Hot jobs market piles pressure on Federal Reserve to raise rates later this summer

Unexpectedly strong hiring across the US economy has piled pressure onto the Federal Reserve to raise interest rates later this summer if it skips an increase at its forthcoming policy meeting this month. 

Payrolls growth once again boomed in May, with nearly 340,000 positions added to a broad swath of sectors, data released on Friday showed. The result underscored the powerful momentum that sustains the US labour market, and raised the prospect that the central bank has not yet damped demand sufficiently to get inflation under control.

The jobs report comes as Fed officials debate what to do at their next policy meeting, with several among the top ranks advocating for the central bank to forego a rate rise, while keeping the door open to further tightening later.

That, they argue, will give the Fed more time to assess the impact of its rate increases so far as well as the effects of the banking turmoil caused by the collapse of Silicon Valley Bank and Signature bank in March. Philip Jefferson, the governor tapped to be the next vice-chair, was the most recent senior official this week to lay out this argument.

Others, including a handful of voting members on the Federal Open Market Committee, appear more steadfast about the need to more immediately raise borrowing costs again, citing disappointing progress on eradicating price pressures.

“They’re entering into a stage of policy where we can’t assume a move at each meeting, but they are still data responsive, so this policy decision is a close call,” said Brian Sack, who previously served as the head of the markets group at the New York Fed.

Sack said the odds slightly favoured a rate rise when officials next gather, and that an increase in July was “strongly in play” if they opted against an increase this month.

Since March 2022, the Fed has lifted its benchmark rate by more than 5 percentage points. Another quarter-point rate rise would increase the target range to 5.25-5.5 per cent.

Giving the Fed some cover to adopt a more circumspect approach and pass up a June increase are signs that the labour market, while still robust, is beginning to lose some steam. While hiring was strong — and upward revisions also meant jobs gains over the past two months were 93,000 positions higher than initially reported — the unemployment rate rose 0.3 percentage points to 3.7 per cent. That is the highest level since October 2022.

Wage growth also cooled, edging down to a 4.3 per cent annual increase after another 0.3 per cent monthly gain. Average hours worked for all employees, meanwhile, slipped, suggesting companies may be starting to cut back.

“The FOMC will need to dig a little deeper if it wants to see signs that the labour market is loosening, but I think those signs are there,” said Blerina Uruci, chief US economist at T Rowe Price.

“I’m looking for the Fed right now to change the pace of hikes and move to something like an every-other-meeting increase in interest rates, which would allow it to maintain a tightening bias, while also being mindful that a lot of tightening has already been implemented and we’re still absorbing the repercussions of the banking sector stress.”

She now expects the probability of a rate rise in July to increase further. Economists at Morgan Stanley also on Friday said the employment report “raises the risk” of an increase in two months’ time after a skip in June. According to fed funds future markets, traders already slightly favour the central bank omitting a June move and delivering a quarter-point rate rise in July.

Many economists expect the Fed to signal its proclivity for further tightening by raising the median estimate of the fed funds rate for this year by at least a quarter-point in the so-called “dot plot”, which tracks officials’ individual projections about the path forward for policy.

In March, when estimates were last aggregated, most officials thought the fed funds rate would peak between 5 per cent and 5.25 per cent, its current level. Back then, chair Jay Powell indicated that the string of bank failures that preceded the meeting diminished expectations about how much more the Fed would need to do. Still, seven policymakers estimated that the policy rate would need to eclipse this level at the time.

“What makes the current policy situation harder is that the Fed wants to react to the momentum in the economy, but it may worry that the bank credit headwind to the economy will be felt increasingly over time,” said Sack.