It has been an important week for central bankers, given the Bank of Japan’s (BoJ’s) and Federal Reserve’s (Fed’s) deliberations on monetary policy. As most observers are aware, the Fed has a statutory mandate to maximize employment, stabilize inflation, and maintain moderate long-term interest rates.

The hawkish camp—consisting of those who see inflation and advocate measures to stave it off—points to the tightness of the labor market and associated compensation costs as key arguments for a Fed rate hike this year. However, our research suggests that the macro backdrop is softening, and the U.S. economy isn’t robust enough to withstand further monetary policy tightening.

Cyclical Indicators Point to a Softer U.S. Economy

In Exhibit 1, we showcase our smoothed composite of the Institute for Supply Management’s (ISM’s) Non-Manufacturing and Manufacturing Employment Indices (see the green line on the left axis), weighted by the services (84%) and goods (16%) shares of private employment. We juxtapose this composite against the year-over-year percentage change in private payrolls (see the black line on the right axis) since 1998.

As shown, non-government employment growth has been slowing since early 2015, led by goods-producing industries. Looking ahead, our private employment composite suggests that this trend will continue in the coming months.

U.S. Employment, Federal Reserve, U.S. Stocks

Why did we assign different weights to the ISM Non-Manufacturing and Manufacturing Employment Indices? Exhibit 2 illustrates the Great Moderation and post-World War II transformation of the U.S. economy. As a group, goods-producing industries—which include manufacturing, mining & logging, and construction—are much smaller than they were more than 70 years ago. Meanwhile, services-providing industries have grown much bigger.

Using the shifting mix of job creation as a proxy, the goods sector has shrunken from a peak of 44.1% of total nonfarm payrolls in March 1943 to a current trough of 13.6% in August 2016. However, the services sector has ballooned from its low of 41.2% to its present high of 71.1% in the same time frame.

U.S. Employment, Federal Reserve, U.S. