Labor weakness argues against Fed hikes
The Fed's hold case strengthens as US payrolls disappoint, Canada's labor market rebounds, and Japan's economic resilience supports further policy normalization.
Weekly highlights
And huge downward revision
Declined for “wrong” reasons
Multi-year low
Better than expected
Expanding at slower rate
Back to growth.
Below expectations
Strong wage growth
Not solid, but not bad either
US: No pre-emption needed
Last week we noted that the three dissents in favor of an immediate rate hike all implicitly viewed that hike as a pre-emptive move aimed to avoid larger/faster hikes down the road. This week’s employment update says that no pre-emption is needed. We reiterate our view of a Fed on hold through year-end on the basis of a “do no harm” approach to the labor market and better leading indicators for inflation.
The July employment report was a double-whammy miss. The economy lost 23k jobs (versus the 80k addition expected by Bloomberg consensus) and there was a massive 103k downward revision to the prior two months. The combination dramatically lowered the 3-month average change to just 20k, the lowest since February and a far cry from 142k in May. The weakness was concentrated in private services (only 5k jobs added overall) and in government (-53k). The former likely reflects pullback from earlier World Cup-related hiring, and the latter may reflect some seasonality skews in public education. Both could therefore reverse to some extent, suggesting that the July headline is likely weaker than the true underlying trend in hiring.
Nevertheless, wage inflation retreated further, with AHE (average hourly earnings) inflation easing to 3.2% YoY for both the overall population and for production and non-supervisory employees. Aside from a couple of months during the early days of Covid, these were the mildest increases since right before the pandemic. In conjunction with decent productivity gains, the message is clear: the labor market is NOT a source of inflationary pressures, nor are labor income dynamics supportive of strong second-round inflation effects from the energy shock. There is no need for pre-emptive hikes.
The one data point that could be used to argue for a hike is the one tenth decline in the unemployment rate, now at 4.1% and just below the estimated neutral level. But this decline occurred for undesirable reasons, namely people leaving the labor force, not because unemployment itself declined. Given this, we see payrolls and wage inflation as the more important signal-carrying indicators for the Fed.
Canada: Unemployment rate edged down
July labor market report delivered a clear upside surprise, supporting our view that the economy is regaining momentum after a softer period. However, cooling wage growth, still-elevated unemployment at 6.4%, and lingering tariff risks argue for caution. Against this backdrop, we continue to expect the BoC to remain on hold through year-end.
The headline gain was impressive. Employment rose by 75k in July, well above consensus expectations for a 20k increase, with the gains almost evenly split between full-time jobs (+38.6k) and part-time roles (+36.6k). The unemployment rate edged down from 6.5% to 6.4%, its lowest level in two years. That mix is encouraging as job creation was strong enough not only to absorb new entrants into the labor market, but also to bring unemployment modestly lower.
The breadth of hiring also added credibility to the report. Gains were spread across several cyclical and service-oriented sectors, led by wholesale and retail trade (+21k), finance, insurance, real estate, rental and leasing (+18k). The few weak spots were concentrated in public administration (-15k) and agriculture (-9.6k), suggesting that July’s improvement was not driven by a single sector or temporary distortion.
Still, the report does not remove the case for caution. Average hourly wage growth slowed to 2.8% YoY from 3.3% in June. Softer wage momentum should help ease inflation concerns, while the still-elevated unemployment rate points to remaining slack in the economy. With energy-price volatility and potential trade headwinds from new tariffs, the BoC has little reason to rush into either renewed tightening or early easing. The July data supports a more constructive growth narrative but also reinforces a patient policy stance.
Japan: Cautiously, decisively and independently
The focus remained firmly on Japan's interest rate outlook last week, with political developments dominating the headlines. Markets are now almost evenly split in pricing the next Bank of Japan (BoJ) rate hike in September and October. In our view, however, the BoJ increasingly has sufficient evidence to proceed cautiously, decisively, and independently.
Economic growth remains resilient, domestic consumption continues to strengthen, and underlying inflation pressures remain consistent with further policy normalization. While political pressure on the central bank has intensified and fiscal policy is turning more accommodative, the macroeconomic backdrop appears strong enough for the BoJ to continue setting policy based on its inflation and growth objectives rather than external demands.
Recent activity data support our constructive growth outlook. The BoJ's Consumption Activity Index fell 1.7% MoM in June, but the decline largely reflects mean reversion after two consecutive strong gains. As a result, the index still rose 0.7% QoQ in Q2, marking its strongest quarterly increase in two years. We believe this reinforces the view that private consumption remained firmly in the driver’s seat and should help offset a likely drag from inventories, which were probably drawn down amid the energy shock linked to the Iran conflict. With Q2 GDP data due in two weeks before the September meeting, policymakers will receive further confirmation that economic momentum remains sufficiently robust to support policy normalization. We see growth surprising positively in the ballpark of 0.6% QoQ.
The key risk will be composition; exports may have declined in a worst-case scenario, even if a similar decline in imports may lift net trade. Furthermore, as Q2 is dated and we are already in mid-Q3, there is a risk that markets may not grasp the importance of the resilient domestic spending. Nonetheless, that is the most important takeaway.
The growth backdrop is being complemented by persistent underlying inflation pressures and firm inflation expectations, both of which remain consistent with the BoJ's normalization agenda. At the same time, the political environment has become more challenging. Prime Minister Takaichi had reportedly urged Governor Ueda to increase JGB purchases, drawing attention to an often-overlooked aspect of policy normalization: the BoJ's balance sheet. While markets remain fixated on the path of the policy rate, balance-sheet normalization has been proceeding faster than widely appreciated, pushing the Bank's JGB purchases toward historic lows.
Separately, the government has announced a two-year reduction in the consumption tax on food from 8% to 1%, alongside annual cash transfers worth ¥600 billion. The measures are intended to alleviate cost-of-living pressures and effectively reduce the household tax burden, but they are also expected to create an annual fiscal shortfall of roughly ¥5 trillion. Despite this, the government has indicated that it does not intend to fund the package through additional debt issuance, which is the most important takeaway. Against this backdrop, calls for greater BoJ support through increased JGB purchases have become more prominent, even as the Bank continues to shrink its balance sheet and reduce its footprint in the government bond market.
Despite the growing political scrutiny, we believe the BoJ retains sufficient policy space to act cautiously, decisively, and most importantly, independently. Stronger growth, resilient consumption, and persistent inflation pressures increase the likelihood of a September rate hike in our view. September also offers a cleaner window for policy normalization. The Federal Reserve will meet the day before and could remain on hold, reducing the risk of policy cross-currents, while the subsequent public holidays may provide a more favorable backdrop for absorbing any market volatility than an October move. As a result, we now see a higher probability of the BoJ delivering its next rate increase in September rather than waiting until October. The Summary of Opinions from the BoJ’s July meeting should bring newer information next week about the Bank’s thinking.
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