Relative comfort on inflation should allow the Fed to shift its focus to the goal of full employment. But with labour market data pointing in different directions, we sift through the mixed messages and the impact on the Fed’s rate cut plans.
July 25, 2024
By Atul Bhatia, CFA
In 1977, the U.S. Congress updated the Federal Reserve Act to lay out three clear goals for the U.S. central bank: “maximum employment, stable prices, and moderate long-term interest rates.” The third of these goals has effectively been subsumed into the other two, with economists deciding that stable prices and maximum employment will inevitably result in moderate long-term interest rates. The result is the Fed’s so-called dual mandate to keep unemployment as low as possible while keeping consumer inflation at or near two percent.
While the dual mandate is a legal reality for the central bank, we believe it’s a mistake to think the Fed pursues both objectives simultaneously. Instead, we see the policies as sequential, with price stability a prerequisite for providing labour market support. In our view, the central bank’s upcoming July meeting is likely to be the last where price stability considerations dominate, with labour market concerns transitioning to the forefront of Fed policymaking in September. The result is that employment data – already important to investors – could play an even greater role in driving bond markets in the months ahead.
We believe that the June Consumer Price Index shifted the burden of proof in the inflation debate. The trend leading into June was positive for the price stability argument, but the latest data – which we discussed in a recent report – make it unreasonable, in our view, to maintain that higher-for-longer interest rates are needed to achieve price stability in an economically relevant time horizon.
This does not mean that there are no risks to the inflation forecast. We would expect continued volatility in monthly price data, for instance. More importantly, the U.S. economy remains vulnerable to policy and geopolitical shocks. But barring significant external events, we expect investors to largely look through any single month of disappointing price data, given the solid backing to the narrative of falling inflation.
The relative comfort on inflation should give the Fed room to shift to the second half of its dual mandate, the goal of full employment.
Here, the picture is mixed. Payrolls continue to grow at a solid clip, with over 200,000 jobs created in June 2024 alone. That level of growth really doesn’t provide much sense of urgency for rate cuts and argues for a wait-and-see approach, in our view. But at the same time, the unemployment rate shifted higher, topping four percent for the first time since late 2021. We think unemployment levels give a much stronger argument in favour of pushing rate cuts into the discussion, even if part of the rise is attributable to a growing labour force.
The chart compares the total employment in the U.S. as calculated by the Bureau of Labor Statistics Household Survey and the employer nonfarm payroll count, from June 2004 through June 2024. The household survey shows nearly four million fewer jobs currently than reported by employers.
Source – RBC Wealth Management, U.S. Bureau of Labor Statistics, Bloomberg
There are a few reasons why the two indicators can point in different directions.
One is their source. Payroll numbers come from employers, while unemployment data – which by definition includes people who currently lack an employer – comes from a survey of households. This leads to workers with multiple jobs contributing to higher totals in the employer count than in the household count, for instance.
Another difference is the definition of employment – the household survey has a much broader concept of working that includes the self-employed, workers on leave, and household employees. The net result is that the household survey usually reflects a higher overall level of employment than the employer survey.
The Bureau of Labor Statistics (BLS) has a robust statistical approach to account for these differences. Since the mid-1990s, the federal agency has published an adjusted household survey that has closely tracked the employer-derived payroll counts. Unfortunately, that close relationship has broken down over the past two years. Adjusted household data from June shows nearly four million fewer jobs in the U.S. than reflected in the employer data.
The trend in household data is also decidedly more negative. Total adjusted household employment shows a loss of nearly 230,000 jobs in the U.S. economy since August 2023. In that same period, employers reported a net 2.2 million increase in payrolls. Discrepancies between the adjusted numbers and the employer counts have occurred in the past, but not at this magnitude.
We have two reasons to give credence to the adjusted household survey. First, while it may seem like a simple process to just add up payroll data, one complication is that businesses are continually opening and closing. The BLS adjusts for this dynamic, but that adjustment may be insufficient. The early phase of the pandemic saw significant business creation, and it would not be surprising to think that business closures are now above trend. Another potential issue is the rise of so-called gig workers. The BLS adjustments are based on historical data that may not fully reflect the prevalence of this type of household income generation.
Obsessing over survey methodologies can distract from the real goal, which is gauging the strength of the labour market. Employment levels are a key input in that analysis, but we also have other measures like economic activity, wage data, and levels of household debt delinquencies. By the Fed’s estimate, after looking at the broad economic context, unemployment is still slightly below the theoretical level for “full employment,” but central banks need to account for policy lags as it takes time for rate changes to filter through the economy.
On balance, and even accounting for pockets of economic strength, we think it is more reasonable than not to conclude the labour market is likely softer than reflected in headline payroll growth.
The column chart compares the overnight U.S. interest rates at several points in the next six months as implied by interest rate futures prices on July 1 and July 23, 2024. The estimates (July 1 vs July 23) are: July 31, 5.31% vs 5.32%; September 18, 5.16% vs 5.06%; November 7, 5.06% vs 4.90%; December 18, 4.88% vs 4.68%; January 29, 2025, 4.75% vs 4.50%.
Source – RBC Wealth Management, Bloomberg
We think the trend in inflation data and the Fed’s dual mandate give the central bank the latitude to consider cuts as early as next week’s meeting. But it’s the second leg of the central bank’s job – the goal of keeping folks working – that will provide the driver to lower rates, and we think that’s a September call.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiary is not covered by the UK Financial Services Compensation Scheme; the office of Royal Bank of Canada (Channel Islands) Limited is a participant in the Jersey Bank Depositors Compensation Scheme. The Scheme offers protection for ‘eligible deposits’ up to £50,000 per individual claimant, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any 5 year period. Full details of the Scheme and banking groups covered are available on the Government of Jersey’s website www.gov.je/dcs or on request.
We want to talk about your financial future.