As some state and local governments grapple with dwindling income tax receipts, unemployment figures - due Friday - will weigh heavily on the Fed's decision making on interest rates at next week's meeting, and for the remainder of the year. The decline in income tax receipts can be partly attributed to the weakened labor sector, market observers and participants said yesterday.
Analysts expect the economy to shed an additional 72,000 non-farm payroll jobs in Friday's report and for the household unemployment rate to increase to 5.6% in July, according to the median estimate by IFR Markets. It would be the seventh consecutive monthly decline for non-farm payrolls. Observers also expect the Federal Reserve to hold the federal funds rate steady at 2.0%.
The labor sector's continuing weakness or a surprise resurgence in jobs would have a greater impact on the Fed's interest rate decisions than inflation concerns, economists said.
"Employment is the key indicator for the Fed right now, especially if labor costs remain the same," said John Lonski, chief economist with Moody's Investors Service. The cost of labor traditionally spells higher inflation, but the rise in headline inflation in today's economy is spurred by energy and commodity prices, Lonski said.
Most state legislatures are required by law to balance their budgets. With declining tax revenues, states are cutting spending to close the revenue gap. The National Conference of State Legislatures last week released a report for fiscal 2008 that said taxes receipts have declined in most states, except in strong energy producers like Alaska.
Some states have made layoffs or hiring freezes to balance their budgets. Four states will layoff about 6,000 government workers, while nine others initiated hiring freezes in to balance their budgets, the report said.
"I'm sure all these state treasurers are watching the economic data very closely," said Chris Mier, a municipal strategist for Loop Capital Markets LLC in Chicago. The eroding labor base affects sales in addition to income taxes as consumers rein in spending, he said. Individual income and sales taxes account for about two-thirds of states' revenue according to the NCSL report.
The municipal bond market traditionally follows Treasury bonds after a major economic report is released or interest rate announcement. If the labor report is weak as expected, the news will push Treasury prices higher and the municipal market should follow, Mier said.
As unemployment weakens state tax revenues, a state's credit rating can be put at risk. A sudden, steep drop in employment could affect a state's credit rating and ability to issue general obligation bonds. Rating agencies account for the impact unemployment has on a state's revenue, but it is only one of several factors that determine a credit score, said Edith Behr, a senior credit analyst with Moody's.
Nine states have triple-A ratings from Standard & Poor's and Moody's, and just one, Utah, was among the 10 lowest unemployment states, which suggests that there is not a strong link between a state's rating and its unemployment rate.
The Fed is unlikely to make strong policy statements in the release that accompanies its interest rate decision.
"I think the outlook is so uncertain that they don't want to portray a sense of balanced risks," said James Glassman, senior economist with JP Morgan Chase & Co.
While oil prices continue to pressure the economy, Glassman said the Fed has been proven right that a weaker economy will reduce demand, and therefore the price of oil, reducing headline inflation.
"The policy statement will probably be a textbook exercise in jawboning," Lonski said, as the Fed talks tough on inflation without increasing interest rates.
Most economists do not expect the Fed to change rates before the presidential elections in November. However, the federal funds futures market is priced for a rate increase when the Fed meets on Oct. 29, which Lonski called a case of the market's "wishful thinking."
