U.S. labor force surge could ease pressure on the Fed for big rate hike

The strong August jobs report means the Federal Reserve will continue to aggressively raise interest rates, though a surge in the U.S. labor force could give central bankers the option to back off a little if they choose.

Nonfarm payrolls increased 315,000 last month and the unemployment rate unexpectedly rose to a six-month high of 3.7%, the first increase since January, as the participation rate climbed, a Labor Department report showed Friday.

“You could still flip a coin on how big of an increase they do in September,” said Diane Swonk, chief economist at KPMG.

While the surge in the labor force was “wonderful,” she said: “I don’t think they want to show at any point in time that they have stopped in their resolve to really get inflation down.”

Central bankers raised rates by 75 basis points at their last two meetings and Chair Jerome Powell has said another move of that size could be on the table when they meet Sept. 20-21, depending on the data.

The Fed will get one final important report – the consumer price report for August – on Sept. 13, a week prior to the meeting.

Investors are still pricing in the likelihood of a 75 basis-point hike for September, though odds of such a hike declined a bit from prior to the report.

Bets on where rates will peak showed a clearer reaction, shifting up by 10 basis points to the vicinity of 3.9% in the second quarter next year.

“Today’s jobs data-point skews the odds towards a 50 basis point rate hike in September so long as the next CPI report notes stable to low-ish core inflation as well,” said Guy LeBas, chief fixed income strategist for Janney Montgomery Scott in Philadelphia.

Fed officials have been aggressively raising interest rates to cool the hottest price pressures in nearly four decades and have vowed they will keep at it despite the likely pain this will cause the public.

“What has been taken as good news this morning is that the economy is not continuing to run away from the Fed,” said Vincent Reinhart, chief economist at Dreyfus and Mellon.

“However, it still requires the Fed to keep running to keep up with the economy. Employment gains are still not sustainable.”

Reinhart, a former senior Fed official, said a 75 basis-point hike is still the baseline for the next meeting.

“It is not as hardened because there is a key data point that they responded to previously – and that is CPI,” he said..

“The report doesn’t settle the issue of whether the Fed will raise rates by 50 or 75 basis points in September, but – even though we expect a very soft CPI report for August – we still think the risks tilt slightly toward a 75-basis point move,” economists Anna Wong, Yelena Shulyatyeva, Andrew Husby and Eliza Winger wrote in a note for Bloomberg Economics.

Powell has said the economy could need to sustain some “pain” with below-trend growth to reduce inflation.

At the same time, he and other Fed officials have held out hope they could engineer slower growth without tipping the economy into a recession.