The Fed gets two signals, and they disagree

For a week at the start of October the bond market was sure of one thing: the Federal Reserve would raise interest rates again this month. On Friday the labour market took that certainty away. Employers added just 29,000 jobs in September, against forecasts of about 90,000, and the unemployment rate rose to 4.2 per cent from 4.1 per cent. Earlier months were revised down by a combined 60,000. Futures traders cut the odds of an October rise to about 14 per cent, from roughly 70 per cent earlier in the week.

Then, on Monday, a survey of service businesses pointed the other way. The Institute for Supply Management's prices index for the sector jumped to 74.0, its highest since July 2022. The Fed now has two pieces of evidence that argue for opposite policies, and the next few weeks will decide which one it believes.

A labour market losing pace

The jobs report was weak almost everywhere a reader looked. July, first reported as a gain, now shows a loss of 10,000 jobs. August was cut to 133,000 from 162,000. Health care, which has carried hiring for two years, added 17,000 jobs, about half its 12-month average of 33,000. Financial firms shed 7,000. Construction and manufacturing added 11,000 and 9,000.

Pay told the same story. Average hourly earnings rose by 0.1 per cent in September, to $37.81, and by 3.0 per cent over the year. That is the slowest annual rate since May 2021. Wages growing at 3 per cent are hard to square with an inflation problem driven by workers bargaining for more.

There was one caveat. The rise in unemployment came partly from people joining the workforce. The labour force grew by 485,000 and participation rose to 61.8 per cent from 61.6 per cent. Household employment, a separate survey, rose by 406,000. A jobless rate that climbs because more people are looking for work is less alarming than one driven by lay-offs.

Services that keep charging more

Monday's survey of service businesses did not look like an economy heading for trouble. The headline index slipped to 54.9 from 55.4, slightly below forecasts but comfortably above 50, the line between expansion and contraction. It was the sector's 27th consecutive month of growth. New orders were 59.8. The employment index rose to 50.1 from 47.8, back into positive territory, which sits awkwardly beside Friday's payroll figure.

The prices index is the number that matters for the Fed. At 74.0, up from 72.6, it says a large majority of service firms are paying more for what they buy. Respondents named fuel as their most common problem, with tariffs and supply constraints also pushing up costs and delivery times. Supplier deliveries slowed, with that index rising to 53.2 from 51.3.

Two mandates pulling apart

The Fed is told to pursue both maximum employment and stable prices. Usually the two move together: a hot economy produces both strong hiring and rising inflation, so one policy serves both goals. What the past week showed is the less comfortable case, in which hiring weakens while costs keep climbing. That is the pattern of a supply shock, and oil above $100 a barrel this autumn is a textbook example.

Raising rates does nothing to the price of crude. What it can do is slow demand enough that firms find it harder to pass higher costs on to customers, and stop rising prices from feeding into expectations and wage claims. The cost is paid in jobs, which is why a central bank facing a supply shock with a softening labour market is reluctant to act. Friday's report made that cost more visible.

The rate is already 3.75 to 4.00 per cent after September's rise. Olu Sonola of Fitch Ratings said the combination of weak job growth, a slightly higher unemployment rate and contained wage gains argued against another increase in October. Traders agreed, but only up to a point: markets still put the chance of a rise at the December meeting at about 78 per cent. The weak report moved a hike back by a meeting rather than removing it.

What the bond market believes

Long-term Treasury yields were the clearest sign that investors see the jobs report as a pause, not a turn. The 10-year yield had risen above 5.34 per cent earlier in the week, its highest since 2002. After the report it fell by about 7 basis points, to roughly 5.18 per cent, as oil slipped below $100 a barrel. By the afternoon much of that fall had been reversed as crude recovered.

That reaction says the market is more worried about inflation and heavy government borrowing than about a weakening labour market. A bond investor who expected slower hiring to bring down inflation would have bought long-dated debt on Friday and held it. Few did.

What to watch

Wednesday brings the minutes of the Fed's September meeting, which will show how many officials were already worried about hiring when they voted to raise rates. September's consumer price figures follow later in the month. If service-sector costs show up in core inflation, the soft jobs report will look like a pause before a December rise. If they do not, the Fed may decide that a labour market adding 29,000 jobs a month needs no further squeezing.

Either way, the past week has narrowed the Fed's room. It cannot claim that the labour market is too strong to worry about, and it cannot claim that inflation is under control. It will have to choose which risk to take.