The labor market puzzle: Why the Fed may be flying blind

October 17, 2024 | 6 min read
Christian Floro, CFA, CMT
Market Strategist

The Federal Reserve has made it clear that as their confidence in the path of disinflation has grown, they have increasingly focused their attention on labor market data.

The recent triggering of the Sahm Rule—a more than 0.5% rise in the three-month moving average of the unemployment rate relative to the minimum over the past year—shook markets and sparked an equity sell-off given the rule’s historical accuracy, correctly predicting the onset of every recession since 1970. Surprisingly, however, the signals that can be gleaned from today’s labor market require a more nuanced interpretation than the Sahm rule alone. And in fact, the balance of evidence points to a labor market skewing less weak, and less recessionary, than once thought.

Traditional labor market data has become harder to interpret due to noisy revisions and potential measurement issues, complicating the task for policymakers. As a result, the data-dependent Federal Reserve may be navigating the labor market without clear direction, raising the likelihood of frequent shifts in Fed perspectives and commentary which in turn keeps market volatility at elevated levels, and the future path for rates uncertain.

What is the labor market data trying to say?

Don’t be mistaken; the labor market is indeed moderating, but the impact has so far been seen through just a softening in labor demand rather than actual layoffs.

For example, the JOLTs survey highlights that job openings have come down significantly since the peak of the pandemic. There is just one job per unemployed worker now, down from a peak of two jobs per unemployed worker in March 2022.

The pace of job creation has also slowed, with payroll data decelerating from over 500,000 new jobs added per month over a rolling three-month average back in January 2022 to about 186,000 new jobs on average added per month as of September of this year. While the slowdown in job creation can be attributed to normalization following the surge in hiring driven by the pandemic reopening, it's important to note that the current rate of job creation still exceeds the 150,000 mark, a historical indicator of a strong economy. This positive trend is further reinforced by job growth remaining well above the 50,000 per month threshold, a level that would signal serious concern.

Crucially, decreasing labor demand has yet to translate into aggressive or widespread layoffs just yet either. Job cut announcements have so far remained limited, with most increases attributable to the technology and manufacturing sectors, both of which are facing a normalization of demand as pandemic-era consumption patterns shift back closer to historical patterns. A cross check of initial jobless claims, which remain below the 300,000 threshold that typically marked recession territory, paint a similarly benign layoff picture.

Rather than layoffs, the rise in the unemployment rate has instead been driven by rising labor supply, a function of a rebound in participation from prime age cohorts and women. Illustrating this is the fact that the employment-to-population ratio—which helps adjust for these labor supply dynamics and tends to historically co-move with unemployment—has otherwise remained steady. Moreover, an increase in immigration has driven foreign-born job market participation to levels higher than where they were immediately prior to the pandemic. These factors, whereby rising labor supply, rather than layoffs, are driving the rise in unemployment, imply that the recessionary signal from the Sahm Rule may be much weaker than it traditionally would be. The triggering of the Sahm Rule with the July jobs report, followed by a growing understanding that the rule cannot be taken at face value this time, has resulted in significant market volatility as investors have been whipsawed by swiftly changing narratives on the labor market.

Where are the problem spots, then?

Despite the Sahm rule not being the recessionary indicator this time around that it has been, the labor market is still exhibiting signs of an economic slowdown. Soft data— derived from sentiment surveys such as those from the Conference Board, ISM PMI indices and NFIB—are starting to show weakness, adding to growing uncertainty and market volatility.

While these surveys are directionally consistent with a softening of conditions, their levels imply a much worse outcome than has so far been seen in the actual data. It could be possible that reality eventually catches up with sentiment. Still, the key takeaway is that the traditional relationship between hard- and soft-data has seemingly broken down in the post-pandemic period.

There could be some merit to this view, as studies have found that factors like a persistent increase in pessimism brought about by elevated prices or borrowing costs since COVID could be disproportionately weighing on survey respondents’ outlook.

The hard data isn’t infallible either, however. Payrolls data is subject to noisy revisions, which are exacerbated by survey response rates that have declined to close to the lowest in history. Moreover, measurement difficulties also exist, such as those pertaining to migrant flows, which present logistical (and political) challenges to quantify. These dynamics, in particular, make parsing the very strong September employment report more difficult, given the possibility that this strength is simply revised away. Furthermore, the very recent jump in initial jobless claims also highlights the potential outsized impact of one-off factors like weather disruptions and ongoing strike activity can on the data.

It is becoming increasingly evident that focusing on a single piece of data is ill-advised and instead, investors should be looking across a host of labor market data to build out a cleaner picture of U.S. economic health.

What today’s labor market means for the outlook

As a result of the elevated levels of uncertainty within the labor market data, it’s unlikely the Fed will outright stop its easing cycle due to a singular employment report. With inflation approaching their 2% target and given the Fed’s increased confidence around the disinflation process, they are committed to moving policy rates from a restrictive to a more neutral setting. Clear inflationary risks, or a series of very strong employment reports, with monthly payroll growth to the tune of 200,000 or more, would need to remerge for the Fed to consider stopping its easing cycle within the next few months.

Yet, given the increasing fuzziness of the data, there is potential that the heavily data-dependent approach of the Fed is putting them at risk of flying blind, complicating what little forward guidance they are providing markets. This has already played out in recent months as the noisy July jobs report likely flat-footed the Fed, prompting a 50bps cut, but then the much stronger September jobs report and weekly jobless claim numbers, along with reassuring JOLTs data have prompted Fed speakers to partially walk back their dovish commentary. Odds of an outright policy mistake remain low for now, but the current environment has potential to generate significant market volatility and turn each print to a potentially market moving event, whipsawing unwitting investors as a result.

Activity and the labor market are slowing—yet without any glaring household or corporate financial vulnerabilities, coupled with a Fed that has a clear commitment to a soft landing, recession is unlikely. We expect two more 25bps Fed cuts this year, followed by further easing towards a neutral policy stance next year. This sets up a constructive backdrop for risk assets so, while elevated volatility may be uncomfortable, investors should take a step back, keep a cool head, and take advantage of the various market dislocations that elevated volatility likely brings.

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