Mixed Employment Data Highlights the Challenge the Fed Faces

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Stocks finished lower last week as employment and wage data failed to provide the markets with clear direction on when the Fed may begin to cut rates. The mixed picture of the labor market came out a day after Federal Reserve Chairman Jerome Powell told congressional leaders that the Fed was “not far from” gaining enough confidence that the rate of inflation was sustainably on a path to 2 percent. While Powell’s acknowledgement that the Fed was close to concluding it could cut rates grabbed the headlines, his overall message of the Fed taking a data-dependent approach reiterated a stance he and other members of the Fed have been broadcasting for months. As we’ve consistently noted over the past several months, the data that the Fed is focused on now is the employment picture and wage growth. As long as the data remains strong, we believe the Fed will be hesitant to make significant rate cuts. That’s because a tight labor market and elevated wage growth are sticking points in the Fed’s efforts of achieving its goal of 2 percent inflation. Unfortunately, the data out last week provided the Fed with little clarity on those two items.

The nonfarm payroll report for February from the Bureau of Labor Statistics (BLS) showed that hiring was robust for the month, with 275,000 new positions added, up from January’s revised reading of 229,000 and above Wall Street estimates. It’s worth noting, however, that revisions to the December and January readings resulted in a net reduction of 167,000 positions in the total number of jobs added for the two months combined.

Conversely, the BLS’s other jobs report, the household survey, showed 184,000 job losses in the month and the unemployment rate rising to 3.9 percent from last month’s level of 3.7 percent. While this report tends to be more volatile given its smaller sample size, many economists view it as a better measure than the nonfarm payroll report during inflection points in the employment picture. With that in mind, it’s worth noting that during the past six months, the household report has shown an average of 89,000 jobs lost each month. Meanwhile, over the same time period, the nonfarm report has shown an average of 231,000 jobs gained each month.

While the two BLS measures gave mixed signals, wage data offered some signs of encouragement as it relates to inflation. Average hourly earnings for production and non-supervisory employees rose by just more than 0.2 percent for the month compared to a rise of .44 percent in January. On a year-over-year basis, wage gains are up 4.5 percent, a decrease of 0.3 percent from January’s year-over-year pace but still well above the 3 to 3.5 percent range we believe is necessary for the Fed to sustainably achieve its goal of 2 percent annual inflation.

The seemingly conflicting employment data follows a trend we’ve seen in economic readings for the past several months and highlights the difficulty the Fed faces in deciding when it is appropriate to begin cutting rates. While significant progress has been made in the battle to bring rising prices under control, we don’t believe the Fed will conclude it has compelling evidence that inflation is headed to 2 percent on a sustainable basis until it sees a string of data all pointing convincingly to the pace of wage growth subsiding and that there is enough slack in the labor market to prevent wage pressures from reigniting. Put simply, we believe that conflicting or inconsistent inflation and employment data is likely to delay the Fed from reducing rates aggressively. As such, the longer rates stay at or near their current level, the more of a drag they have on the economy and labor market. Therefore, our base case outlook remains that higher rates for longer will eventually cause a mild and short-lived recession. Fortunately, with inflation falling as it has, the Fed should have room to cut rates to soften the length and depth of the blow of an economic downturn.

Wall Street wrap

A closer look at the employment picture: Despite a strong headline number for the BLS’s nonfarm report, the latest data shows pockets of underlying softening of the unemployment picture. The nonfarm payroll report showed temporary help services—a leading indicator of the broader labor market—fell by 15,400. This is a timely measure because employers typically let go of temporary workers before cutting permanent staff. This indicator has been trending lower since it peaked in March 2022, with the latest decline putting the year-over-year decrease at negative 7.0 percent.

Furthermore, the household report shows that the total number of unemployed people now sits at 6.45 million, up from January’s level of 6.12 million. At the same time, the household report shows 150,000 additional workers entered the workforce in February. The additional workers along with the 184,000 jobs lost results in the increased unemployment rate (3.9 percent). Importantly, February’s unemployment rate is now 0.5 percent higher than it was in April of 2023. The increase puts us ever closer to triggering the so-called Sahm rule. According to this rule, developed by former Federal Reserve economist Claudia Sahm, since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession has followed. The current three-month moving average is 0.27 percent over the prior 12-month low. But any further movement higher in the unemployment rate over the coming months could push us to 0.5 percent.

