Fed May Cut Rates Sooner if Unemployment Rises

Unemployment Rate Matters: A Closer Look at Economic Trends and Federal Reserve Actions

by Faruk Imamovic
Fed May Cut Rates Sooner if Unemployment Rises
© Getty Images/Michael M. Santiago

In recent weeks, there has been a noticeable softness in the U.S. labor market data. This trend is evident in initial unemployment claims and employment sub-indexes in the Purchasing Managers' Index (PMI). Given this context, it is reasonable to expect that Non-Farm Payroll (NFP) growth in May might be less than in April, potentially slowing to around +150k for private payrolls. However, it is the rise in the U-3 unemployment rate that would truly capture the Federal Reserve's attention. Coupled with a series of monthly core Personal Consumption Expenditures (PCE) inflation prints closer to 0.2% than 0.3%, a higher unemployment rate could prompt a rate cut sooner than anticipated. While our baseline scenario predicts the Fed's first rate cut in 2025, the possibility of a cut in December 2024 is growing if the current unemployment rate hits 4.0%.

Market Reactions and Central Bank Activities

Overnight stock trading has been relatively uneventful, with major currency pairs like EUR/USD, GBP/USD, and AUD/USD hovering near their previous closing levels. Traders are eagerly awaiting the U.S. employment report for May. In other news, the People's Bank of China (PBoC) announced that its gold holdings remained unchanged in May, following a multi-month streak of accumulation. This announcement triggered a $32 per ounce drop in gold prices and provided some support to the U.S. dollar during a session where it might have otherwise weakened.

Globally, the outlook for policy rates continues to captivate traders. This week has been particularly eventful for central bank watchers, with the Bank of Canada (BoC) and the European Central Bank (ECB) both cutting their policy rates by 25 basis points. However, the ECB's announcement was met with mixed reactions. Traders were initially unimpressed by the ECB's ambiguous stance, adopting a "neutral bias" after the rate cut and raising inflation projections slightly for 2024 and 2025. Despite this, traders sensed that the ECB's hawkish tones were more performative than serious.

ECB President Christine Lagarde's press conference reiterated official positions such as "data-dependency," "meeting-by-meeting decisions," and "no pre-commitment" to a specific rate path. Yet, hints in her forward-looking statements suggested an implicit easing bias. Lagarde mentioned the "speed" of future policy adjustments, implying a focus on how frequently to cut rates rather than whether to cut them. She expressed confidence in the ECB's current path and downplayed the staff's inflation projections as helpful but not definitive.

Traders concluded that more rate cuts from the ECB are likely in the second half of 2024, despite the forward policy rate only shifting higher by 3 basis points after the announcements. The Overnight Index Swap (OIS) market still projects one to two more rate cuts from the ECB this year. Meanwhile, the forward rate outlooks for the ECB and the Fed have converged slightly, with the ECB's outlook becoming marginally more hawkish and the Fed's becoming slightly more dovish.

FED© Getty Images/Manny Ceneta

U.S. Labor Market Data and Fed Policy

In the past six weeks, U.S. labor market data has shown particular softness. The April employment report revealed a non-farm payrolls miss, with 175k jobs added compared to a pre-release consensus of 240k. Other indicators have also shown weakness, including a rise in the four-week average of initial claims, an employment sub-index in the services PMI falling below 50, and low labor turnover measures such as quit rates and hiring rates. Additionally, the May ADP employment report was soft, further highlighting labor market weakness.

Given this backdrop, the expectation for the U.S. employment report for May is low. A non-farm payroll (NFP) print of around 150k would not automatically trigger a Fed rate cut. For the Fed to consider cutting rates, there would need to be a noticeable increase in the unemployment rate to above 4.0%, aligning with the Fed's median projection for the U-3 unemployment rate at the end of 2024. More importantly, the Fed would need evidence of PCE inflation converging towards 2%, which could occur with several month-over-month core PCE inflation prints in the 0.20-0.25% range.

Our baseline scenario remains that the Fed will make its first rate cut in 2025. However, the prospect of a rate cut in December 2024 is increasing if the unemployment rate continues to rise and reaches 4.0% by May. Some Fed officials still use a Phillips Curve-informed and Taylor Rule-driven approach to decision-making on rates, even though the focus has been more on inflation and inflation expectations recently.

The Future of Monetary Policy

The labor market's performance and inflation trends will continue to shape the Federal Reserve's monetary policy decisions. As the U.S. economy navigates these challenges, the Fed's responses will be crucial in maintaining economic stability. Traders and investors will keep a close eye on upcoming employment reports and inflation data to gauge the likelihood of future rate cuts. The evolving economic landscape requires vigilance and adaptability from policymakers to ensure sustainable growth and stability.

The recent softness in the U.S. labor market and the mixed reactions to the ECB's policy decisions underscore the complexity of the current economic environment. As central banks navigate these challenges, their actions will have significant implications for global markets and economic stability. The coming months will be critical in determining the direction of monetary policy and its impact on the broader economy.

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