A Shift in Focus: Fed Eyes Unemployment as Labor Market Hints at Slowdown
The Federal Reserve, long fixated on battling inflation, is now shifting its attention towards the unemployment rate, a key indicator of economic health. Recent data suggests that the labor market, while not in freefall, is showing signs of slowing down, raising concerns about a possible recession. This shift in focus comes as the Fed attempts to balance its dual mandate of achieving full employment and price stability.
Key Takeaways:
- Unemployment rate is a rising concern for the Fed. The recent slowdown in job growth and revised figures pointing to an overestimation of previous job gains have shifted the Fed’s focus from inflation to unemployment.
- The Conference Board’s Consumer Confidence Survey reveals a shift in sentiment. Respondents are increasingly perceiving jobs as more difficult to find, mirroring a similar trend observed during previous recessions.
- The Fed is likely to start cutting interest rates soon. Market expectations point to a 100% chance of a rate cut in September, with the labor market’s health playing a major role in determining the pace of future cuts.
- The "Sahm Rule" raises red flags. The recent rise in the unemployment rate, which is consistent with historical recessionary trends, could force the Fed to act more aggressively to prevent a downturn.
- Businesses are showing signs of caution. Companies are holding onto their workers but are canceling job openings, indicating a slowdown in hiring and potential for future job losses.
A Turning Tide in the Labor Market
The Fed’s concern over the labor market’s health stems from a confluence of recent data points. The Labor Department’s July report showed a meager 114,000 nonfarm payroll jobs added, a significant decline from previous months. Additionally, the department revealed a substantial overestimation of job gains for the period from April 2023 to March 2024, the largest annual revision in 15 years.
The Conference Board’s monthly Consumer Confidence Survey further underscored the changing labor market sentiment. While the headline number for August showed a minor improvement, the survey revealed a decline in the percentage of respondents who considered jobs "plentiful" and an increase in those who said employment is "hard to get." This gap between these two responses has narrowed significantly, potentially signaling a shift towards a weaker labor market.
"Declines of this magnitude tend to occur when the economy is heading into recession and when the unemployment rate is on the ascent," said Troy Ludtka, senior U.S. economist at SMBC Nikko Securities. He added that the current gap suggests an unemployment rate of 4.8%, a significant jump from the July rate of 4.3%. This rise in unemployment, combined with the historical trends known as the "Sahm Rule", adds to the growing concerns about a potential recession.
A Balancing Act for the Fed
The Fed faces an increasingly complex situation, juggling the need to control inflation while also preventing a sharp economic downturn. While inflation has been gradually easing towards the Fed’s target of 2%, the risks to both sides of the Fed’s mandate are now considered more balanced. This shift in focus has led the Fed to prioritize a less restrictive monetary policy, avoiding any actions that could further weaken the jobs market.
"The focus on the Fed is going to be on the jobs front," said Beth Ann Bovino, U.S. Bank’s chief economist. She highlighted the feeling of frustration among workers who are witnessing a shift from a highly competitive job market to one with fewer opportunities. While businesses continue to hold onto their employees, they are increasingly canceling open positions, leading to a slowdown in hiring.
A Pause Before the Pivot
While recent data has sparked concerns, not all indicators are pointing to a complete deterioration of the labor market. Job vacancies have contracted, but they remain significantly higher than pre-pandemic levels, with more than one available worker for every job opening.
"We haven’t seen any deterioration in the labor market," said Mary Daly, President of the San Francisco Fed, despite acknowledging that the central bank is likely to begin cutting interest rates soon. The markets are anticipating a 100% chance of an initial rate cut in September, an expectation seemingly confirmed by Jerome Powell’s speech last week.
Data Remains the Driving Force
The primary question now is the speed at which the Fed will cut interest rates. This decision, more than inflation figures, will likely be driven by the performance of the labor market. While the Fed’s economic projections suggest a stable unemployment rate through 2026, historical trends suggest that extended plateaus are unlikely and that the unemployment rate typically experiences either an upward or downward trend.
The consensus estimate for August is a slight drop in the unemployment rate to 4.2%, with an anticipated increase of 175,000 in nonfarm payrolls. However, SMBC Nikko projects a higher unemployment rate in the mid-5% range within a year, which could force the Fed to adopt a more aggressive rate-cutting strategy.
"When you talk to firms … it doesn’t look like the labor market is not healthy," said Loretta Mester, former President of the Cleveland Fed, on CNBC, acknowledging that the labor market is "moderating." She emphasized the challenge of balancing monetary policy with a gradually cooling labor market while maintaining vigilance in addressing remaining inflationary pressures.
"That balancing of those risks to both parts of the mandate is sort of what is happening now, and what is new," Mester concluded, highlighting the unprecedented challenges faced by the Fed in navigating the current economic landscape.