Strong labour market complicates Fed outlook

Non-farm payrolls stronger than expected, focusing extra attention on Jerome Powell’s testimony this week
Federal Reserve

Markets remain almost certain that the Federal Reserve will cut its policy rate at the July 30–31 meeting, but unexpectedly strong labour market figures are adding fresh complications to what is already a complex decision.

Non-farm payroll figures released on July 5 were substantially higher than expected, with 224,000 jobs added in June, comfortably above the consensus forecast of 160,000. Unemployment ticked up to 3.7% amid a small rise in participation.

The stronger economic data sent markets into a spin, with the S&P 500 falling 0.5% in early trading today (July 8), as investors reassessed the prospect of forthcoming rate cuts. US 10-year Treasury yields leapt around 10 basis points on July 5, to 2.07%.

Though markets may have adjusted their views, pricing indicates a cut remains highly likely this month. CME Group says futures prices currently indicate a 100% chance of a cut, with an 8% probability that it will be 50bp and a 92% chance of 25bp.

JP Morgan’s head of the global market insights strategy team, David Kelly, says the bank expects two rate cuts this year, and possibly three. Though the payrolls figures were high, it was an “unsurprising rebound” from a weak May, he said in a note to clients today.

Meanwhile, the Fed is struggling to raise headline inflation, which was flat at 1.6% in May. Inflation expectations have been falling, with the 5y5y measure dropping from a peak of 2.3% in October 2018 to 1.8% on July 3. The indicator shows average inflation expectations for the five-year period, starting five years from now.

Wage growth has also slowed somewhat. Year-on-year growth in average hourly earnings has fallen back, from 3.4% in February to 3.1% in June.

The Federal Open Market Committee is split down the middle. The ‘dot plot’ of members’ forecasts showed in June that seven members expected two cuts this year and one saw the need for a single cut. That was set against eight members who thought a hold was necessary and one who saw the need for a single hike.

Loretta Mester, president of the Cleveland Fed, is one of those in favour of holding. Speaking on July 2, she warned cutting rates “at this juncture” could “reinforce negative sentiment”. However, she said it was understandable that there was a wide range of views across FOMC members, given the high level of uncertainty.

Fed watchers will be focused on a Congressional hearing by chair Jerome Powell on July 10–11, in which Powell is likely to clarify the outlook somewhat.

Broadly, Fed policy-makers have adopted more dovish language in recent weeks. In a report released on July 5 ahead of the hearing, the Fed restates its promise to “act as appropriate to sustain the expansion”.

Similarly, in its June meeting statement, the FOMC dropped the phrase that it would be “patient” and instead said “uncertainties about the outlook had increased”.

Powell may also give some further hints about the prospect of adjusting the balance sheet plan this week. Currently the balance sheet is set to keep shrinking until September. “The committee is prepared to adjust the details for completing balance sheet normalisation in light of economic and financial developments,” the Fed says in the report.

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