There are many indicators to monitor for reading the monetary policy tea leaves, each with its own distinctive set of pros and cons. Here’s one more that’s worth pondering: the unemployment rate.
Reviewing the historical record suggests, unsurprisingly, that higher (lower) rates of unemployment align with a lower (higher) Fed funds rate. That’s an intriguing relationship because in the current environment, the two time series are unusually close – a scenario that’s rare in the historical record, and one that implies a change is near.
The median Fed funds rate is 4.33% vs. a jobless rate of 4.2%, which looks like an inflection point. If history’s a guide, this similarity will soon give way and open a gap that shifts the relationship closer to the usual state of affairs. Deciding which way the gap will widen is the key question.
In the current environment, it’s reasonable to expect that the Fed funds rate will fall and unemployment will rise. The tariff war is slowing growth, and there are signs that the labor market is cooling, albeit gradually and in fits and starts.
Jobless claims rose to a seven-month high, suggesting that hiring will continue to ease. Payrolls are still growing at a moderate pace, but the three-month average has fallen and is close to the slowest pace since the rebound from the pandemic.
If unemployment ticks higher in the months ahead, the rise would extend a gradual but conspicuous upside trend over the past two years. In turn, the increase implies that the Fed funds rate will decline.
Much depends on how inflation changes in the months ahead vs. unemployment. Economists are expecting the outlook to be too close to call in terms of clear signaling for the Fed.
A new Reuters poll reports that most economists expect the central bank will leave its target rate unchanged for the next several months – a view that aligns with expectations for Fed funds futures.
“As long as the labor market looks fine, we expect the FOMC to continue to stay on hold, and use rhetoric to bolster their inflation-fighting credibility. Until there is a cost, why signal otherwise?” said Jonathan Pingle, chief U.S. economist at UBS. “At the moment ‘grey area’ seems more ‘charcoal’… the Committee is facing a substantial amount of uncertainty.”