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Why a 'weakening economy' will stop Fed from raising rates

Aaron Task
Editor in Chief

The Federal Reserve is facing new kind of conundrum: The U.S. economy is slowing even as labor costs are rising.

Consistent with the minuscule first-quarter GDP growth already reported, the government on Wednesday said Q1 productivity fell 1.9% on annualized basis -- marking the first back-to-back quarterly decline in productivity since 1993. In the same report, unit labor costs rose 5%, the most since the first quarter of 2014 and the latest sign of what the Fed called "modest upward pressure on wages" in last month's Beige Book report. Meanwhile, ADP reported private sector payrolls rose just 169,000 last month, the lowest since January 2014 and the fourth-straight month of weaker-than-expected growth.

The latest reports aren't making life any easier on Fed Chair Janet Yellen and the FOMC.  While "further improvement" in both growth and the labor market remain elusive, a rebound in oil prices, rising wages and the recent backup in bond yields could mark the early stirrings of higher inflation expectations, if not actual inflation.

But don't expect a Fed rate hike in June or September -- or anytime in 2015 for that matter, says Sri Thiruvadanthai, director of research at the Jerome Levy Forecasting Center. "The Fed is not going to be able to raise rates" this year, he says. "Underneath all the distortions, the economy is weakening."

While the first-quarter tally for corporate profits isn't in quite yet, "we have enough pieces to figure out profits are weak [and] starting to erode," Thiruvadanthai says. Along with the reversal of investment in the U.S. energy sector, a weak global economy and (until recently) a rising dollar are all putting a crimp on U.S. growth. "Hiring is already showing signs of tiring," he says, but it's "too early to say it's conclusive given the noise in the data."

Speaking of noise, Thiruvadanthai describes Friday's jobs report as "a big wildcard," citing the potential for upward revisions to the March data or a big snapback in April. The consensus forecast is for payroll growth of 240,000 but Thiruvadanthai declined to give a prediction: "I don't believe in making a forecast on something so flaky."

Either way, he says "it could be a doozy," which is pretty much the one thing you can count on when it comes to the jobs report.

Aaron Task is Editor-at-Large of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at atask@yahoo-inc.com.