An undershoot in February's US employment report might actually be market pleasing

A soft payrolls number could be more positive for the markets than a stronger number, if it chooses to look through the headlines and assess what it means for Fed policy

By Stuart Cole | @Stuart Cole | 1 February 2024

  • Inflation and wages growth are already largely compatible with the Fed cutting interest rates

  • This week's JOLTS report showed the quits rate unchanged at 2.2%, pointing to wages growth on the ECI measure falling to 3.5% by the middle of this year, a level compatible with the Fed's inflation target

  • A soft payrolls number would undermine the remaining Fed argument for keeping interest rates on hold

  • As such, an undershoot could be market positive, as it would boost expectations of a policy loosening being delivered by the May FOMC meeting at the latest

This week's FOMC meeting saw the Fed’s narrative shift markedly, away from warning about the potential need for further interest rate rises to instead noting that “the risks to it achieving its employment and inflation goals are moving into better balance.” We already know that inflationary pressures – as measured by the various metrics – and heading lower and, at least privately, are unlikely to now be offering any material impediments to the Fed considering a cut in interest rates. In contrast, the bugbear has been the US labour market, in particular its capacity to stoke a wages/price spiral. Accordingly, given the Fed’s apparent move towards a less hawkish stance, tomorrow’s employment report potentially takes on even more significance than usual, but not as might normally be expected.

The perceived concerns the Fed has regarding the labour market were underscored by this week’s job openings number in the December JOLTS report. Jumping from 8790k in November to 9026k in December, they did nothing to convince the market that these Fed fears would be disappearing any time soon; if anything they seemed to be getting worse. But remove the hype and the truer picture is that this unexpected jump did not really tell us much. The reading is quite erratic and prone to frequent revisions and as such its value on a monthly basis is limited. What is far more important is the 'Quits' rate, which is very much a leading indicator for the all-important Employment Cost Index (ECI), the Fed’s preferred measure of the strength in both the labour market and wages growth.

During the heavy post-pandemic labour re-hiring period of 2021-22, the Quits rate surged higher as employees hopped between jobs, forcing employers to raise wages more rapidly than was implied by the unemployment rate. It was this surge in wages growth that proved so alarming to the Fed, contributing directly to inflation as it raised costs in the services sector, facilitated a widening in retail and wholesale margins and allowed rents to be increased rapidly. It was only as the US labour participation rate began to rise that the Quits rate started to head lower once again and pull wages growth lower with it.

Published with the JOLTS report, the December Quits rate was unchanged at 2.2%, remaining at its lowest point since September 2020 and which, given the approximate 6-mth time lag between it and the ECI, points to wages growth on the ECI measure falling to around 3.5% by mid-2024, a level of growth that is consistent with the Fed’s 2% inflation target assuming that US productivity growth remains unchanged. Historically, a 0.1% fall in the quits rate typically depresses wages growth by around 0.3%, so small movements in the rate matter. On an annual basis, the rate has now fallen by 0.4%, i.e. consistent with an approximate 1.2% fall in annual wages growth.

Which brings us to tomorrow’s labour market report, where expectations are currently for a headline payrolls print of 185k and a small tick up in the rate of unemployment to 3.8%. It has been the strength of the payrolls number that has allowed the Fed to desist from cutting rates so far in this cycle, providing the argument it needed to overlook the progress being made on the inflation and wages front. But with inflation and wages now no longer providing a material impediment to cutting interest rates, an undershoot in tomorrow’s payrolls number might actually be welcomed by the market, in as much as it undermines the Fed's argument for keeping rates on hold and potentially completes the puzzle it needs to loosen policy. Thus a soft payrolls number this month could actually be more positive for the markets than a stronger number, as it will boost expectations that an interest rate cut will be delivered by the May FOMC meeting at the latest.

Two parts of the triad needed by the Fed to cut interest rates - CPI definitively moving lower and wages growth compatible with its inflation target - are largely in place. An undershoot in this month's payrolls report would complete the picture and could therefore actually provide a boost to the markets.