By Orphe Divounguy
The Center Square

The August jobs report delivered a shocking blow, revealing an economy teetering on the edge of a jobs recession. Just 22,000 jobs were added in August, while massive revisions showed employment actually fell in June – the first decline since December 2020, in the middle of the pandemic.

The numbers paint a dire picture: only 107,000 jobs created since April across the entire economy. That’s stagnation territory by any measure. Even more concerning, nearly 800,000 people have left the workforce on net since April, masking what would otherwise be a much higher unemployment rate.

What’s Really Happening: Supply Meets Demand Destruction

The unemployment rate’s apparent stability at 4.2% is misleading. Without the massive exodus from the labor force, unemployment would likely be approaching 4.5% already. These structural forces are reshaping the labor market:

Labor force is shrinking (supply constraint partly due to immigration restrictions)Job growth has structurally shifted lower (from 160-170k monthly last year to near-zero now)

The Fed’s Narrowing Window

Financial markets are now expecting the terminal rate in the 2.75%-3% range. An unemployment-adjusted Taylor Rule suggests the Fed funds rate should be in the 3.5-3.75% range – that’s 75 to 100 basis points of cuts from current levels. However, perhaps we won’t see as many rate cuts if the natural rate of unemployment – the lowest unemployment rate that can be sustained without accelerating inflation – has also risen due to structural changes in labor supply.

But tariffs complicate the analysis. Here’s why:

The Tariff Shock Reality

PCE inflation sits at 2.6%, well above the Fed’s 2% target. Core inflation was 2.9% in July. Inflation has been accelerating since April. While tariffs are expected to put upward pressure on prices in the near term, research shows that even temporary tariff hikes permanently reduce economic activity. A tariff shock that raises the average tariff rate by 0.5 percentage points lowers real GDP by roughly 1 percentage point for a year or two before a recovery. Although inflation is expected to increase temporarily, it could fall below its average level for several years.

The effective tariff rate shot up by roughly 6 percentage points – enough to send the U.S. economy into recession territory. Preventing a contraction in economic activity is why the Fed has to lower the fed funds rate despite the current inflation readings.

Key Data This Week: CPI Takes Center Stage

This week’s main event will be the Consumer Price Index – the first look at inflation for the month of August. CPI increased 0.2% in July, down slightly from 0.3% in June, rising to 2.7% on a year-over-year basis. This is up significantly from 2.3% in April. Economists expect the CPI to rise 0.3% in August on a monthly basis and move up to 2.9% year-over-year.

The good news is that persistent downward pressure coming from housing prices and rents at the start of this year will keep the uptick in core CPI somewhat subdued. Rent growth measured by the Zillow Observed Rent Index – which predicts movements in the ‘rent of primary residence’ measure of housing inflation by roughly 6 months – was more subdued than usual this spring and is now decelerating further.

Bottom Line: Multiple Rate Cuts Coming

The employment data is so weak that the Fed has no choice but to resume its easing cycle, starting with 25 basis points in September. The Taylor Rule math suggests 75-100 basis points of cuts are warranted immediately.

But this won’t be a normal easing cycle. The Fed is cutting into an inflationary headwind, not a deflationary tailwind. Expect increased volatility in both bonds and equities as markets struggle to price this unprecedented combination of weakening employment and rising prices.