By John Veit

Outpacing expectations

The U.S. labor market added 275,000 jobs in February, outpacing consensus expectations and higher than January’s gain of 229,000.¹ The labor market remained strong despite high interest rates, high inflation and slowing economic indicators.

Although more jobs were added than expected, other indicators suggest labor market activity has cooled. Payrolls gains for December and January were significantly revised down, the unemployment rate increased and wage growth was weaker than forecasted. The labor market continues to rebalance – but too slowly for the Fed.

In upcoming quarters, economic indicators suggest the pace of job growth will slow and help bring down inflation. Alongside the rise in the unemployment rate to a two-year high and a much weaker rise in wages, there is less reason now to be concerned that renewed labor market strength will drive inflation higher again.

Industry breakdown

Payroll gains in February were distributed across many areas of the economy. Health care, leisure and hospitality and government led the way, contributing to almost three quarters of the job gains. Employment grew by 85,000 in the health and education industry, by 58,000 in the leisure and hospitality industry and by 52,000 in the government. The Bureau of Labor Statistics payroll diffusion index showed that increasingly more industries reported job gains, which further drove headline payroll growth.

Employment in the goods-producing industries also ticked higher, with 19,000 jobs added in February. Construction jobs rose but were offset by a decline in manufacturing jobs. Retail employment rose by 19,000, transportation employment rose by 29,000, and professional and business services employment rose by 9,000.²

The headline gain in payrolls partly reflects the end of cold weather conditions in the Northeast that prevented many people from working, as they returned to the workforce in February. The return of these workers boosted headline job growth and job gains particularly in construction, retail and food services. These gains were partly offset by sharp downward revisions to December and January’s job growth, and other indicators point to a weakening labor market.

Unemployment rates and growth

The labor market remains resilient, though it does show some signs of further slowing. The overall unemployment rate rose to 3.9% in February from 3.7% the prior month, the highest rate since January 2022. This rise was driven by another drop in the household measure of employment, by 184,000 in February. This sharp 150,000 rise in the labor force in February also led to increased unemployment.³ The labor force participation rate was unchanged, as participation rates for younger workers fell and participation rates for prime-age workers rose.

Weekly jobless claims came in slightly higher than forecast and prior weeks, suggesting the pace of job growth is slowing. Jobless claims increased notably in California and New York and indicate labor market conditions continue to ease, which is welcomed news for the Fed.

Wage growth increased by less than expected last month. Average hourly earnings, an important measure for inflation, rose by 0.1% in February. Over the past 12 months, average hourly earnings have increased by 4.3%, softer than forecasted and the 4.4% increase the prior month.⁴ While annual wage growth remains too strong for the Fed, the job quits rate fell below its pre-pandemic level, pointing to potentially weaker wage growth in upcoming months.

The number of job openings fell slightly in January to 8.86 million from 8.89 million the prior month, according to the Bureau of Labor Statistics’ Job Openings and Labor Turnover Summary report released last week.⁵ The quits rate also fell slightly, indicating wage pressures continue to ease, which is a welcomed development by the Fed.

Another sign that economic growth is moderating is the fall in the Institute of Supple Management’s (ISM) services index to 52.6 in February from 53.4 the prior month.⁶ This suggests core inflation could potentially decline further in upcoming months. However, we can’t put too much weight on one data point, as mixed economic data suggests the Fed must stay alert, continuing to analyze the data trends over time given month-to-month volatility.

Rate implications

The labor market plays a key role in the Fed’s interest rate hike decisions as it continues its battle to bring inflation down to its 2% target. At the most recent Federal Open Market Committee (FOMC) meeting last month, the Fed held its benchmark overnight interest rate steady at 5.25% to 5.5% for the fourth straight meeting.⁷ In projections released after the meeting, the Fed indicated it would begin to cut rates in 2024, likely three times, given the welcomed moderation in both inflation and economic growth over the past year. Fixed income markets expect the Fed will begin to cut rates in the second half of 2024.

Despite some moderation, the labor market must further moderate to bring inflation down to the Fed’s 2% target. The Consumer Price Index came in at 3.1% in January compared to a year earlier and down from over 9% in 2022,⁸ calming fears that the economy has to enter a recession with high unemployment to lower inflation to the Fed’s goal.

Last week Fed Chair Jerome Powell's semi-annual monetary policy testimony offered no major surprises. He indicated that the Federal Open Markets Committee (FOMC) will consider cutting rates at some point later this year, and that the timing is data dependent, although the Fed is "not far from" having the confidence that inflation is moving sustainably toward 2%.

The February inflation report is set to be released March 12.