Rate cut hopes fall with unemployment

One employment report and suddenly the markets are having second thoughts about a rate cut by the Federal Reserve.

On Friday, the US Labor Department reported that nonfarm payroll employment rose by an unexpectedly low 51,000 in September. Average weekly hours was unchanged while average hourly earnings rose by just 0.2 percent.

On the other hand, average hourly earnings rose 4.0 percent from a year earlier, the highest since a 4.1 percent gain in March 2001, and the monthly average job gains for the third quarter was 121,000, up from 115,000 in the second quarter after August payrolls were revised up to show a gain of 188,000 from an originally-reported 128,000 and July's gain was revised up to 123,000 from 121,000.

And there could be more upward revisions to come. In a preliminary estimate, the Labor Department said establishment survey employment for the 12 months through March will be revised up by 810,000, a figure that it describes as "larger-than-normal".

Suddenly, the establishment survey employment data look a bit more consistent with the low unemployment rate obtained from the household survey -- 4.6 percent as reported for September, down from 4.7 percent in August -- than previously thought.

And suddenly, markets are worried that the US labour market is a bit tighter than previously thought, and that an interest rate cut by the Federal Reserve is a little further off.

As a result, US Treasuries fell at the end of last week, pushing the yield on the 10-year note up to 4.7 percent, while US stocks fell from multi-year highs on Friday. Based on federal funds futures, traders think that the odds that the federal funds rate will be cut to 5 percent by the end of January have fallen to 20 percent from 32 percent on 2 October.

The jobs data only added to the doubts on a rate cut triggered by earlier remarks from Federal Reserve officials.

On 4 October, Federal Reserve Vice Chairman Donald Kohn had said in a speech to the Money Marketeers of New York University: "I think that the risks to my outlook for economic activity may be skewed a bit to the downside, while those to my forecast of gradually declining inflation are tilted to the upside. In my view, in the current circumstances, the upside risks to inflation are of greater concern."

On 5 October, Philadelphia Federal Reserve President Charles Plosser spoke to the CFA Society of Philadelphia. "There remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon," he said. "So we need to remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy’s long run performance."

Indeed, if past patterns hold, the unemployment rate may be telling us that inflation as measured by the personal consumption expenditures (PCE) price index -- the Federal Reserve's preferred measure of inflation -- has yet to peak.

The accompanying chart relates the 12-month rate of increase of the PCE price indices for both overall and core with the unemployment rate.

The chart shows that at inflation peaks, a sustained downtrend in the PCE inflation rate -- for both overall and core -- usually does not start until after the unemployment rate has bottomed. With the unemployment rate of 4.6 percent still at a five-year low, the year-on-year PCE inflation rates look likely to stay elevated for a while more.

And that in turn makes it unlikely that the Federal Reserve is about to cut the federal funds rate any time soon.