Unemployment Uptick May Pressure Fed To Cut Interest Rates Aggressively

In the wake of Friday’s jobs report showing the labor market deteriorating unexpectedly sharply, the question on the mind of investors and economists is no longer whether the Federal Reserve will cut interest rates at its next meeting in September, but how steeply it will cut them.

The jump in the unemployment rate in July to its highest since 2021 could give the Fed motivation to cut its benchmark fed funds rate faster than previously expected. Several forecasters changed their predictions for the central bank’s next moves, calling for three quarter-point rate cuts by the end of the year instead of two. Financial markets priced in an even more aggressive path, with five rate cuts for 2024, up from three the day before, according to the CME Group’s FedWatch tool, which forecasts interest rate movements based on fed funds futures trading data.

The Fed is now under pressure to respond to the weakening labor market because of its twofold mission to to keep inflation low and employment high. Recent reports have shown inflation falling towards the Fed’s goal of a 2% annual rate from its post-pandemic surge, and with the threat of rising unemployment growing larger, the central bank may shift its focus towards preventing mass layoffs.

“This clearly gives the Fed the green light to start cutting rates in September, and the market’s attention will now shift focus toward how many and how deep the coming cuts will be,” Scott Anderson, chief U.S. economist at BMO Capital Markets, wrote in a commentary.

The downshift in the labor market was alarming enough that markets are now pricing in the likelihood that the Fed will not only cut rates in September but will slice them by half a percentage point. On Friday, there was a 72.5% chance of a half-point cut in September being price in, up from 22% the day before, according to the FedWatch tool.

Fed Has Said Rates Could be Cut in September

Earlier this week, the Fed’s policy committee opted to leave its influential fed funds rate at a range of 5.25% to 5.50%, where it has been for a year. Fed Chair Jerome Powell said that the central bank could cut the rate as soon as the Federal Open Market Committee’s next meeting in September.

The shift to possible rate cuts marks a turning point for the Fed, which raised interest rates starting in March 2022 to combat inflation. By lifting the fed funds rate to their current level, the highest since 2001, the Fed put upward pressure on interest rates for mortgages, credit cards, and other debt, discouraging borrowing and spending in an effort to cool off an overheated economy and allow supply and demand to rebalance.

Further economic data is due to be published before the Fed has to make a decision on interest rate moves in September, including several reports on inflation and another major report on the job market, which could shift the outlook.

Could the July Jobs Data Represent a Blip?

There’s also a chance that the jump in unemployment may prove to be a temporary blip rather than the start of a trend. As Matt Coylar, an economist at Moody’s Analytics noted, many of the unemployed in July simply couldn’t work because of bad weather caused by Hurricane Beryl.

“I think this is just too narrow of data just yet to really inspire panic,” Coylar said in an interview with Investopedia. “And I would say that financial markets are potentially overreacting.”

However, even if the job slowdown isn’t as bad as it seems at first glance, the psychological impact could make it a self-fulfilling prophecy, especially if future data reinforces the impression, Coylar said.

“People who are expecting an imminent downturn, they may feel vindicated, and maybe it’s time to pull back spending hunker down, then it becomes self perpetuating,” Coylar said.

Markets Already Pricing in Lower Rates

At least for now, fed-watchers are betting that the days of high interest rates are numbered.

Just as the rate hikes pushed borrowing costs to their highest in decades, a lower fed funds rate is meant to ease some of that financial pressure, and could lead to lower borrowing costs for many kinds of loans.

For example, rate cuts could offer some relief to homebuyers who have been priced out of the market by high mortgage rates. The expectation of rate cuts, in and of itself, also helps push mortgage rates down.

“The market is moving ahead of the Fed, bringing down longer-term rates including those for mortgages, which should lead to both more home purchases and a pickup in refinance activity,” Mike Fratantoni, chief economist at the Mortgage Bankers Association, wrote in a commentary.

The yield on 10-year Treasurys, which is closely tied to mortgages, fell to around 3.80% Friday, the lowest level since last December.