Exploring the Fed’s Influence on Jobs

Last Friday the Bureau of Labor Statistics released May’s jobs report, which revealed nonfarm payrolls rose 390,000, exceeding estimates of 322,000, while the 3.6% unemployment rate was a tick higher than expectations for 3.5%.^[i] Oddly, some pundits fretted the data were too strong, arguing the Fed must act to cool the economy and hot labor market, which they posit could further fan already hot inflation. Ergo, with an eye toward next week’s Fed meeting, ongoing quick jobs growth may mean more rate hikes are coming—risking a sharper-than-desired economic slowdown. However, this argument overstates the link between jobs and monetary policy—and the Fed’s powers, in our view.

Since the Fed’s dual mandate targets maximum employment while ensuring price stability over time, one might think it stands to reason there is a link between unemployment and inflation—and that the Fed will use its tools to raise or lower unemployment as needed to maintain price stability. Fed officials’ public comments seem to imply as much. Fed Chair Jerome Powell said recently that an unemployment rate consistent with stable inflation “is probably well above 3.6%” these days while Fed Governor Christopher Waller spoke last week about curtailing excess job openings to help cool prices.^[ii]

But changes in interest rates don’t directly affect hiring. For one, businesses generally don’t borrow to fund payroll. Borrowed capital typically goes to longer-term investments in facilities, capital equipment and intellectual property. That may mean some hiring further downstream, but the impact isn’t direct and it certainly isn’t quick.

Despite analogies of the Fed manning the US economy’s steering wheel, its influence on output is much smaller than most people think. There is this notion of Fed heads “tapping on the brakes” with a rate hike, presuming some immediate and direct response to follow. Not so! Monetary policy is a blunt tool that influences money supply growth, which in turn influences economic growth, which then influences hiring. Fed decisions have some impact on market-set interest rates, which can have macroeconomic implications—e.g., the shape of the yield curve. But those effects aren’t necessarily make or break for the huge, complex US economy, as many other factors affect businesses’ hiring (and firing) decisions. Take the business cycle: In an expansion, a company may find it worthwhile to ramp up hiring despite rising interest rates. But during recession, a company could reduce headcount to survive even as the Fed cuts rates. Industry-specific trends matter, too. High oil prices, for instance, can encourage oil producers to go on hiring sprees because it makes business sense, regardless of what interest rates are doing. Political or regulatory matters—e.g., tax changes—could incentivize or discourage hiring. Moreover, beyond practical business reasons, the whole economic theory (Phillips Curve, wage-price spirals, etc.) underlying the premise of unemployment and inflation being tied together is bunk, but that is a topic for another day.

History also argues against a direct connection between interest rate changes and jobs. See Exhibit 1, which shows the average monthly percentage change in nonfarm US payrolls in the 12 months before, during and after a Fed hike cycle began. (We show this as a percentage versus raw hiring numbers to eliminate skew caused by population growth.) As shown, there is very little statistical difference. Hiring doesn’t slow noticeably until well after hikes end—illustrative, in our view, that monetary moves don’t have the immediate effect on companies’ employment plans that many seem to think.

Exhibit 1: Average Monthly Percentage Change in Nonfarm Payrolls During Rate Hike Cycles

Source: St. Louis Federal Reserve and Board of Governors of the Federal Reserve System, as of 6/9/2022. Seasonally adjusted total nonfarm payrolls, average month-over-month percentage change, February 1994 – December 2018.

If you remain unconvinced jobs and monetary policy aren’t connected, consider: To the extent monetary policy has an economic effect that does eventually flow through to hiring, it doesn’t show up in jobs data overnight. Somehow unmentioned by most coverage we saw is the generally accepted notion that monetary policy hits economic activity (e.g., affects growth) at some uncertain length of time ranging from 6 to 18 months. There are myriad academic papers on this very subject. None we are aware of suggest two months is sufficient lag time for monetary moves to hit activity. Yet the Fed only began hiking in March. Even that was a 0.25 percentage point hike. The 0.50 percentage point hike came in May. We are aware of no theory suggesting the economy should already reflect such small moves so soon.

Beyond this, sweating the jobs data is an implicit forecast of Fed actions, which is a practice fraught with peril. Now, monetary policy’s lagging economic impact is well known, including by policymakers. (Again, there is a bevy of central bank and academic research on this.) They may choose to simply not pay heed to a month’s data based on that. Or maybe they think the transmission mechanism for monetary policy to hit the economy is somehow on warp speed now, though they have said nothing to that effect. Or maybe they will look to other data points. You can’t know. We aren’t saying the latest jobs numbers don’t factor at all into Fed officials’ thought process or decisions. But central bankers are human, and their interpretations of the data can change based on new information. We have pointed out plenty of examples in recent history of central bankers here and abroad demurring or updating their guidance after the data didn’t conform with their projections.

Rather than getting caught up in speculation about jobs numbers’ impact on Fed decisions, we suggest waiting for actual actions. Monetary policy is important, and we don’t think investors should ignore what the Fed does, but it is just one factor among many affecting the economy. In our view, acting on potential Fed moves with an unknown impact is an investing mistake.