The Pace of Job Creation Might Start to Slow Down (and That Might Be OK)

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Back-to-back months of employment growth that came in far below economists' expectations would seemingly belie the notion that the U.S. economy is firing on all cylinders.

But the recent job numbers paint the picture of an economy that's losing slack—not steam—and offer a sneak peak at what nonfarm payroll net additions will look like later in the cycle.

An increasing number of Wall Street economists and those inside the Federal Reserve are concluding that job growth is bound to shift into a lower gear as the aging population drags on the amount of available labor.

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People with jobs are exiting the workforce in large numbers, marking the retirement of the Baby Boom generation as the U.S. moves towards Peak Polident:

Over the next few years, the growth of the working-age population in the U.S.—those between the ages of 15 and 64—will be downshifting to 0.4 percent and trending even lower, said RBC Capital Markets Senior Economist Jacob Oubina. And immigration is no panacea for this development, he added.

"The problem is that immigration isn't big enough," Oubina said. Even under the Census Bureau projection that takes the most optimistic view on the potential influx of people to the U.S., "we're still looking at a sub-1 percent growth rate for the working-age population over the next five years."

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Both Oubina and JPMorgan Chief Economist Michael Feroli think that once the U.S. labor market reaches full employment, the amount of monthly net job growth needed to keep it there will be roughly half of what it was in the allegedly disappointing September report.

"The pace of monthly job growth that is consistent with a stable unemployment rate right now is probably around 75,000," said Feroli in an interview on BloombergTV. "Now, you go back to, say, the late ’90s, that number was more like 200,000."

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The notion of a slower trajectory for U.S. job growth is also gaining traction inside the Federal Reserve.

In the fourth quarter of 2014, Daniel Aaronson, vice president and director of microeconomic research at the Federal Reserve Bank of Chicago, co-authored a paper that examined how labor force participation and employment growth were likely to trend in the future. The authors found that the labor market would muster only "typical employment gains of under 50,000 per month" once it fully normalizes, an even lower estimate than Feroli and Oubina put forward.

"Estimates of potential output growth and the natural rate of unemployment should also reflect lower projections for labor force participation and changes in the composition of the work force," they wrote.

RBC's Oubina contends that Fed policy makers had failed—until recently—to condition the market adequately for a slowing pace of job growth. San Francisco Fed President John Williams is one such example of how the thinking of decision-makers at the central bank has evolved. He recently hailed Aaronson's work as a "best in class" analysis and echoed some of the sentiments expressed therein when discussing the September payroll numbers.

"The numbers were a little bit softer than market expectations, but I also—as I've said a number of times—think that we've got to start realizing that we can't see 200,000-300,000 jobs per month like we saw last year," said Williams. "We had 3 million jobs, we add another 3 million jobs over the next 12 months, we will see the unemployment rate get down to 4 percent in no time.''

In the short run, however, employment growth will not be governed solely by this structural issue.

"There are three factors driving headline nonfarm payrolls here," said Conor Sen, portfolio manager at New River Investments. "The magnitude of economic growth, pace of retirements, and how much a stronger job market and faster wage growth can get new entrants into the job market."

The reported headline figure, he added, doesn't tell us much about the interplay between those dynamics. And Sen doesn't think it's a foregone conclusion that nonfarm payroll growth starting with a "2" is going the way of the woolly mammoth soon.

"It's possible that we could get a surge of new entrants as we approach full employment," he said. "Measures like employment to population show that we're still a fair amount below pre-crisis levels, so it's possible those people could enter or come back and keep us printing 200,000."

The extent to which a vibrant labor market entices people who are not in the labor force will be a key driver in how soon a slower trend of job growth materializes. But even so, CIBC World Markets chief economist Avery Shenfeld contends that employment growth is due for a cyclical slowdown absent the aforementioned demographic forces that will weigh on the growth of the working-age population in the future

"If we don't get a miracle in labor force participation, we're going to start bumping up against full employment," he said. "So if we didn’t get slow job growth on its own, we would get it from the Fed raising rates."

This development should not be construed as a negative one, said Shenfeld, because a tight labor market in which employment growth is slowing is also likely to be one that's seeing a healthy rate of wage inflation.

When you look at prevailing labor market dynamics with a broad lens, the incidences of shortages, turnover, or difficulties filling positions in the Beige Book, extremely low initial jobless claims, small businesses indicating they have a hard time finding qualified applicants, spiking job openings, and slowing employment growth all point to the same thing, according to RBC's Oubina: a pickup in wages.

"Not only do we have an existing supply problem, but the supply issue is going to continue to worsen because growth in available labor is going to slow," said Oubina. "That tends to have ramifications for wages—one of firming wages over the next six to 12 months."

New River's Sen, however, notes that a scenario in which wage growth and employment growth could both be strong—"if demand is so robust that we're pulling new people into the labor force and current employees are getting raises, too."

As labor becomes scarcer—and more expensive—increases in productivity, potentially fueled by efficiency-enhancing capital expenditures, would be necessary to avoid a precipitous drop-off in headline economic growth.

CIBC's Shenfeld contends that a meaningful uptick in business investment is unlikely and that the U.S. economy won't get as much capital spending as it used to at any given future interest rate.

"Slower trend growth entails less pressure on capacity," he explained. "That, along with a shift in the nature of the economy to companies like Uber that generate growth without much capital spending will keep nominal interest rates low."

And as for financial markets? Well, investors don't seem to have incorporated the potential for slowing job growth into their conceptual frameworks just yet.

In the immediate aftermath of the latest job figures, the front-month S&P futures contract took a nose dive:

"Friday's reaction would tell you maybe markets aren't ready for it," said JPMorgan's Feroli, referring to the knee-jerk selloff in the premarket on Oct. 2.

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