U.S. payrolls: one for the doves, but we still expect a June rate hike

The May nonfarm payrolls report was one for the doves, although it wasn't sufficiently weak enough to cause the U.S. Federal Reserve (Fed) to take its foot off the gas pedal: We still expect an interest-rate hike later this month.

However, if the trends we saw in the May report continue, the Fed might be inclined to pause its rate hikes in September.

The U.S. Bureau of Labor Statistics announced that 138,000 new jobs were added in May, after revising down the number of jobs added in April. Average hourly earnings were par for the course over the past year, growing by 2.5% year over year and 0.2% month over month. The unemployment rate ticked down to 4.3%—the lowest figure we've seen since 2001—but that's largely because people dropped out of the workforce, with the labor force participation rate falling from 62.9% to 62.7%.

We don't view the nonfarm payrolls headline number as a concern. The three-month average for jobs is down to 121,000, which is roughly what would be expected after so many years of economic expansion. We only needed to add 80,000 jobs to our economy to meet the demand of new entrants.

Some of the weakness in the headline figure was seasonal. The May report had an early survey week, so it didn't incorporate some of the pickup in summer hiring that may have been included if the survey had been a little later.

Digging into the details, there are some worrying signs. Most of the jobs being added continue to be in low-wage, low-hour sectors, such as education, healthcare, leisure and hospitality, and transportation. Meanwhile, goods-producing jobs, such as those in manufacturing—higher-wage and higher-hour positions—shed workers this month.

If most jobs added are in low-wage, low-hour sectors, it's no wonder that wage growth is decidedly uninspiring. While average hourly earnings were only up 2.5% this year, that's still about 1% above inflation, so at least real, or inflation-adjusted, wages grew in May after being generally stagnant previously. That should provide a moderate boost to the consumer.

Finally, the labor force participation rate ticked down in May. While this is certainly in line with a much longer trend of a falling labor force participation rate owing to demographics, there's no clear trend for the year. It isn't enough to panic over, although it's the main reason unemployment fell in May.

With the unemployment rate falling even further below the Fed's estimate of full employment, the Fed faces a bit of a conundrum. The labor market continues to tighten, but inflation has been softer, with core personal consumption expenditure growth—the Fed's favorite measure—of only 1.6% in March. In our view, this jobs report does nothing to shift the Fed's thinking in June, and we expect a rate hike at the next FOMC meeting.

But if the inflation and jobs data continues to play out the way it has recently, the Fed might hold off on hiking rates again in September. We expect the Fed to announce a plan to start shrinking its balance sheet toward the end of this year, and U.S. financial conditions should tighten as a result. A rate hike in December is therefore more difficult for the Fed to pull off without tightening financial conditions more than intended. We still expect three rate hikes from the Fed for 2017, but the jobs report today suggests that the risk that there may be only two rate hikes has increased.