Job openings decline but outpace available workers: The BLS Job Openings and Labor Turnover Survey released last week showed the number of job openings came in at 8.96 million in January, a decrease of 26,000 from December’s total. The so-called “quits” rate, which is viewed as a proxy for the level of confidence employees feel about the job market, came in at 2.1 percent, down 0.1 percent from January’s rate and tied for the lowest level since August 2020.

Continuing jobless claims rise: Weekly initial jobless claims were 217,000, unchanged from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 212,250. Continuing claims (those people remaining on unemployment benefits) stand at 1.906 million, an increase of 8,000 from the previous week. The four-week moving average for continuing claims rose to 1.888 million, up 10,250 from last week’s upwardly revised figure and the highest reading since December 2021. The trend in continuing claims is a timely market indicator that suggests the labor market is weakening and those who have lost their jobs are finding it harder to find new employment.

Growth in services sector shows signs of easing: Institute for Supply Management (ISM) data for the services side of the economy showed that the pace of expansion slowed in February, with a headline reading for the sector coming in at 52.6, down from 53.4 in January (readings above 50 signal expansion). While the pace of expansion softened, growth was widespread, with 14 of 18 Industries recording growth. New orders rose to 56.1, up from January’s reading of 55. Along with slowing growth, demand for workers dipped into contractionary territory, with the employment index coming in at 48, down from January’s reading of 50.5. The latest employment index reading marks the second time in the past three months that both ISM’s manufacturing and services surveys have been in contractionary territory. On the inflation front, the prices paid index in the survey remains in expansionary territory at 58.6; however, the latest reading is down from January’s level of 64.  Despite the drop, 13 of 18 industries report that they’re paying higher prices.

Beige book points to lackluster growth: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that the pace of economic growth improved slightly in the majority of the 12 Federal Reserve Districts from the prior reading. Eight districts reported slight to modest growth in activity, with three others reporting no change. One district reported weaker activity. Despite the modest uptick in economic activity, consumer spending eased in recent weeks, and shoppers have become more sensitive to inflation. Several districts reported consumers were switching to lower-cost products and were pulling back on discretionary spending.

Given our view that a tight labor market and elevated wage growth are obstacles to the inflation rate falling to the Fed’s goal of 2 percent, it was noteworthy that nearly all districts highlighted improvements in the pool of available workers and employee retention. In an optimistic sign given our wage inflation concerns, it was noted that wages continued to grow in most districts, albeit at a slower pace, with employee expectations for wage increases more in line with historical averages.

Pertaining directly to inflation, most districts reported price growth, with most describing the pace of growth as moderate or slight. Despite rising prices, profit margins continued to be squeezed as “businesses found it harder to pass through higher costs to their customers, who became increasingly sensitive to price changes,” according to the report. Should profit margins continue to face pressures, businesses may turn to cutting payrolls to protect further erosion of margins.

The week ahead

Tuesday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown continued but uneven progress in the disinflationary process; we will be dissecting the data to see if pockets of stubborn price pressures remain.

The National Federation of Independent Businesses Small Business Optimism Index readings for January will be out before the opening bell. Recent readings from this survey show that price pressures and the state of the labor market are top concerns among small businesses, with many firms planning on raising wages in the coming months. We will be watching for any signs that suggest these challenges are easing.

Thursday: The U.S. Census Bureau will release the latest numbers on retail sales for February before the opening bell. Last month’s report showed a dip in sales, and we will be watching to see if consumers have continued to pull back on spending.

Initial and continuing jobless claims will be out before the market opens. Initial filings were unchanged last week, while the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

The latest readings from the BLS on its Producer Price Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by businesses and can indicate how prices may move at the consumer level in the future.

 Friday: The University of Michigan will release its preliminary report on March consumer sentiment and inflation expectations. We will be watching to see if the recent improvement in consumer confidence and easing inflation expectations are continuing.

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