August Employment Report Opens Up Potential For Fed Downshifting But Maybe Not

The stock market is likely to remain under pressure as seasonal selling dominates in this data-light week.   The August Employment Report raised the possibility of a downshift in Fed tightening at the September 20-21 FOMC Meeting.  And, the August CPI, due September 13, risks doing the same.  But, it is not clear whether one or two reports will convince the "data-dependent" Fed to pull back from the pace of rate hikes.  There are reasons why the Fed may continue with another 75 BP hike.  Conceivably, the Fed may risk "overshooting" to ensure a sustainably low-inflation economy, which is what an "optimal control" solution would suggest.  This risk could hit the headlines on Thursday, when Fed Chair Powell will likely repeat the Fed's hawkish message in a speech.

The August Employment Report shows some softening in labor market conditions that should be welcome news for the Fed.  Payrolls slowed and the Unemployment Rate rose.  The 0.2 percentage point increase in the Unemployment Rate to 3.7% resulted from an increase in the Labor Force Participation Rate, which means there is more room for the economy to grow.  And, wage inflation moderated, although it is too soon to say the moderation will continue.  The 0.3% m/m increase in Average Hourly Earnings, after +0.5% in July, could just reflect volatility.  

Nevertheless, the slowdown in AHE hints at the possibility that the Unemployment Rate may not have to move much higher to permit inflation to settle down to the Fed's 2% target.  A 0.3% m/m pace (3.6% annualized), is consistent with this target, taking account of the 1.0-2.0% trend in Productivity Growth.  As I discussed last week, there are fundamental reasons why wage inflation may moderate -- the end of the decline in Unemployment and the easing of inflation expectations.

What might keep the Fed aggressive is that the Employment Report shows a strong underlying economy.  The +315k m/m increase in Payrolls is solid, even though less than the huge +526lk July gain.  Although Total Hours Worked slipped in August, the July-August average is 2.7% (annualized) above the Q222 average.  This is close to the 3.0% pace in the prior quarter.  The Atlanta Fed's model raised its projection of Q322 Real GDP Growth to 2.7% before the release of the Employment Report.  

An "optimal control" approach to the issue of how much to tighten suggests maintaining the 75 BP pace of hikes in the face of these mixed data.  Optimal control is a way to maximize an "objective function" subject to constraints.  In this case, the objective function shows the goal of as low as possible unemployment and inflation over the next two years (the time-frame of the Fed's Central Tendency forecasts).  The constraints are the Fed's econometric model, which posits an inverse relationship between unemployment and inflation.  The typical "optimal control" solution of the Fed's model calls for a sharp recession initially.  This allows for faster growth and lower inflation afterwards (my dissertation).  In other words, the economy needs slack to be able to achieve strong growth without stoking inflation.  Currently, the Fed's warning of near-term pain to achieve longer-term growth and low inflation seems to fit this optimal control solution.  If so, the latter suggests that we need to see much more of an increase in the Unemployment Rate to satisfy the Fed -- and thus a continuation of 75 BP hikes.

The next important piece of data is the August CPI, due September 13.   The Total should be depressed by the drop in gasoline prices, while the Core could be held down by the pass-through of lower oil prices to a wide range of other prices as well as by slower wage inflation.