Weak July Jobs Data Dims Fed Rate Hike Odds, But Tightening Case Remains

Financial markets have sharply reduced their expectations for a U.S. Federal Reserve interest rate hike in September following a weaker-than-expected July jobs report. The shift comes after a week in which several Fed officials publicly made the case for further tightening to combat persistent inflation.

Futures markets now see a worse-than-even chance that the Fed will hold rates steady at its September 15-16 meeting, a reversal from earlier in the week when a hike was seen as more likely. The change was driven by data showing the U.S. economy lost 23,000 jobs in July, even as the unemployment rate ticked down to 4.1% from 4.2% — a decline attributed to workers leaving the labor force.

The soft hiring figures raise the possibility that the labor market is more fragile than previously assumed. This creates a tougher policy trade-off for the Fed, as officials weigh the risk that a rate hike aimed at curbing inflation could further weaken an already cooling jobs market.

At its last meeting, the Federal Open Market Committee (FOMC) held its benchmark rate steady in the 3.5% to 3.75% range, with three officials dissenting in favor of an increase. Inflation continues to run well above the Fed's 2% target, with the personal consumption expenditures price index up 3.7% year-on-year in June.

Several Fed officials have since voiced support for, or openness to, higher rates. The leaders of the Kansas City and St. Louis Fed banks said they argued for a hike at the last meeting. New York Fed President John Williams said it would be "absolutely appropriate to act" if the economy does not move toward the inflation target. Governor Lisa Cook said she would support an increase if necessary, while Philadelphia Fed President Anna Paulson said she has an "open mind" on the path ahead.

Richmond Fed President Thomas Barkin, however, said the July jobs report was "very consistent" with his view of a labor market that is "not loose, it's not tight."

The public commentary marks a notable shift for the Fed under new Chairman Kevin Warsh, who has avoided providing guidance on the policy outlook. His silence has frustrated some market participants.

Despite the market's reaction, several economists still see a case for tightening. Omair Sharif of Inflation Insights noted that Fed officials have indicated the breakeven pace of job gains is fairly low, and the committee is focused more on inflation data. Rick Rieder of BlackRock said nothing in the jobs report radically changes the inflation picture. Citibank analysts, however, argue that softer labor data and cooler inflation ahead mean hikes are unlikely, and they expect the next move to be a cut, possibly in October.