Jobless rate expected to tick higher in November

WASHINGTON (MarketWatch) -- The weakening data could soon force the Federal Reserve to change its tune and acknowledge that an economic slump is as big a risk as a sustained breakout in inflation.

"The mounting evidence that growth has slowed further in the fourth quarter is bolstering the case that the next Fed move will be a rate cut -- perhaps as early as the first quarter," wrote Nigel Gault, chief U.S. economist for Global Insight, in his weekly note to clients.

The data in the coming week could move the Fed closer to shifting its rhetoric, if not its policy. An expected increase in the unemployment rate, and a significant downward revision to labor costs could reduce the Fed's worries that the economy is actually overheating, despite all the signs of cooling.

On Friday, the unemployment rate is expected to tick higher to 4.5% amid another month of sluggish job growth. Meanwhile, a key source of inflationary pressures -- unit labor costs -- could look a lot more favorable after revisions to the quarterly productivity data on Tuesday. See economic Calendar.

"The second straight month of sub-par job gains will be another small step towards Fed easing in 2007," wrote Avery Shenfeld, an economist for CIBC World Markets, in a weekly note to clients.

What the Fed needs

If the Fed is to shift its tone, it'll need more support from the economic data. One of the necessary conditions for a switch to a more neutral policy stance is already in place with the news Friday that the Institute for Supply Management's index fell below 50% in November, signaling no growth in the factory sector.

The Fed, of course, doesn't change course on the basis on one-month decline in one indicator.

"One number does not a trend make, and you always have to be careful about reading too much into one month's number," said Philadelphia Fed President Charles Plosser after the ISM report.

Before cutting rates, economists said, the Fed would also like to see declining core inflation and a rising unemployment rate. There could be news on both in the coming week.

Late Friday Federal Reserve Vice-Chairman Donald Kohn said difficulties in gauging the economy are "especially pronounced" at the present. See related story.

"The key to a change in the Fed's assessment of the balance of risks lies in continued deceleration in core inflation and evidence that the labor market is moderating," said Peter Kretzmer, an economist for Bank of America, in his weekly research note.

By some measures, core inflation has already begun to come down, although the evidence is tentative. The core personal consumption expenditure price index hit 2.5% year-over-year in August and has declined slightly each of the past two months. At 2.4%, it's still uncomfortably higher than the Fed's informal 2% cap.

The unemployment rate sits at a cyclical low of 4.4%, mocking anyone who suggests that the economy is weak. However, the unemployment rate is a lagging indicator, which means it's of no value in telling us where the economy is heading. Just before the 2001 recession, the jobless rate was at near a cyclical low of 3.9% when the Fed made its first emergency 50-basis rate cut.

And in that same episode, the core inflation rate didn't peak until the last month of the recession.

Clearly, the Fed hasn't let either a low unemployment rate or a still-rising core inflation rate deter it from easing policy if it decides it needs to.

Jobs report

Nonfarm payrolls are expected to rise about 110,000 for November after a 92,000 gain in October, according to a survey of economists conducted by MarketWatch.

At the high end are forecasters such as Brian Jones of Citigroup Global Markets, who sees payroll gains of about 140,000 along with an upward revision to October to about 150,000. Jones is counting on hiring in the services and fewer layoffs in construction and manufacturing.

"Labor market conditions remain tight," said Dean Maki, economist for Barclays Capital, in his weekly research note. He does expect the jobless rate to rise to 4.5% from 4.4%, as October's two-tenths drop was "overdone."

"A soft economy, particularly in the key cyclical industries, has to, at some point, start to take its toll on hiring," Shenfeld said. Shenfeld argued that construction layoffs should accelerate as builders complete the homes started during the more optimistic summer months.

Global Insight economist Gault says job growth will be "sluggish," at about 90,000.

Average hourly earnings are expected to rise 0.3%, compared with 0.4% in October, which would push the year-over-year gain to a cyclical high of 4.2%, noted Drew Matus, an economist for Lehman Bros.

Productivity

Productivity and unit labor costs are expected to look much more favorable following last week's revisions to income and gross domestic product.

For the third quarter, productivity growth is expected to be revised to 0.4% from 0% earlier. Unit labor costs - a big concern to inflation hawks at the Fed who fear the tight labor markets will translate into a burst of inflation - should settle down to 3.3% from 3.8%. See full story on the productivity revisions.

The revisions in the second quarter will likely reduce the year-over-year increases in unit labor costs to about 3.6% from 5.3% earlier.