The Fed's long-awaited rate cuts will open up the job market — but it could take a while

The spiking unemployment rate will rise further before improving, but rate cuts will work eventually, experts say.

• Unemployment is currently at its highest level since 2021 amid corporate cost-cutting efforts.
• Fed rate cuts could help drag the job market out of its ongoing slowdown.
• But experts told BI the cuts work with a lag, meaning labor-market relief won't come for a while.

The US job market has certainly seen better days.

After a red-hot hiring boom during the pandemic, labor conditions have steadily weakened, with a trifecta of bearish signals flashing for US workers in the last week.

Over the course of two days, jobless claims spiked to their highest level in nearly a year. The economy also added fewer jobs than expected, with payrolls missing July forecasts by 61,000. Meanwhile, unemployment saw a surprise surge to 4.3%, triggering a highly accurate indicator that could suggest the economy is on its way to a recession.

The streak of weak data drastically altered forecasts for rate cuts. Mere days ago, consensus was for a 25-basis-point move at the September Fed meeting. Now, a majority of investors are pricing in a 50-basis-point reduction, while some now expecting an accelerated pace of decline.

Those rate cuts will help pull the job market out of its slowdown — but likely not before the unemployment rate climbs higher, says Oliver Allen, a senior US economist at Pantheon Macroeconomics.

Higher borrowing costs in the economy are one of the main reasons why hiring weakened over the past year, Allen told Business Insider in an interview. Central bankers raised rates a whopping 525 basis points to lower inflation, a move that's raised debt-servicing costs for businesses and cut into profit margins, Allen said.

"We saw this really big blowout in margins for wholesalers, retailers, manufacturers," Allen told Business Insider in an interview. "That's what's really driving that pressure, and the easiest thing for them to do in the short-term to counter that is to cut back on hiring … potentially lay some people off as well."

The net profit margin of S&P 500 firms slumped to its lowest level in three years at the end of 2023, according to an analysis from FactSet. Around the same time, job cut announcements spiked 136%, data from Challenger, Gray & Christian showed.

Fed cuts are expected to relieve borrowing-cost pressure, which will alleviate some of the pressure to slash workers.

But there's a problem: the Fed isn't cutting rates until at least September, when their next policy meeting is scheduled. And even then, it could take time for the effects of rate cuts to fully work their way across the job market, said Mark Hamrick, a senior economic analyst at Bankrate.

"If you think about what the Federal Reserve does with monetary policy being analogous to medicine, this is not medicine that hits the bloodstream immediately," Hamrick told BI. "It's going to take quite some time for that adjustment to have a noticeable positive impact."

Allen added: "The thing that often gets lost in the discourse around monetary policy is just how long the lags are. We think that the Fed really should be cutting already."

Slowdown in the pipeline

Until rate cuts kick in, Allen thinks the joblessness rate has even more room to climb. He's forecasting an increase to 4.5% by year-end with the rate peaking around 5.5% by the end of next year.

Their predictions of higher unemployment are in line with what some other experts have forecasted. Renowned economist David Rosenberg told BI he sees the unemployment rate hitting 5% by the end of the year, as debt-straddled firms struggle to pay their dues.

At this point, rate cuts would only "make a small dent in the problem," Allen said, referring to the lagged impact of monetary policy on the labor market.

"A lot of that weakening in the job market I think is in the pipeline because of the impact of the rates, which is already working its way through the system," he added.

Forward-looking indicators of job market strength have also been flashing signs of incoming weakness. In July, hiring slumped to its slowest pace since 2012, Challenger data shows, while small business hiring intentions remain near their lowest level since the pandemic, per the National Federation of Independent Business.

Meanwhile, 11% of business owners say labor costs are their "top business problem," according to the NFIB's most recent Small Business Optimism Index.

The latest data suggest steeper-than-expected rate cuts could be in order, the two policy experts said.

"I think that the story really is, basically, by the time we get to the end of this year, inflation is normalized, and the market has weakened quite considerably," Allen said. "I think that's going to be clear as day and the Fed's going to potentially move quite quickly Q3, Q4."

Investors have already started adjusting their forecasts in preparation for deeper and sooner cuts than have already been signal.

"A key question is whether it is a bigger cut than previously thought," Hamrick said in a note on Friday. "Another will be whether the central bank should have cut rates in July when it opted to keep them steady."