Economic Commentary: Labor Market Surprises May Impact Fed’s Next Move on Interest Rates

As expected, September saw the first interest rate cut by the Federal Reserve since the initiation of their efforts to rein in inflationary pressures in March 2022. The only question was whether they would cut 0.25% or 0.50%. Due to their increasing concern about the health of the labor market that was related to their mandate to pursue maximum employment, they opted for a cut of 0.50%, bringing the target range for the Federal Funds down to 4.75% to 5.00%. Although they are not taking their eyes off inflation – related to their mandate to pursue price stability – they have gained the needed confidence that inflation is moving sustainably toward their 2% target, and consequently the pace of interest rate cuts will be determined by developments in the labor market.

Inflation

The August readings for inflation were mostly in line with expectations. The headline CPI was up 0.2%, bringing the year-over-year figure to 2.5%, the lowest reading since March 2021. The core CPI, which excludes food and energy, did come in slightly stronger than expected at 0.3% for the month due to a re-acceleration of owners’ equivalent rent and transportation services. The year-over-year number for core CPI remained at 3.2%. The Fed’s preferred inflation measure, the core PCE, was well behaved in August, advancing 0.1% with the year-over-year increase at 2.7%.

GDP & Real Disposable Income

Late September saw the annual revisions to GDP, personal income, personal spending and the savings rate, with data from 2019 to the present being revised. The revisions all indicated a stronger than originally reported economy with personal income exceeding personal spending, resulting in a higher savings rate.

Prior to the revisions, real disposable personal income growth was lagging spending, causing the savings rate to decline. From 2019 to July 2024, real disposable personal income was revised up $600 billion while spending was only revised up $196 billion. This resulted in personal savings increasing over $400 billion from original estimates, and the personal saving rate increasing from 2.9% in July to 4.9%. Real disposable income is now growing 3.1% year/year, up from 1.1% before the revisions. Real personal spending is now growing at 2.9% year/year, up from 2.7%. In short, the consumer is in better shape than originally thought.

Real GDP was revised up $300 billion over the past five years and is running at a 3.0% annualized rate through second quarter 2024. This suggests that productivity has been stronger than initially reported, which is supportive of lower inflation. You might recall that in early 2022, it was originally reported that real GDP contracted in first and second quarters, causing some to say that the two successive quarters of negative real growth indicated a recession. The revisions changed that with the only quarter of negative growth occurring in first quarter 2022.

Manufacturing

The September reading of the ISM Manufacturing index was unchanged from August’s reading of 47.2 and has been below 50 in 22 out of the last 23 months. Any print below 50 indicates contraction. On the other hand, the ISM Services index showed surprising strength with a reading of 54.9, indicating strength in the non-manufacturing portion of the economy. However, it was interesting to note that the employment sub-indices in both surveys recorded readings below 50.

The Labor Market

The September employment report provided the latest surprise in economic data. Non-farm payrolls in September rose 254,000 – the most in six months and much stronger than expectations – while the previous two months of data were revised up by 72,000. All major categories of labor saw increases during the month except for manufacturing. The leisure and hospitality, healthcare and government sectors accounted for 70% of the net job gains. The unemployment rate dropped from 4.2% to 4.1% and wage growth accelerated 0.4% during the month bringing the year-over-year increase to 4.0%. Wage growth greater than the inflation rate means that workers are seeing real earnings gains which is supportive to consumer spending.

The Challenger report for September cast a slightly different light on the labor market. While job cuts in September were down 4% from cuts in August, they were up 53% when compared to September 2023. “Layoff announcements have risen over last year, and job openings are flat,” stated the report. On a year-to-date basis, employers hiring plans are down 33% compared to the same period in 2023 and are the lowest since 2011.

The Fed & Interest Rates

The next meeting of the Federal Reserve’s Open Market Committee (FOMC) is November 6-7. The Fed now views the upside risks to unemployment to be greater than the upside risks to inflation pressures. With consumer spending being the engine of the U.S. economy, the Fed does not seek or welcome any further cooling in labor market conditions. The October Employment report will be released on November 1 for them to assess ahead of their meeting, but there is no doubt that September’s strong Employment report will ease concerns that the employment market was weakening faster than expected. Nevertheless, there are reasons to continue to closely monitor the labor market. It’s taking longer for unemployed workers to find a job, and employers are cutting hours. Average weekly hours for employees are down to 34.2 (down from 35.0 in 2021), and consequently the aggregate hours worked (the total labor input into the economy) have declined in two of the past three months.

The Fed’s Summary of Economic Projections (SEP) that was released after the September 18 meeting shows that the Fed believes the neutral Fed Funds rate is close to 3%. While this number cannot be calculated definitively, the current Fed Funds rate is well above that level, suggesting that monetary policy remains restrictive. A restrictive monetary policy will continue to slow overall economic growth. Knowing that changes in Fed policy work their way through the economy with variable lags, it will likely take some time along with additional rate cuts for economic growth to develop sustainable acceleration.

The strong September Employment report also altered views on how aggressively the Fed will decrease interest rates. The thinking is that if the labor market is not cooling as quickly as previously thought, the Fed won’t cut rates rapidly. Prior to the Employment report, markets were fully pricing in another 0.50% cut in the Fed Funds rate at the November meeting and a 0.25% cut in December. Those expectations quickly shifted to a 0.25% cut in both November and December. Sensing a slower pace to interest rate declines, Treasury yields rose after the Employment report. The 2-year Treasury yield increased 0.22% to 3.92% after the Employment report and the 10-year Treasury yield increased 0.12% to 3.97%.

As previously mentioned, with the Fed’s focus now on data related to employment, the pace of interest rate cuts will be determined by developments in the labor market as long as inflation continues to move toward their target of 2%.