US labour market tight. Weekly jobless claims falls to lowest level in 7 months. Immaculate disinflation vs the Phillips Curve: is this time different? History informs job losses required to return inflation to targeted levels

By Stuart Talman, XE currency strategist

Last week's soft tier 2 US labour market data (JOLTS & ADP employment change) and a mixed August Nonfarm Payrolls report provided encouragement to those who subscribe to the view the Fed has already ended its tightening regime - the terminal rate has been reached. The downside misses provided evidence that the jobs market is materially loosening under the weight of one of the most historically aggressive monetary tightening cycles.

Thursday's initial jobless claims data suggests otherwise.

The number of Americans filing for unemployment benefits fell by 13,000 to 216,000 (vs 234K, expected), marking the lowest level since the week ending February 11. It was the fourth week of declines following a peak of 250K during the first week of August.

The weekly claims data sets are regarded as an important forward-looking indicator for the health of the US economy as they typically rise before recessions as the Federal Reserve raises the target rate to intentionally cool economic activity.

Following 500bps of monetary tightening, Fed Chair Powell and his FOMC colleagues are still waiting for the labour market to turn. Whilst headline jobs growth has slowed (NFP has fallen from 350K+ 12 months ago to sub-200K in August) and the unemployment rate jumped from 3.5% to 3.8% last month (some of which can be attributed to a spike in the participation rate), the labour market remains undesirably tight.

History informs that unfortunately, stress must be applied to the labour market to reign in above-target inflation. Job losses induce a decline in consumer spending which in turn cools the broader economy given household consumption accounts for almost 70% of GDP in the US.

Yes, progress has been made to return inflation to the Fed's 2% target, however core PCE (the Fed's preferred inflation gauge) remains above 4% and worryingly, ticked higher in July.

Proponents of the Phillips Curve subscribe to the theory that inflation and unemployment have a stable and inverse relationship. During periods of economic growth, inflation rises as more jobs are created, the unemployment rate falls.  When inflation overshoots targeted levels, central banks raise the cost of borrowing, contracting the economy which in turn raises the unemployment rate.

Those who dismiss the Phillips Curve's modern-day relevancy believe that the inflation/unemployment relationship is defunct, the Fed can engineer a "soft landing" or even "no landing", returning inflation to the 2% target without catalysing widespread job losses whilst sustaining economic growth. 

They've even coined a phrase for it: immaculate disinflation.

Whilst it is still not clear how the full effects of the Fed's cumulative rate hikes will play out, it is misinformed to rely on the this time is different argument, to jump to the conclusion that inflation returns to target without widespread job losses….. and perhaps recession.

What is clear is the Fed will not be hiking in 2023 and is one or two hot CPI prints away from planting its foot back on the hiking pedal.

The Fed funds target rate will be held higher for longer.

Recall back in March as the SVB and US regional banking crisis unfolded, the bond market priced in over 100bps of easing before the end of the year. Not only have 2023 rate cut expectations evaporated, but the timing of the Fed’s pivot has also been pushed further and further out, now expected to be sometime later in 1H 2024.

And that's why the chorus of calls for the US dollar's demise have proven out of tune.

In addition to this week's downside miss in weekly claims data, the ISM Services PMI surprised to the upside, adding to a sustained run of hot macro data that paints a picture of US economic exceptionalism.

Resilient and robust, the performance of the world's second largest economy has re-ignited the dollar's rally, now extending into an 8th straight week of gains as US treasury yields probe levels that have not been breached in over 15 years.

At some point the data will turn, the US economy will buckle under the weight of a Fed funds target rate that may well be north of 6% at the cycle peak. But until that time comes, the dollar will continue to outperform its peers.

Shifting our focus to the final sessions of the week, it may prove to be a tepid end given the economic calendar is absent any tier 1 market moving events in the US. GDP for Japan, CPI for Germany and Canadian jobs numbers are worthy of attention.

New Zealand dollar price action has been compressed over the past two trading days trading in a tight ~30 pip range through Thursday, mostly contained between 0.5870/90.  Remaining within reaching distance of the weekly and year-to-date low near 0.5860, NZD sellers are in full control.

A soft end to the week sets up for further downside next week when direction will be likely derived from the headline event: US CPI for August.

Stuart Talman is Director of Sales at XE. You can contact him here.