The focus has shifted! The Fed's next move may hinge on the labor market

The latest inflation data broadly meets expectations and continues to cool, while investors are debating the extent to which the Federal Reserve will cut interest rates.

Although inflation was the reason for the Fed to start raising rates, in the debate over rate cuts, the central bank's other mandate—full employment—is now becoming the focus.

"These labor market data will be the focus of action in the coming months," said Nathan Sheets, global economist at Citigroup. "This is where the Fed will pay the most attention."

Economists believe that given the current inflation rate is below the Fed's 2% target over a three-month period, the more concerning trend in economic data is the labor market, where the unemployment rate has been steadily rising and monthly job additions have been declining.

"We are at a turning point now," said Nicholas Brooks, head of economic and investment research at ICG. "I think for the past six months or even longer, most of the Fed's attention has been on inflation data, trying to bring them down. Now, as core inflation begins to fall to levels the Fed is more comfortable with, I think their attention is now turning to the labor market."

The soft non-farm payroll report in July also shifted the focus to the slowing labor market, with job additions in the report being the second lowest since 2020 and the highest unemployment rate in nearly three years, triggering a commonly used recession indicator, the Sam Rule. This indicator shows that historically, the recent rise in the unemployment rate tends to continue to deteriorate.

Mark Zandi, Chief Economist at Moody's, believes that while the Fed's focus on inflation will not disappear, the risks in the labor market are higher than those in inflation. He said, "The trend line indicates a higher unemployment rate and a lower inflation rate."

Zandi believes that if this trend continues, further deterioration in the labor market could prompt the Fed to start cutting rates sooner.

Despite the clear cooling of the labor market, economists have found some comfort in the current dynamics, as the rise in the unemployment rate is mainly due to more workers entering the labor force and fewer companies hiring new workers—rather than companies conducting large-scale layoffs.

This puts greater pressure on layoff data, with Zandi calling it a "key statistic."

"Companies have reduced hiring, leading to a slowdown in job growth," Zandi explained. "But fortunately, they have not significantly increased layoffs so far. But if that happens, we will enter a different scenario, where the risk of recession will be much higher than I currently expect."

Zandi stated that he currently sees a 33% chance of a recession in the U.S. in the next 12 months, and pointed out that the weekly initial jobless claims will be a key data point to monitor layoffs.

Last week, initial jobless claims in the U.S. unexpectedly declined, providing some comfort to those concerned about further deterioration in the U.S. labor market The latest initial jobless claims data will be released at 20:30 on Thursday Beijing time. Economists expect the initial claims to reach 235,000, slightly higher than the 233,000 from the previous week