While optimism in the U.S. has been increasing amid high vaccination rates, the most recent unemployment data presented a negative surprise. Now, President Biden’s American Families Plan, part of his proposed infrastructure package, tops many news headlines. This plan brings with it significant economic implications, but first it will have to make it through what good be an arduous approval process. Meanwhile, in Canada, another round of lockdowns has hampered recovery.
U.S. — Positive fundamentals despite negative unemployment surprise
The U.S. unemployment report was a huge miss relative to expectations, with non-farm payrolls up 266,000 versus consensus expectations of 1,000,000. The unemployment rate crept up by 0.1 percentage point, to 6.1%, due to a slight pick-up in participation. Meanwhile, average hourly earnings increased by 0.7% month over month, well above consensus expectations.
This news comes in tandem with other evidence of rapid growth in economic activity, sending conflicting signals. The unemployment report suggests that there may be supply-side constraints on labor growth, but it would be rash to set too much store by a report of a single month’s (relatively noisy) data. Lingering coronavirus concerns and the impact of enhanced unemployment insurance (UI) may be effecting labor supply in the short term, but other measures of labor market supply point to huge amounts of slack. Moreover, there’s little reason to expect labor demand to slow sustainably, so the stage may be set for a very significant pick-up in employment growth over the next few months.
On the demand side, various indicators are consistent with very strong economic growth. The ratio of unemployed workers to job openings is relatively low, and, while certainly not back to pre-pandemic levels or even full-employment levels, has improved recently. Moreover, workers and firms have both reported strong growth in job openings. On that basis, it seems difficult to conclude the weak job numbers reflected a sudden decline in labor demand.
Perhaps most significantly, the prime age employment ratio is still very depressed (chart below). However, it’s plausible that the economy is still experiencing a very short-term bottleneck, with short-run supply much lower than true supply capacity. The federal government topped up UI by $300 per week, which may have contributed to supply-side frictions. Because this UI is quite “generous,” it’s possible that some potential workers have chosen to remain outside the workforce, pushing down on labor supply (and up on worker bargaining power). It’s unclear right now how much this dynamic, along with lingering Covid-19 fears, is keeping potential workers from becoming employed.
Source: Federal Reserve Bank of St Louis, U.S. Bureau of Labor Statistics, April 30, 2021.
This being said, these very same effects were in operation earlier this year, and should have decreased in magnitude since the vaccine rollout has picked up. But this didn’t stop the economy from posting very large payroll growth in those months, so it would be surprising if this effect suddenly became a more binding constraint. Instead, we expect that this number largely reflects noise in the time series, potentially exacerbated by quirks and seasonal adjustments.
The underlying drivers of labor-market demand appear strong. The U.S. seems set to enjoy a path of activity above its pre-crisis trend rate over the next few years thanks to very accommodative monetary and fiscal policy. Meanwhile, we are unconvinced that UI payments have fundamentally changed labor-supply dynamic. In fact, we believe that there is still a huge degree of spare capacity in the economy. Thus, we expect employment growth to rise dramatically in the next few months.
U.S. — Infrastructure in Congressional negotiations
To mark his 100th day in office, President Biden released the details of the $1.8 trillion American Families package, which include:
- Funding for early education
- Free community college
- College grant expansion
- Childcare and family tax credit expansion
- Paid leave
- ACA expansion
The administration has proposed increasing the capital gains tax rate from 20% to 39.6% for those with incomes greater than $1 million. The new rate would bring the capital gains rate broadly in line with the income-tax rate for high earners, breaking with a long standing precedent that capital is taxed at a lower rate in part to incentivize savings and capital formation. The administration and many Democrats believe instead that the lower capital rate has been exploited by high-income individuals who divert income into vehicles that then get taxed at a lower rate than the capital gains otherwise would be.
It is plausible that this may spark uncertainty over future tax rates. Investors may question how tax regimes could fluctuate under future administrations, which may incite them to depress investment, waiting for a potentially lower tax rate down the line. This is a dynamic we will be watching closely.
In terms of the politics of passing the infrastructure packages, there are three main questions facing the Biden administration:
- Will the two infrastructure bills be combined into one big bill?
- How big will the bill(s) be?
- Who will pass Biden’s infrastructure plans?
We think that the answer to the first question could be yes. As time goes by, it will become more likely that the bills are combined into a single “mega bill” because of how time consuming passing budgetary legislation can be. We should have a better idea of this by the end of May. However, we think that if the two bills are combined, there is likely to be more downward pressure on the overall figure than if there were passed separately. This is because such a massive bill will have to go through many Congressional budget hoops.
Regarding the size of the bill(s), technically, the combined American Jobs Plan and American Families Plan total about $4 trillion in spending, funded by tax rises on corporate, capital and high-income individuals. However, things could look quite different once the sausage gets made. Republicans have outright rejected the size of the plan, expanding the role of the government and large elements of its green agenda. Moderate Democrats, too, have expressed discomfort with the size of the plan and the tax raises involved. If there is downward pressure on spending, we expect it will come down more so on the Families Plan because there is more space to spend less here and because it is less critical to Biden’s success than his green infrastructure agenda. This month will be important for hammering out differences and progressing in negotiations.
The answer to our third question looms. While Biden has continued to signal a willingness to work with Republicans, the gap between the two sides is dauntingly wide. This was the case before the Families Act and is even more glaring now as Republicans bristle at what it considers a much bigger government. As such, we expect that these bills will be passed by reconciliation without Republican support.
So, it becomes a question of where the middle ground is within the Democratic party. There are some clear divergences between moderates and progressives that will need to be bridged. Moderates might be willing to compromise size to reduce tax rises, but progressives would strongly oppose such a move. Moderates could be bought off with SALT deduction reversal, but progressives like Bernie Sanders would oppose such a move, which seems to favor the wealthy. This debate may be heated — and will likely play out very visibly in the media — but we do expect both sides to find compromise. We expect that at least $3 trillion of spending will be approved by the end of this process, funded mostly (if not entirely) by tax hikes.
Canada — Labor market suffers during another lockdown
Further north, in Canada, amid a severe third wave of Covid, unemployment increased in April. The government had to, once again, put lockdown measure in place to help contain he virus, leading to large job losses in sensitive sectors. These include service sectors, such as retail trade, accommodation and food, as well as culture and recreation. Employment growth is likely to remain weak over May, before vaccine rollouts allow for a sustained re-opening of the economy from June onward.
Interestingly, the Bank of Canada has revised its growth and inflation forecasts sharply at its last policy meeting in late April. The Bank suggested that the conditions under which it would consider raising rates would be met in the second half of 2022 (it had previously said 2023). Recent developments may see the bank revise these forecasts down again, as this latest wave of Covid infections will almost certainly have pushed back the time at which we can expect the economy to return to full employment.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.