Strong Job Growth Points to an Even More Aggressive Fed

It turns out the jobs market is even stronger and more resilient than many had thought.

For investors, this means once again ratcheting up expectations for how fast the Federal Reserve will raise interest rates in coming months.

Bond market prices are now suggesting there’s a 30% chance the Fed will kick off its rate increases in March with a 0.50% boost instead of 0.25%, and for rate hikes to continue throughout the year. Just a few months ago, the Fed wasn’t even expected to raise rates until May or June.

“I would say the wage data provides the most unambiguous support for the Fed accelerating rate hikes,” Morningstar’s chief economist Preston Caldwell says. The strength of the labor market shown in Friday’s report now sets the stage for five interest-rate increases in 2022, beginning in March. “This course correction will help to prevent inflation from becoming entrenched.”

Most economists were expecting to see weak numbers on the hiring front for January because of the omicron outbreak. That wasn't the case. The Labor Department reported payrolls grew by a strong 467,000 last month.

“Omicron didn’t stop payroll employment from growing in January, despite the likely drop in consumer spending that occurred,” says Caldwell. “Partly, this may be because employers were reluctant to lay-off workers, given that business will rebound quickly and labor markets remain very tight.”

In addition, the government revised up its numbers on the pace of hiring throughout much of last year. Nonfarm payroll growth for the last three months of 2021 was revised to an average 610,000 jobs, up from roughly 360,000.

“The most significant news from today’s report comes from the revisions to historical data,” Caldwell says. “Based on new, more accurate survey data, the BLS [U.S. Bureau of Labor Statistics] estimates that the job recovery in recent months has been far stronger than previously reported.”

Caldwell notes that the jobs report did show some impact from omicron. The number of workers with unpaid absences increased by about 1.2 million year over year. This suggests “omicron did take a toll but was offset by overall strong hiring,” Caldwell says. “Regardless, any negative impact from omicron is clearly temporary, as COVID-19 cases in the U.S. are now heading back down again.”

A key factor also supporting expectations for a more aggressive Fed are wage gains. Average hourly earnings rose 0.7% and are up 5.7% from a year ago. This follows a strong reading on wage gains in the fourth-quarter employment cost index.

“Wage growth remains high and has continued to broaden out into other industries,” Caldwell says.

Caldwell adds that one counterpoint to the notion that the strong employment and wage gains put more pressure on the Fed is that strong hiring also suggests the labor market still has substantial slack despite the big gains seen in 2021. “The prior narrative that labor markets were approaching full employment relied on data showing that job gains were slowing.”

Yet even with five rate increases in 2022 from the Fed, interest rates would still be low by prepandemic standards, especially when compared with inflation rates. Morningstar expects inflation to run at a 3.6% rate in 2022 with year-over-year monthly inflation rates falling back toward 2% in the second half. “Monetary policy will still be fairly accommodative after five hikes,” he says.