Policy normalization or labour market rescue?

A benign moderation in the labour market remains our base case. The recent increase in the unemployment rate, from a local trough of 3.4% in April 2023, to 4.2% in August 2024, was more supply than demand driven. The initial increase last year was due to a normalization in layoffs from extreme lows, and a fall in labour demand from extreme highs. The more recent increase came from workers entering the labour force and not finding jobs right away, itself reflecting weaker hiring rather than layoffs. Thus the unemployment rise through August appears different from the usual cyclical turning point a triggering of the Sahm rule would otherwise indicate.

But with inflation concerns receding and the labor market having rebalanced, the Fed’s current stance of monetary policy is too restrictive. A situation where labor demand is too weak to absorb the temporarily elevated growth in labor supply is a slow-moving issue that the Fed can likely deal with by easing policy. 

We do not see signs of a sharp rise in layoffs, or a deterioration in hiring that would call for an aggressive policy response. Barring a significant financial shock, we are sticking with our view of a policy normalization cycle starting with 25bps rate cuts in September, November, and December this year.

However, risks of more front-loaded easing, meaning cuts in bigger increments and a faster return to neutral, are rising. If evidence of weaker labor demand, or increases in layoffs emerge, FOMC would react forcefully.

The current environment of low hiring and low firing could be a fragile equilibrium because, first, it makes the labour market more vulnerable to shocks and, second, even if labour demand remains robust, the volatility and noise in monthly jobs growth will inevitably cause payrolls to print noticeably lower at times. A major concern is whether weak hiring will lead to labour cost cutting and widespread layoffs, triggering a negative feedback loop between job losses and reduced spending that would be hard for policymakers to counteract.

Fed funds futures are now pricing in around 32bps of rate cuts for September, but about 40bps for November and December each, reflecting the market’s view that the probability for the Fed to switch to larger cuts later on is high. Growth scare could persist for a while.