Trescothick’s Take: The Market Is Watching Jobs. The Fed Is Watching Inflation.

There’s something rather amusing happening in the markets at the moment.

The US labour market is showing signs of cooling, and investors have responded with the sort of enthusiasm normally reserved for finding a forgotten £20 note in an old pair of trousers.

Why?

Because weaker employment means, in the market’s mind, a less hawkish Federal Reserve.

The logic is simple: fewer jobs, weaker economy, less pressure on the Fed to raise rates.

And equities breathed a collective sigh of relief.

But there’s just one problem.

The Fed isn’t looking at the jobs market in isolation. It is looking at inflation.

The July employment report showed the US economy unexpectedly losing 23,000 jobs, while the unemployment rate actually fell to 4.1%. That was enough for markets to start thinking that the prospect of higher interest rates had diminished.

But the Fed has another number on its noticeboard.

2%.

That is its longer-run inflation target, measured by the Personal Consumption Expenditures price index.

And inflation is still above it.

That matters.

Because if inflation remains stubbornly above target, a weakening labour market doesn’t automatically hand the Fed an excuse to loosen policy.

In fact, yesterday we got a rather useful reminder of where the Fed’s thinking may actually be.

Chicago Fed President Austan Goolsbee said inflation remains the biggest economic problem, rather than a collapse in jobs or industry.

In other words, while the market is staring at the employment numbers and thinking “Great, fewer jobs means fewer rate hikes,” the Fed may well be looking at inflation and thinking:

“Lovely. Now what are you going to do about that?”

And this is where investors need to be careful.

The Federal Reserve has a dual mandate: maximum employment and price stability. But the two don’t always cooperate.

If the economy slows and inflation falls towards 2%, that’s the scenario markets would probably like.

But if the labour market weakens while inflation remains stubbornly elevated, the Fed finds itself in a rather unpleasant position.

Raise rates and risk putting more pressure on employment.

Or ease policy and risk allowing inflation to remain above target.

Neither option is particularly appealing.

And this is why I think the market may be getting a little ahead of itself.

We have become so conditioned to thinking that bad economic news is good news for markets because it means lower interest rates that we’ve almost forgotten that bad news is only good news when the Fed agrees with us.

Markets are watching the jobs number.

The Fed is watching inflation.

And until inflation gets convincingly back towards that 2% target, investors might want to be careful about assuming the next move in rates is automatically lower.

Because there is one thing markets dislike almost as much as higher interest rates.

Being wrong about higher interest rates.

And if inflation decides to stay stubborn, that could make for a rather uncomfortable few week.

So perhaps don’t celebrate the weak jobs number just yet.

The market may have heard the first half of the sentence.

The Fed is still reading the second.

Anyway, till next time, all of you trade safe.

By James Trescothick
Head of Market Research and Market Analysis

Risk Disclaimer: This information is for educational purposes only and does not constitute investment advice. Financial markets involve risks, and past performance is not indicative of future results. Always conduct your own research and seek professional advice before making investment decisions.