The most recent employment situation report posted the first drop in overall employment in four years. A number of economists and Fed officials have stated that with housing in recession and business investment slowing, the consumer sector will be the determining factor for whether or not the U.S. economy goes into recession. And the strength of the labor market will play a key role in the strength of the consumer. While the latest payroll numbers were negative, what are other labor market indicators telling us about potential recession?

Any leading information from payroll jobs?

The January jobs report released earlier this month indicated that the U.S. economy netted a 17,000 loss in payroll jobs – the first decline since August 2003. Do the payroll numbers give us any leading information about whether we are in recession? Economists agree that overall payroll numbers give NO leading information about whether we are in recession or not.  The last official recession started in March 2001 and ended in November 2001. For that period, there were a few random decreases in payroll employment prior to the start of recession (followed by one or more gains), but there was not a consistent decline in employment until March 2001! Economists call payroll employment a “coincident” indicator since employment moves with the business cycle rather than leading or lagging it. Any recession chatter for total employment would be that we might already be in recession – other than the fact that a one month decline could either be reversed or even revised away the next month.

Looking at broad categories for payroll employment, there seem to be some long-term trends taking place as well as cyclical ones. Weakness in employment is primarily in construction and in manufacturing. But by broad sectors, there are divergent long-term trends overlapping the recent cyclical swings. Both service-providing and construction employment have been on long-term upward trends. Meanwhile, manufacturing has been on at least a medium-term downward trend due to productivity gains and outsourcing overseas. At least a portion of the recent decline in manufacturing employment is due to productivity effects and limits the usefulness of the job losses for pointing to recession.

Temporary hiring is pointing to flat growth or mild recession

While the broad payroll numbers do not have much leading information, there is one component that does – temporary help. The idea is that businesses use temporary workers to buffer swings in personnel needs due to swings in demand. When business is strong, the hiring of temps is strong. When business falters, temp hiring slows or falls. Prior to the 2001 recession, temp jobs fell in seven of the 10 months just prior to the start of recession with a number of months in the minus 30,000 to minus 40,000 vicinity. Recently, we have seen temp jobs declining every month except one since January 2007. The declines have been modest however – generally in the minus 10,000 vicinity. Temp help has been pointing to a soft labor market for a number of months – but more to one that is sluggish and not suffering a major drop-off.

Payroll diffusion index hints at mild recession

Whether the economy goes into recession or not can depend on whether there are just a few industries in decline with remaining industries keeping growth positive. That is, the greater the number of industries in decline, the more likely the economy is in or headed into recession. A diffusion index measures the percentage of those increasing versus those decreasing. The official definition for payroll diffusion indexes is that the figures “are the percent of industries with employment increasing plus one-half of the industries with unchanged employment, where 50 percent indicates an equal balance between industries with increasing and decreasing employment.” A level of 50 is the break-even point between positive growth overall and negative growth.

With the latest payroll employment report, the overall diffusion index for month-ago changes in employment came in at 46.2 for January, compared to 50.0 for December and 48.2 for November. The recent peak was 64.4 in March 2006. The overall diffusion index is at about the same level as just prior to the 2001 recession.

Average weekly hours have eased

A final important series from the payroll report is that for average weekly hours. Businesses use the workweek to adjust to changes in demand – at least for hourly employees. When sales are soft, businesses cut back on employee hours and later cut back on the number of employees if needed. The latest months of data indicate that the average workweek has slipped. The overall average workweek was down to 33.7 hours in January 2008, compared to a recent high of 33.9 hours seen as recently as June 2007.

Jobless claims paint fuzzy picture

Outside of payroll employment and the unemployment rate, the favorite labor market numbers for traders in the financial markets are likely initial jobless claims and continuing jobless claims. Indeed, these are two labor series that clearly lead the rest of the economy. Both initial and continuing claims turned up sharply well before the start of the 2001 recession. But initial claims and continuing claims have been painting slightly different pictures recently. Continuing claims have been on a mild upward trend since 2006, likely reflecting some increased “structural” unemployment. That is, there may be too much of a mismatch between skills demanded by the market and skills some workers have.  This is a long-term problem. On the other hand, until a spike in initial claims for the week ending January 26, 2008, initial claims data had been indicating a tight labor market.

Also suggesting that the modest uptrend in unemployment is possibly “structural” is the fact that the duration of unemployment has been rising for over a year – well before the latest overall economic weakness set in. The average duration of unemployment is now 8.8 weeks, compared to a recent low of 7.5 in December 2006.

The bottom line

The bottom line is the labor market has softened in recent months. But at least some of this appears to be due to a mismatch between actual job skills and those now demanded by the markets. Leading indicators are now suggesting job growth in the near term that is either flat or slightly negative. There are not yet indications of either notable declines or extended declines and hopefully the recent interest rate cuts by the Fed will keep it that way and even boost labor demand by mid-year.