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Job Market's Signals for the Fed

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The keenly awaited monthly snapshot of U.S. employment conditions is likely to reinforce the notion of continued and gradual healing. It will show that: 

• The economy continues to generate jobs at a sound pace.

• Long-term unemployment is still edging lower.

• Discouraged workers are being attracted back into the labor force at a slow pace. 

• Perhaps wages are starting to increase.

All of this would speak to a U.S. economy that continues to expand and outperform most other countries. But keep in mind that growth also falls short of the escape velocity needed to make a material difference in the population’s well-being, and that the economy lacks the strength to counter potential domestic and external headwinds to growth.

In itself, these insights would do little to change market perceptions and pricing. But Friday’s numbers could be important if they influence perceptions of the Fed’s policy outlook.

The Fed’s Countdown

The gradual strengthening of the U.S. labor market has been a major driver of recent signals from the central bank, suggesting that the Fed could start the cycle of raising interest rates this year. In what would constitute the first interest rate increase since 2006, the initiation of such a cycle would force investors to firm up views about the subsequent pace of rate increases and their final level. This would influence a whole range of prices in the bond, commodity, currency, equity and volatility markets – and not just in the U.S., but the rest of the world.

As of now, about half of investors expect the Fed to increase rates in September, while most of the rest anticipate a move in December or even next year. Such an expectation distribution would change notably if:

• Monthly job growth continues in the 200,000 range.

• Wage growth picks up to about a 2 percent annual growth rate.

• And the labor force participation rate, now at 62.6 percent, is little changed — a sign that the job market faces structural impediments that are largely insensitive to further monetary policy stimulus.

The Fed doesn’t need a super strong jobs report in order to act in September. What it needs is a relatively solid assurance that the labor market, having grown by more than 2.9 million jobs during the past 12 months, retains its firm footing. With concerns lurking behind the scenes that the Fed has gone too far in decoupling financial markets from the economy’s fundamentals, just a slight strengthening of labor market conditions (particularly on the wage front) would be enough to increase the probability of a September rate hike.