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U.S. employers added jobs at an alarming rate in July — and that could spell trouble for the future.

The U.S. economy added 528,000 jobs in July, far exceeding expectations of 258,000, the U.S. Labor Department said, suggesting the labor market hasn’t cooled after three rounds of rate hikes by the Federal Reserve.

It’s obviously good news that so many Americans have found jobs. The unemployment rate fell to 3.5%, matching Trump’s pre-pandemic lows. The unrounded unemployment rate was 3.458%, the lowest level since the 1970s.

In a low-inflation environment of economic growth, as we enjoyed under President Joe Biden’s predecessor, this is certainly good news. In a Biden economy, bewitched by four years of high inflation and a shrinking economy, there’s a lot to worry about.

The increase in employment was accompanied by a substantial increase in average hourly earnings. More workers combined with higher wages create more demand in the economy. In the short term, this could push up core inflation, especially in the services sector. When the Labor Department releases its consumer price index for July next week, it may show that headline inflation has dipped slightly due to lower gasoline prices, but underlying inflation is likely to still rise. Economists see this as particularly worrying because core inflation — inflation minus food and fuel — is a leading indicator of future inflation. Therefore, rising core prices means that inflation will remain elevated for a longer period of time.

Mass hiring is also an indicator of inflationary forces. Businesses hire when demand is high, with 528,000 jobs indicating a wave of demand. Services added 402,000 jobs in July, with leisure and hospitality adding nearly 100,000. Education and health services rose by 122,000, the highest since the May-July hiring spree that reopened. Businesses that see enough demand to attract large numbers of workers will raise prices — especially since their own labor and material costs are rising.

No wonder the market believes the Fed will have to keep raising rates during its September meeting. There are even rumours of an emergency meeting if the CPI data overheats next week, although it seems unlikely we’ll get enough inflation data to call for that.

The increase in employment could also mean another drop in labor productivity. The government measures productivity by simply dividing economic output by hours worked. When the economy contracted and employment grew rapidly in the first quarter, productivity fell by 7.3%. This was the largest drop in labor productivity since 1947. We’ll have productivity data for the second quarter next week, and economists expect it to fall by 4.5%, which is overly optimistic. If the forecast is correct, it would be the worst decline since productivity fell 5.1% in 1981 – excluding the previous quarter. A surge in employment in July could mean lower productivity in the third quarter as well.

Falling productivity coupled with rising wages means higher labor costs. Unit labor costs — the cost of labor to produce a unit of output — rose 12.6% in the first quarter. A 10% increase is expected in the second quarter. We expect wage growth and a decline in labor productivity in July to further push up labor costs.

When unit labor costs rise in a low-inflation environment, both economic theory and empirical research suggest that the rise does not necessarily push up inflation. In a high inflation environment, when inflation expectations rise and prices have recently surged, unit labor costs are highly likely to cause additional inflation. What’s more, when unit labor costs rise due to an explosion in labor demand rather than a contraction in supply, they are more likely to lead to inflation. What’s more, when unit labor costs in the service sector rise rapidly—in fact—they can lead to inflation, as it becomes more difficult to import-substitute services or increase productivity through technology.

Some time ago, people used to say Goldilocks Economy. The idea was that the economy was just right, not too hot and not too cold, like Goldilooks finding porridge for baby bears. Today’s employment figures suggest that we may be experiencing an economy on the other side of the story, when Goldilocks wakes up surrounded by three bears and has to flee through a window into a dark forest, never to be heard again.

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