The US Federal Reserve is paying more attention to a cooling labor market, as Chairman Jerome Powell all but confirmed that the first cut to benchmark rates will occur in September.

On Aug. 23, Powell said the "time has come for policy to adjust" as inflation has dropped closer to Fed officials' 2% target and the labor market has "cooled considerably from its formerly overheated state."

Powell's comments during the Federal Reserve Bank of Kansas City's Jackson Hole Economic Symposium followed the Bureau of Labor Statistics' (BLS) preliminary annual benchmark revision to jobs numbers on Aug. 21 that showed US employers added about 818,000 fewer jobs in the 12 months through March than originally thought, resulting in employment gains of about 2.1 million. The remarks also came against the backdrop of rising unemployment, which hit 4.3% in July, signaling that a weaker labor market is weighing on the Fed's policy decisions.

"We do not seek or welcome further cooling in labor market conditions," Powell said. "The upside risks to inflation have diminished. And the downside risks to employment have increased ... we are attentive to the risks to both sides of our dual mandate."

Gradual cuts expected

Still, recent unemployment numbers continue to be influenced by disruptions stemming from the coronavirus pandemic, and they do not necessarily point to drastic economic turmoil, Powell said.

"Rising unemployment has not been the result of elevated layoffs, as is typically the case in an economic downturn," Powell said. "Rather, the increase mainly reflects a substantial increase in the supply of workers and a slowdown from the previously frantic pace of hiring."

While the recent weak employment data may increasingly influence the Fed's decision to issue an interest rate reduction next month, it likely will not be viewed as representing a dire labor situation that warrants an aggressive slate of cuts.

"Even with the revision, the economy added 174,000 net jobs each month on average in the 12-month period through March, a strong showing no matter how one slices it," RSM US economist Tuan Nguyen said.

Recent jobless claims data are also encouraging, Nguyen said. Initial jobless claims of 232,000 for the week ended Aug. 17 were up from 228,000 in the prior week but below the 234,000 expected by analysts, according to consensus estimates compiled by Econoday. This has decreased fears that US labor trends have sharply faltered in recent months.

"The rate-cut expectation at the September meeting is firmly between 25 and 50 [basis points] and importantly, on the jobs front, the data has been quite benign, which supports the notion that the jobs market is cooling but not falling off a cliff," said Jeff O'Connor, head of market structure for the Americas at Liquidnet.

Labor on Fed radar in July meeting

The rate-setting Federal Open Market Committee (FOMC) already signaled in July that employment data merited close monitoring, according to the minutes of its July 30–31 meeting, released Aug. 21. FOMC members noted an easing labor market marked by a better balance between the supply of workers and employers demanding them.

Any "further gradual easing in labor market conditions could transition to a more serious deterioration," according to the minutes. Yet there was disagreement among committee members regarding the extent or timeline for a change to monetary policy restraint in response to the jobs data.

At the time of the FOMC meeting in July, the most recent labor data for June showed a 4.1% unemployment rate for June, slightly better than July’s 4.3% rate.

"There's no denying the recent softness in the labor market, an observation that likely carries more weight than the BLS revision covering the 12 months through March 2024," eToro US investment analyst Bret Kenwell said.

Other recent positive data like strong retail sales have balanced out concerns over employment, tempering expectations of more urgent interest rate cuts, Kenwell said.

"Short of a dire monthly jobs report on Sept. 6, the Fed seems most likely to dial up a 25-basis point cut, irrespective of the BLS revision," Kenwell said.

The odds of a 25-basis-point cut at the FOMC's September meeting stood at 65.5% on Aug. 23 immediately following Powell's speech, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market. Sentiment has shifted in recent weeks amid market turmoil and the release of fresh economic data.

Inflation trending down slowly

Inflation continues to trend downward, albeit somewhat slowly. The consumer price index — the market-preferred inflation metric — increased 2.9% in July from a year ago, the lowest 12-month increase since March 2021.

Meanwhile, the Fed-preferred personal consumption expenditures price index, excluding food and energy costs, grew 2.6% annually in June, well below its recent peak of 5.6% in 2022, according to the latest government data.

Similar to employment data, the inflation metrics point to the potential for gradual interest rate cuts in the coming months.

"The Fed will temper expectations of aggressive easing as the economy remains resilient and there continue to be jobs added, providing no reason for emergency cuts, and as inflation is still above target," Craig Fehr, principal of investment strategy at Edward Jones, said. "Two- to three-quarter-point rate cuts this year are a realistic expectation based on the evolution of growth and inflation."