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Market Update -- Economic Comment

Written by Jane Caron, CFA, Chief Economic Strategist

September 28, 2007

Initial unemployment claims for the week ending September 21 came in at a healthy 298,000, one of their lowest levels of the past year. This follows improvement the previous week, which helped bring the four-week average close to its 12-month low. Our takeaway from these and other employment data is that the August nonfarm payroll report overstated weakness when it showed that payrolls shrank by 4,000. Thus, we expect to see a snapback in payroll growth in the September report, which will be released next Friday.

While we expect a better tone in the September employment report compared to August, we are not revising our view that the labor market is softening. We continue to look for nonfarm payroll growth to average less than 100,000 in the months ahead, and we expect to see the unemployment rate rise to 5% over the next few quarters. This expected slowdown is consistent with our forecast that GDP growth will slow to an average pace that is below 2% over the next few quarters.

We expect this slowing to induce the Fed to cut the funds rate another 75 basis points in the months ahead. At this time, the markets are nearly fully priced for a 25-basis point cut in the funds rate at the October 31 FOMC meeting. While we think a rate cut is probable, it is not a foregone conclusion. Economic data outside of the housing market is likely to remain firm between now and the FOMC meeting and the inflation outlook is likely to deteriorate slightly. Thus, the Fed may prefer to sit on the sidelines this month. Waiting to lower the funds rate would also help limit the "moral hazard" side-effect caused by the 50-basis point easing that occurred in September.

If our view on the September employment report is correct and credit markets continue to show signs of stability, we think investors will adjust their expectations about the October FOMC meeting. In the near term, this could lead to higher short-term interest rates before the long-term downtrend reestablishes itself.