Economic Commentary: Softening Labor Market Could Lead to Interest Rate Cuts Earlier Than Expected

At the midpoint of the year, the economy has clearly slowed from the faster pace seen in the second half of 2023. Elevated first quarter 2024 inflation concerns have eased, with more benign readings in the second quarter. The labor market is cooling as evidenced by a slowing trend in nonfarm payroll gains and a rising unemployment rate. The Fed has acknowledged that both components of their dual mandate – price stability and full employment – have moved into better balance which, if continued, may enable the Fed to feel confident enough to make their first interest rate cut as soon as September.

Inflation, Personal Income & Spending

The various readings of inflation in May were generally softer than expected, and importantly showed that the disinflationary process is continuing, as interest rates remain elevated. Both the headline CPI (0.0%) and core CPI (+0.2%) numbers came in below expectations, bringing the year-over-year figures to 3.3% for the headline and 3.4% for the core. The Producer Price Index (PPI) fell 0.2% for the month and was up 2.2% year-over-year. The Fed’s preferred inflation index, the core Personal Consumption Expenditure index (PCE), rose 0.1% in May, marking the weakest monthly reading since November 2020, and it increased 2.6% year-over-year. Although year-over-year figures are not likely to move much lower for the remainder of the year due to the base effects of weak inflation readings in the second half of 2023, continued soft monthly readings will help convince the Fed that inflation is moving sustainably toward their 2.0% target.

Mild monthly inflation readings in May, coupled with solid personal income gains, resulted in real (inflation adjusted) disposable personal income (DPI) increasing by 0.5% for the month and 1.1% year-over-year. However, this is well below the 4% to 5% year-over-year growth in real DPI that occurred in the summer of 2023. High prices are being met with more resistance from consumers. Real personal spending only increased by 0.3% in May, causing the personal saving rate to increase to 3.9% from 3.7%. Real consumer spending grew at a disappointing 1.5% annualized rate in the first quarter, and the second quarter is tracking only slightly better.

Key Indices & GDP

Having declined again in May, the Leading Economic Indicators (LEI) continue to point to a fragile outlook for the U.S. economy. The main drivers of weakness in May were new orders, consumer expectations, building permits, interest rates and jobless claims. The six-month diffusion index of the LEI has been below 50% for eight consecutive months.

The June readings for both the ISM Manufacturing index and the ISM Non-Manufacturing index came in below the neutral threshold of 50, suggesting that GDP growth will remain weak in the third quarter. It is noteworthy that the employment and new orders sections of both indices were particularly weak.

The final reading for the first quarter GDP came in with a slight upward revision to 1.4%, annualized from 1.3%. The upward revision primarily reflected a downward revision to imports, which are a subtraction in the calculation of GDP, and upward revisions to nonresidential fixed investment and government spending. The biggest surprise, however, was a broad-based downward revision to real consumer spending in first quarter from 2.0% annualized to 1.5%.

Employment & The Labor Market

The June employment report was weaker than expected despite nonfarm payrolls rising by 206,000. Job gains were narrowly based, with about 75% of the increase coming from healthcare and government hiring. Revisions to the April and May reports indicated 111,000 fewer jobs than originally reported, and the unemployment rate edged up to 4.1%. Average hourly earnings rose 0.3% in June, bringing the year-over-year growth down to 3.9% from 4.1% in May.

The labor market is cooling as there continues to be an improvement in the balance between demand and supply of workers. Competition for jobs is becoming more intense because of an increase in the participation rate for the prime adult (25-54) working-age population which rose for the third consecutive month to a 23-year high of 83.7%. Over the last 12 months, the labor force has grown by a little more than one million, but the number of employed has only risen by 195,000. This competition for jobs will help to control wage inflation – something that the Fed keeps an eye on.

Interest Rates

At the June 11-12 meeting of the Federal Open Market Committee (FOMC), the target range for the Fed Funds rate was maintained at 5.25% to 5.50% for the seventh consecutive meeting, as expected. They repeated their prior language saying the FOMC doesn’t expect to cut rates “until it has gained greater confidence that inflation is moving sustainably toward 2.0%.” However, the Committee did acknowledge “modest further progress” toward their inflation goal in recent months. 

In its updated quarterly Summary of Economic Projections (SEP), the FOMC marked down its forecast for the number of interest rate cuts this year to just one, down from three in March. Once rate cuts begin, the FOMC’s projections point to a gradual but steady pace of normalizing policy in 2025, with cuts occurring at every other meeting, resulting in a 4.125% Fed Funds rate at the end of 2025. 

As the pace of hiring and wage growth slows, personal income growth will slow, which will negatively impact overall economic growth. Recognizing this, the minutes from the June meeting of the Fed indicated that they are growing more attentive to the downside risks to the labor market, noting that further weakening of labor demand may now generate a larger unemployment response than in the recent past. Markets are assuming softness in the labor market will continue through the summer as inflation eases, and thus are pricing in the likelihood that the Fed will initially cut rates in September with another cut in November or December.