(Bloomberg View) -- Even though the Federal Reserve is poised to start shrinking its $4.5 trillion balance sheet, the outlook for continued rate increases is very much in doubt following the recent slowdown in inflation. That makes the monthly jobs report on Friday even more important than usual as investors and analysts try to figure out whether the central bank will continue to take its cues from labor market strength rather than inflation weakness as it charts a course for monetary policy.
The Fed set the stage for balance sheet reduction at the July meeting of the Federal Open Market Committee. The bar for starting in September is quite low, as the economic data between now and then will have little impact on that decision. More of an issue for the balance sheet plan is the pending battle over the U.S. government's borrowing limit, or debt ceiling. If that results in bond market turmoil, the Fed will delay its plans.
As far as rate policy is concerned, the Fed remains fixated on the idea that the U.S. economy is near full employment. The unemployment rate currently stands at 4.4 percent, below policy makers' median estimate of the natural rate of unemployment of 4.7 percent. Moreover, central bankers believe that the pace of jobs growth is sufficient to place continued downward pressure on unemployment, allowing them to look through weak inflation as only transitory.
What's peculiar is that they also expect the unemployment rate will remain virtually unchanged through year-end. For that to occur, the pace of job growth must slow to something closer to 100,000 per month or the labor force participation must rise. Something has to change to hold the unemployment rate steady. In the face of low inflation, a steady unemployment rate would be dovish, but if the labor market trends established in the first half the year continue into the second half, the Fed isn't going to get to that place.
There are three main things policy makers be looking for in the July employment report:
- Jobs. The consensus on Wall Street is a nonfarm payrolls gain of 180,000, below June’s 222,000 but consistent with the average of 187,000 over the past 12 months. Job growth of this magnitude will help keep the Fed focused on their current policy path. They will see this pace of growth as likely to lead to a substantial undershooting of the natural rate of unemployment and thus indicative of an overheated economy. According to their thinking, this will eventually push the inflation rate to about their 2 percent target. It is only a matter of when, not if.
- Unemployment. Analysts are looking for the unemployment rate to dip back down to 4.3 percent. With the unemployment rate already below its estimate of the natural rate of unemployment, a sharper drop would certainly rattle the Fed. Labor force participation has been generally range bound since 2015. An increase that helped keep the unemployment rate steady or even pushed it higher would indicate that the economy is not as close to full employment as currently believed. If so, the Fed could pull back on rate hike projections, especially if inflation remains weak.
- Wages. Despite reports of tight labor markets, wage growth remains anemic. Analysts expect it to remain soft in this report as well, rising 2.4 percent from a year ago. Considering low productivity growth, the Fed would like to see something closer to 3 percent to support their contention that the economy is near full employment and inflation is set to move higher. The persistently low wage gains suggest that the Fed’s estimate of the natural rate of unemployment remains too low. If it continues, central bankers will likely feel compelled to mark down their estimate of longer run unemployment, thus providing reason to slow down the expected pace of rate increases for 2018.
If the employment report plays out according to consensus expectations -- which are within my own expectations as well -- the Fed will stick to its plan, anticipating that wages and inflation will eventually rise in the face of what they perceive to be a solid and improving labor market.
In that case, then the market odds of a December rate hike of 32 percent are on the low side. To be sure, we have four months of data until the Fed needs to make a decision about that meeting, but any labor market data that looks likely to maintain downward pressure on the unemployment rate will be on net hawkish even if inflation remains weak. Given the inflation data, though, they might be willing to remain patient and slow the expected pace of rate hikes if unemployment holds near current levels, but that patience will wear thin if it looks like unemployment will soon drop below 4 percent.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
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