The Fed’s Margin for Error Is Shrinking

• January delivered just 130,000 new hires.

• A normal January adds closer to 201,000.

• When the year opens this soft, the annual data usually follows.

Sometimes the year reveals its direction early, and this one isn’t wasting any time…

This year is already off to a weak start from an employment standpoint. As I observed last week, payroll processor ADP’s monthly employment metrics showed a gain of just 22,000 jobs, far below the average January gain of 204,000 since 2011. In five of the six prior instances when this same setup took place, the monthly hiring average for the year ended up below trend…

At the time I noted that the indicators I track never hinted at a rebound. They pointed to a labor market that is still soft. Yesterday’s hiring number from the U.S. Bureau of Labor Statistics (“BLS”) fit the script: better than feared, but not the kind of strength you’d expect if the economy were gearing up for a healthier year of job creation.

That’s the real tell. January is typically one of the most reliable months for forecasting job growth. When the first month comes in weak, the rest of the year rarely catches up. ADP’s figures already flashed the warning, and the BLS data confirmed it. And that’s where policy enters the picture.

If 2026 follows the same path, it could signal softer economic growth. And as several Federal Reserve policymakers reminded us last year, waiting too long to adjust course risks forcing more drastic action down the road. Today’s data isn’t just a weak opening chapter, it’s a preview of the policy response likely to follow. A labor market that can’t regain altitude only sharpens the case for more cuts. That should support a steady rally in the S&P 500 Index.

But don’t take my word for it, let’s look at what the data’s telling us...

Yesterday, the BLS released its hiring data for January. The preliminary estimate showed companies added 130,000 new employees. While that was much better than Wall Street’s estimate for a gain of 66,000, it was still well below the typical January monthly increase of 201,000…

The numbers haven’t been this weak to start back-to-back years since 2010-11. Back then the Fed had cut interest rates to zero. Furthermore, it was significantly increasing its balance sheet in order to maintain low borrowing costs. That way, it could support hiring, borrowing, and spending. All of those metrics helped the economy recover from the financial crisis.

Granted, we’re nowhere near a financial crisis today economically. But we want to ensure that doesn’t happen either. So, an ounce of prevention now is far better than waiting until there’s a bigger problem.

As I’ve been arguing, these signals matter because they shape how the Federal Reserve responds. Policymakers keep saying they want to let the recent rate cuts work through the system. Historically they feel it takes six to eight months for policy changes to work their way through the economy. But a softening labor backdrop shortens that patience. The Fed can’t sit on its hands if the data keeps bending. Acting earlier usually means they don’t have to act aggressively later.

One way to gauge how much room the Fed has to support growth is by looking at the real policy rate or the effective federal funds rate minus inflation. Positive means policy is leaning against price growth; negative means it’s adding fuel. By that measure, the Fed still has meaningful space to ease…

In January, the effective funds rate sat near 3.6% while inflation was running around 2.7%. Subtract one from the other and you get roughly 90 basis points of room before policy hits “neutral,” where rates neither help nor hinder the economy. And because the Fed has managed the real rate to an average of -0.6% since 2000, the true cushion is closer to 150 basis points.

Bottom line: the labor data keeps strengthening the case for more support, but the Fed needs confirmation from the inflation side before it moves. If tomorrow’s Consumer Price Index print lines up with the trend I’m seeing, Wall Street will grow more confident in its expectation for two to three additional cuts by year‑end. With plenty of room to ease through 2027, lower rates should reduce borrowing costs, free up cash, and support economic growth. That backdrop would help underpin a steady rally in the S&P 500.

Five Stories Moving the Market:

Cisco Systems reported quarterly adjusted gross margin below Wall Street’s expectations, as the networking equipment provider grapples with the fallout of a global memory price increase; second quarter adjusted gross margin were 67.5% compared to the 68.14% estimate – Reuters. (Why you should care – the company raised its 2026 sales forecast, while saying it has already adjusted prices for the cost increase)

Japanese Vice Finance Minister for International Affairs Atsushi Mimura said the government remains on high alert over foreign exchange movements in a week that’s seen gains in the Japanese currency; he said the government will continue to monitor market developments with a high sense of urgency – Bloomberg. (Why you should care – the Japanese government is likely trying to talk up the yen without having to intervene in currency markets)

The Pentagon has told a second aircraft carrier strike group to prepare to deploy to the Middle East as the U.S. military readies for a potential attack on Iran; the carrier would join aircraft carrier USS Abraham Lincoln that is already in the region – WSJ. (Why you should care – deployment of another U.S. aircraft carrier to the region could be a signal Iranian nuclear negotiations aren’t progressing as the White House had hoped)

The U.S. government posted a $95 billion budget deficit in January, down 26% from a year earlier as revenue gains including customs duties outpaced growth in outlays, according to the Treasury Department; it said the January deficit would have been $30 billion, or a decline of 63% when adjusting for routine calendar shifts and other factors – Reuters. (Why you should care – shrinking deficits should ease borrowing needs and weigh on Treasury yields)

Federal Reserve Bank of Kansas City President Jeffrey Schmid said the U.S. central bank should hold rates at a “somewhat restrictive” level, as he expressed continued concerns over inflation that remains too high – Bloomberg. (Why you should care – Schmid’s comments hold less weight this year as he is no longer a voting FOMC member)

Economic Calendar:

Earnings – ABNB, AEP, AMAT, ANET, BUD, COIN, EXC, EXPE, IR, PCG, QSR, UL, VRTX

Japan – PPI for January

Japan – Machine Tool Orders for January

U.K. – GDP for Q4 (2:00 a.m.)

U.K. – Industrial, Manufacturing Production for December (2:00 a.m.)

U.K. – Exports, Imports for December (2:00 a.m.)

U.S. - Initial Jobless Claims (8:30 a.m.)

U.S. - Continuing Claims (8:30 a.m.)

U.S. – Existing Home Sales for January (10:00 a.m.)

Treasury Auctions $25 Billion in 30-Year Bonds (1 p.m.)

ECB’s Nagel (Germany) Speaks (2:30 p.m.)

Fed's Balance Sheet Update (4:30 p.m.)

Fed’s Logan (Dallas, Voter) Speaks (7:00 p.m.)