Here's Why Friday's Jobs Report Will Be a Big Deal for Fed Watchers

When the Department of Labor releases the July jobs report on Friday, it will come at a crucial time. Why? It will land as the Federal Reserve is nearing a decision on quantitative easing tapering. The report will also come as economic activity numbers are turning sequentially weaker, which is fueling a narrative that the cycle has already topped out. The dichotomy between the Fed turning more hawkish and the peak growth narrative is a major reason why bond yields have been falling in recent weeks. The dichotomy will ultimately be settled by exactly how the employment picture evolves. Here's my take on where we're headed. 'Substantial Progress' Since the end of last year, the Fed has said it wanted to see substantial progress toward price stability and employment goals before considering pulling back on QE purchases. The press release following the Fed's July meeting included the phrase the economy has made progress toward these goals. Given that the Fed always said it would clearly telegraph well ahead of actually announcing QE tapering, this phrase certainly looks like a form of telegraphing. I think this means that if job growth is just inline with expectations over the next couple months, QE tapering will be announced sometime in the fourth quarter. For July, expectations are for a 875,000 gain, but I'd guess that even a slowdown to the 600,000 area would still result in 4Q tapering assuming wage pressure remains high. Tapering Has Nothing to Do With Inflation The Fed uses QE for a few purposes, none of which is still sensible. First is to signal to markets that it wants to be even easier than the zero lower bound will allow. Under Average Inflation Targeting (AIT), such a signal shouldn't be necessary anymore. Second is to ensure the balance sheet is adequately large to accommodate excess reserve demand. The massive subscription on the Fed's repurchase agreement (repo) auctions indicate banks have more excess reserves than they want. Last is to soak up excess supply of Treasury issuance. Right now there is more than enough demand for long-end Treasuries as evidenced by falling yields. The Fed knows QE is doing more harm than good right now. Just this week Fed Gov. Christopher Waller told CNBC that he thought the Fed should go early and should go fast on QE tapering. Normally, I'd say that a Fed Governor saying such a thing would be a purposeful communication, but this seems way too candid. Given that Waller just joined the Fed's Board, maybe he hasn't quite been briefed on the protocols yet. I think the Fed will be more deliberate than what Waller is describing. That being said, I think his sentiment that QE's value has played out is widely shared within the Fed. Hence, why the decision to taper QE has nothing to do with inflation. By setting this substantial progress goal, the Fed has essentially said they'd be waiting until they are sure the recovery is on very strong footing, not necessarily that their AIT goals had been met. Supply's More Important Back to the jobs report, labor force participation (LFP) has been stagnant since last fall, hovering between 61.7% and 61.4%. In calendar 2019, LFP averaged 63.0%. At the start of the year, I had figured that LFP would recover quickly starting this summer, as vaccine distribution expanded and summer travel began. It may still be that enhanced unemployment benefits are disincentivizing people from seeking work, but as the months pass by, this argument is getting weaker and weaker. If people are still sitting on the sidelines and really needed work to make ends meet, you'd think that they'd want to find a job before those extra benefits expire. So far that isn't happening, which might indicate that some of the people who have left the labor force are gone for good. If so, that's a big problem on two fronts. First it means that the very tight labor market we see now is going to remain. In turn, that means persistent inflation above 2% is both more likely to happen and probably coming sooner than later. Second, if labor supply is going to grow slowly, that will serve as something of a governor on overall growth. The economy can only grow if it makes more stuff, and it can't make more stuff unless it has more workers to make that stuff. So this will be a key thing I'll be watching on Friday. To me a strong total jobs number paired with a weak LFP growth would be very bond bearish, and probably not good for stocks, either. Clarida Gives the Nuance of the Dots Lastly, on Wednesday Fed Vice Chair Richard Clarida made some waves when he said the necessary conditions for raising the target range for the federal funds rate will have been met by year-end 2022, assuming his own personal forecast comes to fruition. This came in the form of a speech before the Peterson Institute, where Clarida laid out his own forecast for the economy in some detail. The short version is this: GDP growth will slow in 2022 but remain above previous trend in 2022 and 2023 Unemployment will fall below 4% sometime in 2022 Core PCE inflation will be around 3% this year and around 2.1% in both 2022 and 2023 As Clarida says in the speech, these figures are basically the same as the median view of the Federal Open Market Committee. In addition, the timing of liftoff that he's describing is the same as what the dot plot released after the June meeting indicated. Clarida is trying to make explicit this link: The output of the dot plot makes perfect sense, if this forecast proves correct. In reality, this linkage should have been obvious all along (and indeed, I wrote as much in my response to the meeting). But markets seemed to miss this nuance, and Clarida is now trying to make it more clear. What this means is that the Fed really is data dependent. If employment remains strong and wage pressure results in persistent inflation, the Fed is going to be hiking before too long. If that inflation pressure remains strong after liftoff, the Fed will get all the more aggressive. But if none of this happens, and inflation falls back below 2%, the Fed is going to remain on hold, indefinitely if that's what it takes. Don't overcomplicate it. It really is just as simple as that.

Here's Why Friday's Jobs Report Will Be a Big Deal for Fed Watchers

Let see what employment numbers and weakening economic data could mean for policies such as quantitative easing tapering.

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