Consensus estimates of employment gains in the US were pretty close to the mark for a change, when the report was released last Friday. So, there weren?t any big surprises to rattle traders. At the same time, oil prices have eased. OPEC agreed to increase production and this gave investors a measure of comfort. But the supply/demand situation hasn?t changed much. It is still quite tight and there isn?t a lot of spare capacity to provide a cushion in the short run. However, there is a considerable political risk premium included in the current price and the market may have lowered that a bit.

Job growth is now proceeding at a good pace, and the latest numbers appear to have persuaded the equity market that it is just enough to keep households spending happily, even as the effects of earlier simulative tax measures wane. At the same time, firmer employment conditions are not regarded as sufficiently tight to prompt the Fed to do anything too aggressive with interest rates. Together with the perceived rosier energy situation, it has given the market a good excuse to push stocks higher. But will it last?

Looking at market conditions, technical indicators add up to a somewhat positive short-term picture of the market?s tendency. But there are two factors that may compromise sustainability of upward momentum. First, volume on the NYSE has been trending down over the past month. Second, individual investors appear to be in an uncertain mood. The AAII (American Association of Individual Investors) sentiment readings have moved sharply from bearish to neutral, rather than bullish. It indicates that investors are undecided about the outlook ? even though equity mutual funds saw further inflows, last week. In passing, we should note that insiders aren?t in a buying mood either.

The household sector is being buffeted by positive and negative trends. On the positive side, we have an improving employment market, with more job creation, as well as a pickup in wage growth. On the negative side, we have rising interest rates and creeping worries about higher inflation. In the past, households have boosted their spending capability by increasing leverage significantly, with the result that their debt service is now a hefty proportion of disposable income.

Well, where is all the money coming from, if we look at it from the point of view of the broad flow-of-funds accounts? Not from the government sector, which as everybody knows is also a deficit unit (i.e. a net borrower). And not really from the corporate sector, even though it is a surplus unit (i.e. a net lender), because its excess outflow is set to shrink. So that puts the onus on the rest-of-the-world (ROW) sector to fund the two deficit units. Unless the ROW is willing to maintain or increase its funding, there has to be some adjustment via the value of the dollar or the saving/consumption pattern of the household sector. In this context, the Fed has an incentive to go easy with interest rate increases, unless its hand is forced by higher-than-expected inflation. In the past few years, Greenspan has been keen on promoting more inflation. Well, here it comes ? not accelerating yet, but noticeably higher. There are a number of reasons why upside risks to inflation have risen. For a start, slack in the economy is dwindling ? the output gap may not be as wide as previously thought. Productivity is set to decline cyclically, with rising labour inputs and higher compensation expenses pushing up unit labour costs. As for material costs, they have come down a bit, recently, but are still fairly high. And there is evidence that firms in a variety of industries are finding a measure of pricing power and passing along costs in the form of higher prices. Not surprisingly, inflation expectations among consumers are also on the rise.

Unlike many major central banks the Fed does not have an inflation target. In the current context, its trade-off between growth and inflation is to favour the former at the expense of the latter. Currently, the steepness of the nominal Treasury yield curve does not show a significant inflation risk premium. If the pace of economic growth holds up, the bond market may have to revise its expectations about the size of the premium.