What Moves the Fed, Part II: The State of the Labor Market

By Scott Welch, CIMA®, Chief Investment Officer & Partner

Reviewed by Carter Mecham, CMA®, IACCP®

In Part I of this “mini-series,” we focused on one part of the Fed’s mandate – price stability, or inflation.

In this next “episode”, we will focus on the other Fed mandate – the labor market.

As a quick reminder, the Fed’s stated dual mandate is to maintain stable prices (i.e., inflation) and optimize the employment environment in the US (i.e., the labor market).

Employment Metrics

Unemployment Rates

Let’s begin by looking at the “headline” employment metrics – the U3 unemployment rate and the U6 “partially employed” rate.

Source: The St. Louis Fed (FRED), as of May 2025.

We see the remarkable resilience of the labor market since the Covid era. Historically, economists considered a 5% unemployment rate as a “fully employed” economy, and we have been below that level since mid-2021.

Job Openings, Hires, and Quits Rates

Now let’s look at some of the “numbers behind the numbers,” specifically the job openings, hires, and quits rates. We like to focus on the quits rate, as it is an indicator of workers’ confidence in finding a new job if they quit the ones they have.

Source: The St. Louis Fed (FRED), through April 2025.

What we see is a general decline in job openings, hires and quits, but relative stability over the past year or so. This suggests the job market may be softening but is holding steady, at least for now.

Jobless Claims

Next, let’s look at jobless claims, both initial and continuing claims. These numbers come out weekly and so are the most contemporaneous of the labor metrics. In other words, if there is a softening in the labor market, these metrics are likely to identify it first.

The weekly numbers can be quite volatile, so we focus on the 4-week moving averages to “smooth out” that weekly volatility. One reason Fed Chair Powell gave for holding rates steady in June was the ongoing resiliency of the labor market, but he also warned that we simply don’t know yet what the inflation and labor market effects will be from Trump’s ongoing tariff campaign.

So far, we do not see those effects in either the inflation metrics discussed in the previous blog nor here in the labor numbers, but we will know more as we move through the summer. There does appear to be a slight upward trend in both claims metrics, particularly in continuing claims (i.e., people already out of work and unable to rejoin the workforce).

Source: St. Louis Fed (FRED), as of June 7, 2025.

Remember that the overall unemployment level is measured across all workers. We see a different story than the headline number if we examine the unemployment levels segmented by educational attainment. The cliché saying “Stay in school, kids” actually rings true when it comes to employment.

Source: US Bureau of Labor Statistics, as of May 2025.

Participation Rates

Next, let’s look at the actual participation in the work force – how many people of “working age” are actually working (the Labor Force Participation Rate, or LPR) and what percentage of the overall population is in the workplace (the Employment to Population ratio, or ETP).

Women entered into the workplace in force in the 1970s and 1980s (not that they weren’t working hard domestically before then, but as measured by the Labor Participation rate), but that peak has declined and held steady for most of the past ten years. We see a similar story in the Employment to Population ratio – not out of line with historical levels and stable for most of the past ten years.

When you factor in the reality that “baby boomers” (workers born between 1945-1960) are leaving the workforce at an increasing rate, and ignore the Covid-induced disruption, the stability of both metrics speaks to the ongoing resiliency of the labor market.

Source, St. Louis Fed (FRED), as of May 2025.

 

Wages and Productivity

Finally, let’s look at wages and productivity.

Productivity

As a simplistic but generally accurate comment, an economy can grow by (a) adding more workers and/or (b) increasing the productivity of existing workers.

In other words, strictly from an economic growth perspective, a decline in the employment level can be mitigated if the productivity rate of the remaining workers increases.

We mention this because of the ongoing and accelerating evolution of artificial intelligence (AI). We are still in the initial stages of the AI revolution, but few people doubt that AI and robotics will eventually replace the need for the same number of workers doing repetitive jobs.

This will be a monumental social challenge, similar to the industrial revolution of the late 1700s to late 1800s and the “tech revolution” of the early 2000s. Workers will be displaced, and it will cause social friction as workers are forced to evolve toward jobs and careers that cater to the new economic reality.

But, in the meantime, here is what we see. Ignoring the Covid-driven disruption, both the number of workers and their corresponding level of productivity have been fairly stable for the past ten years, which to us suggests two things: (a) the AI-driven productivity boom has not yet been fully realized and therefore, (b) any significant decline in the employment level will have a correspondingly significant impact on economic growth.

Source: St. Louis Fed (FRED), data through Q1 2025.

Wages

From a wages perspective, we will use a similar chart we shared in Part I of this “mini-series” where we compared wage growth to the headline inflation rate. Wage growth dramatically lower than the inflation rate can drive “wage inflation” as workers demand higher pay to keep up with the price of goods and services.

The other side of that coin is that, even if wages are going up, workers may feel worse off if their pay doesn’t “stretch” as far as it used to. On this front, it is important to remember that inflation spiked at roughly 9% just after Covid, as the Fed kept rates low and massive amounts of fiscal stimulus were injected into the economy.

Why that matters is because now, even with the inflation rate coming down and approaching the Fed target of 2% annualized, those higher prices are “baked in” to current prices. Put differently, even if the Fed achieves its target 2% annualized inflation rate, that is coming on top of the 9% that we saw a few years ago (and the market will never go back to pre-inflationary prices unless we enter a serious recession / depression).

So, wages matter, even if they have somewhat of a “derivative” effect on the status of the labor market. Here we use the Personal Consumption Expenditure (PCE) index as the measure of inflation, which is the metric the Fed prefers because it accounts for changes in consumer behavior as prices change.

Source: The St. Louis Fed (FRED), through Q1 2025.

There are two things to notice: (1) inflation rose significantly faster than wages from 2021 until 2023, at which point wages rose faster than inflation, but (2) many workers didn’t “feel” better off because they fell so far behind during those high inflation years.

The fact that wages are now growing at a higher absolute level than inflation is a positive for workers, but it doesn’t feel like it to many because they still haven’t caught up to those “baked in” higher prices.

As the economy slows down (which we believe it is, even if we don’t fear a recession anytime soon, barring a major geopolitical event), it will be difficult for workers to demand higher wages. This will be especially true if people begin losing their jobs.

Summary and Conclusions

Remember that the point of this “mini-series” is to examine what the Fed looks at to determine its rate policy going forward. We suggested in Part I that there are no specific indications on the inflation front that provides a catalyst for cutting rates.

Here in Part II, we suggest a similar result when examining the labor market. There are, perhaps, signs of cooling, but the labor market is proving to be remarkably resilient. We remind you that it was a cooling of the labor market back in August 2024 that prompted the Fed to cut rates by a surprising 50 basis points (0.5%).

As we interpret the current data, we just don’t see the same thing happening this year. The Fed may choose to cut in July or August because they fear a cooling economy — which will be our focus in Part III of this series — but, for now, we find it hard to argue with the Fed’s decision to hold fast on cutting rates.

We know this puts us at odds with President Trump and many well-respected economists, but we just don’t see it in the data yet.

In any event, from an investment perspective, we repeat what we said in Part I:

We continue to recommend diversification at both the asset class and risk factor levels, maintaining portfolio discipline, and maintaining a longer-term time horizon.

Focus on the signals, not the noise.

We hope you find this helpful and, as always, we welcome your feedback and questions.