Cooling Labor Market Strengthens Case for a September Interest Rate Cut

For months, investors have been bracing for signs that aggressive new trade policies will slow economic growth by putting upward pressure on inflation and denting demand. Friday’s data was an early signal that economic pressures are affecting the US labor market. The weak data could shift the tide in favor of the Federal Reserve moving to cut interest rates at its next policy-setting meeting in September.

The US labor market saw a sharp contraction in July, adding just 73,000 jobs, falling significantly short of FactSet’s consensus estimate of 117,500. The latest Bureau of Labor Statistics report also shows an uptick in the unemployment rate to 4.2% from 4.1% the previous month, matching consensus forecasts.

Underscoring both a marked contraction in nonfarm payroll gains and a rise in unemployment, the data points to a notable weakening in the labor market. Such a deterioration could ripple through consumer and business spending, the pace of which is already slowing as more Americans struggle to find work.

Following the report, yields fell about 19 basis points for the two-year Treasury bond and 11 basis points for the 10-year bond. The US Dollar Index was also down more than 1%.

Odds Rising of a September Rate Cut

This has increased expectations of a September interest rate cut by the Fed, which decided to hold rates steady for a fifth consecutive time on July 30. “Today’s figures should be a bombshell for Fed Chair Jerome Powell, who called the labor market ‘solid’ in the post-FOMC meeting press conference this week,” says Morningstar senior US economist Preston Caldwell. “Unless the next two months’ jobs numbers improve considerably from the figures released today, the Fed is very likely to cut in September.”

Central bank policymakers opted to leave the federal-funds rate unchanged at a range of 4.25%-4.50% at its last meeting, although this was not a unanimous decision.

Caldwell points to a key distinction between a slowdown in job growth due to a weakness in labor supply versus demand. “The Fed has no reason to loosen monetary policy in response to a decline in job growth driven by labor supply,” he says, adding that “a decline is neither deflationary nor does it create a gap with respect to maximum sustainable employment.”

Still, he remains concerned about the difficulty in interpreting jobs data. “The speed of the deceleration in job growth, along with uncertainty about what exactly the data means, should be alarming to the Fed,” he says. Taken together, the situation “argues strongly for a September cut as a prophylactic measure at the least.”

The Factors Underpinning Labor Market Problems

The weakness in job growth in the last three months has been caused largely by federal government layoffs. However, even private sector employment expanded at an anemic pace of 0.5% annualized during that period. “Employment growth has decelerated across most private sector industries, spanning blue collar to white collar jobs,” Caldwell says.

Some details of the report also point to a slowing manufacturing backdrop amid heightened trade uncertainty. Manufacturing employment declined outright, falling at a 1.2% annualized rate in the three months, while professional services employment fell 0.4% annually. Caldwell contends that despite the sharp drop in payroll employment, the unemployment rate has been stable, averaging 4.2% in the past three months.

Caldwell says falling labor force participation has likely helped mask plummeting job growth, allowing unemployment to remain nearly flat. “That could support a story in which falling labor supply is offsetting falling labor demand,” he says.

Moreover, the labor supply weakness could be a function of tighter immigration enforcement. Still, Caldwell is skeptical over whether its impact is large enough to justify the 40-basis-point downshift in labor force participation seen over the past three months. “It’s possible that instead, the decline in participation reflects people discouraged by poor job prospects,” he says. On the other hand, it simply could be the result of “mismeasurement, as the quality of the Current Population Survey has declined in recent years owing to reduced response rates.”