What Should Be At Stake On Jobs Day: Sufficient Conditions For Frontloading Interest Rate Cuts

We see two individually sufficient conditions for the Fed to proceed with a frontloaded interest rate cut in September above 25 basis points: either (1) the unemployment rate is 4.2% or above, or (2) the prime-age 25-54 employment rate declines in both month-over-month and year-over-year terms.

Back when we first wrote about “Three Motivations For Interest Rate Normalization,” we highlighted that nonlinear downside risk was a distinct basis for cutting interest rates. Moreover, we noted that nonlinear risk also implied a stronger case for the Fed to frontload interest rate cuts, with larger and faster cuts being more justified up front, and slower and smaller cuts more appropriate later in the normalization process. 

Right now we are at a moment of nonlinear downside risk. The unemployment rate has gone up in a manner that is–within an arguable rounding error–empirically consistent with recessionary dynamics. More worryingly, the unemployment rate is also accelerating higher, with larger increases occurring more recently. On its own, this would be a three alarm fire. 

The release of the August 2024 Employment Situation Report (Jobs Day!) tomorrow is understandably pivotal for Fed policy later this month. The size of the Federal Reserve’s first interest rate cut, now projected to take place later this month, will depend on how much of the recent rise in the unemployment rate holds, reverses, or deteriorates further. 

For us, the more-than-complete rebalancing of the labor market and the final signs of progress on inflation are reasons enough to begin normalization of interest rates. It should not require the unemployment rate to go up, or even for it to stay at 4.3%, for the Fed to begin lowering interest rates. 

But more specifically, and for the sake of intellectual transparency and honesty, we want to lay out the conditions that we think should be sufficient for the Fed to cut its benchmark interest rates by 50 basis points or more in September:

1. The unemployment rate is 4.2% or higher, OR
2. The prime-age employment rate is below its peak level and lower than where it was 12 months ago. 

Please note that these are views about what the Fed should do, not what the Fed will do.

Temporary factors may have lifted the unemployment rate in July. The surge in temporary layoffs and the role of Hurricane Beryl are plausible explanations for not taking the July 4.3% unemployment rate reading at face value. But we are skeptical about how much this can explain, and are struck by the consistency of the rise in the unemployment rate over the course of this entire year. Even an unemployment rate of 4.1% in August would still lift its 3-month moving average, but such a complete reversal of July's increase would at least suggest less nonlinearity.

The unemployment rate has been pushed up over the course of the calendar year by two forces, one more welcome, the other more concerning. The welcome development is that the prime-age 25-54 labor force participation rate has actually been rising. Such a rise is rare to see if the labor market is truly headed into a recessionary state. More people participating in the labor force does raise the unemployment rate, all else equal. 

The other force behind the rise in the unemployment rate is the slowdown in hiring and job growth. For the time being, the prime-age 25-54 employment-to-population ratio remains at its peak level, but in terms of its year-over-year change, we have seen a more concerning drop-off. 

The prime-age employment rate has treaded water for 12-15 straight months now. While seasonal adjustment can sometimes exaggerated month-over-month changes, year-over-year comparisons of the not-seasonally-adjusted (raw) data, which are more stable and robust, have also stopped increasing. We would view a decline away from the current prime-age employment rate with more seriousness, as it would imply year-over-year declines as well. Such declines are at least consistent with a meaningful economic slowdown, if not a pre-recessionary labor market state. 

If we see either an unemployment rate that’s 4.2% (or above) OR a prime-age employment rate declining on a year-over-year basis, the case for cutting at least 50 basis points in September should be cemented. In reality, the Fed will likely remain tight-lipped until the release of the August CPI data next week (unless the data tomorrow is truly awful or financial conditions suddenly and sharply tightens). 

Of course, even as we have laid out what we see as sufficient conditions for cutting faster than 25 basis points in September, there might be other pathways to that result. In particular, the inflation data might also tip the scales if we see firmer evidence of an inflation slowdown across the relevant CPI and PPI inputs. 

Jobs Day matters for the Fed again. Let’s hope they do not fall too far behind the curve.