this year, even as there is still some room before they catch up to pre-pandemic trends. (Health care and social assistance is still 2.3% below 2017-2019 linear trend while state and local government is 1.3% short.) In particular, given that the earlier strength of state and local finances last year may have faded as revenue growth slows, there is a rising prospect of a slowdown in employment growth this year, since those governments will be constrained by balanced budget rules.

Public sector aside, the breadth of private-sector hiring--as captured by the diffusion index, where 50% indicates an equal balance between industries with increasing and decreasing employment--narrowed to 60% in the span of last three months, near the lowest level of this expansionary cycle (see chart 5). This reflects concentrated gains in education, health care, and leisure and hospitality in the private service-producing sector, while construction led the private goods-producing sector. Concentrated gains tend to exist either at early stage or at late stage of expansions. While we haven't yet seen a rise in new layoffs that would be considered a red flag, employment in the temporary help services sector--another tried-and-tested leading indicator of the labor market--was down again in December (see chart 6). Temporary help services fell by 33,000, or 6.8% from a year ago--a decline whose magnitude has in the past been a harbinger of recession.

Chart 5

Chart 6

We expect further slowing, consistent with our forecast of slowing GDP growth. Meanwhile, the government sector could potentially pick up slack in the coming months given the shortfall in state and local government jobs (still 255,000 below trend).

Steady Unemployment Rate And Wage Growth Were Less Than Meets The Eye

The unemployment rate remained unchanged at 3.7%, but not for good reasons. It didn't rise only because a 676,000 drop in the size of the labor force almost kept pace with a 683,000 decline in the household survey measure of employment. Household survey measures of employment and labor force have generally been volatile on a monthly basis, so take this December drop with a grain of salt. We believe there is more scope for labor supply to grow, but any gains to participation ahead are likely to proceed at a slower pace.

December brought a second consecutive 0.4% month-over-month gain in average hourly earnings, which was enough to push the annual rate back up to 4.1%, from 4.0% in November. With average weekly hours worked down by 0.1 percentage point, however, the gain to overall incomes will be more modest.

Chart 7

We look for wage growth to decelerate in coming quarters toward 3.5%, consistent with the inflation target of 2% plus the 1.5% labor productivity growth average of the last 30 years. November's Job Openings and Labor Turnover Survey (JOLTS) report, which was directionally worse, also supports this view. The quits rate, which has a high leading directional correlation with wage growth, was back down below the 2019 level for the first time (see chart 8). Folks are not confident to quit their current jobs as much as they did just a year ago since they are beginning to meet resistance finding new employment. This is consistent with job openings that have continued to decline on trend, reflecting a normalization in labor demand, although they remained above pre-pandemic levels. The rate of hiring has also fallen to its lowest level since 2014, outside the pandemic era. The uptick in continuing jobless claims (not new claims, a subtle distinction worth making) over the past year seems to reinforce this notion, suggesting that it is taking longer for laid-off workers to find new jobs even as the overall level of layoffs remains muted.

Chart 8

What Is Next For Monetary Policy?

Market pricing of Fed policy through the second half 2023 had been volatile in recent months, shifting with incoming employment and inflation data, and every word spoken in the Fed's speaking circuit. As of Jan. 10, no more rate hike is baked in for this monetary cycle, and the futures market is pricing in rate cuts to begin in March.

The clearest interpretation of the Fed's view at this point is that it is still in wait-and-see mode (data conditional); the door remains ajar to further hikes if necessary, but the next move increasingly looks to be a cut. The Fed is sensitive to the risks of both remaining restrictive for too long and causing unnecessary economic pain, and easing too soon and risking a resurgence in inflation.

In our December forecast update, we penciled in three rate cuts of 25 basis points for this year, with the first one coming next June. We look for this week's consumer price index (CPI) report to show that inflation continues to slow on trend in a way that positions the Federal Open Market Committee (FOMC) to start cutting rates in June. We expect a 0.2% increase in headline CPI and a 0.3% increase in the core.

For now, we are comfortable with our expectation of the first cut coming in June, consistent with our December forecast for below-potential growth, easing inflation, and a better balance in labor demand and supply.

To be sure, policy risks depend on how the incoming data and forecasts evolve. Chances have moved up that the Fed could cut sooner than we expect in our baseline. First, disinflation has been faster than expected, and it is increasingly looking like core personal consumption expenditure (PCE) inflation will reach 2% before midyear (see charts 9-10). Second, Federal Reserve Chairman Jerome Powell's press conference speech after the Dec. 13 FOMC meeting repeatedly mentioned "dual mandate," insinuating that the Fed has very little patience for employment veering away from maximum employment when inflation is below 3% and moving toward the target.

Chart 9

Chart 10

Perhaps more tellingly, Chairman Powell also suggested in his press conference that the Fed needs reduce the policy restriction on the economy well before inflation reaches 2%, suggesting there is a risk that rate cuts begin earlier than our expectation of a June meeting. The idea is that waiting to cut until that target is reached could hurt the economy because of the lagged impact of monetary policy. This would be also consistent with the fact that the Fed wants to put behind it the days of persistent undershoots relative to central bank targets. Inflation should average 2.0% (was 1.6% average last monetary cycle 2010-2019). To this effect, Powell suggested in early 2022 that the new monetary policy strategy (flexible average inflation targeting framework adopted in 2020) is asymmetric. That is, he indicated the FOMC should aim at inflation above 2% when inflation falls short of the long-run target but need not aim at inflation below 2% when inflation exceeds it.

The Fed wants to avoid falling behind the curve, again.