The strength of the employment report on Friday, May 7, leaves little doubt about the strength of the current recovery. The GDP growth engine seems to be generating torque that is translating into job creation. Payrolls increased by 288,000 in April, accompanied by upward revisions of 66 thousand jobs in February and March. A closer look at the pattern of job creation indicates strength across all sectors of the economy. Add to this a decline in the unemployment rate to 5.6 percent, and we have a situation where employment increases more than compensated for job seekers entering or reentering the labor force. This is good news from the perspective of the strength of the recovery.

What does all this mean for Fed actions? Governor Bernanke's April 22, 2004 statement indicated that the Fed viewed the breakeven job creation rate at 120 thousand per month. With strong job numbers, averaging 235 thousand per month over the last three months, this suggests a Fed rate hike may occur sooner rather than later.

Yet, strong labor productivity gains give the Fed some flexibility. Productivity surged in the first quarter of this year by rising 3.5 percent quarter-over-quarter on an annualized basis, above the 2.4 percent growth rate during the period 1993-2003. While there has been an increase in compensation, year-over-year unit labor costs are declining at a rate of 1.3 percent. It seems safe to conclude that recent increases in the CPI are not likely due to increases in labor costs.

In light of all of this data the Fed believes the "goal of price stability to have moved into balance," and their current perspective is that policy accommodation can be removed at a "measured" pace. This change in stance has added to the market's expectation of rate increases in the near term.

Having built in this very same set of expectations, mortgage rates have climbed from 5.8 percent to 6.1 percent in the last month. This change will reduce mortgage originations, primarily through a drop in refinancing. In spite of this increase in rates, rising family incomes and improved employment conditions will lead to housing starts coming in at a healthy 1.85 million units and home sales close to 7.3 million units for the year. Refinance share, however, will be a casualty. The last three years have seen the refi-share of originations come in at well above 50 percent. For the first time in quite a while, refi-share is expected to come in below that threshold, at about 40 percent for 2004. For now, it looks like "Bye Bye Refi."

Published: May 12, 2004

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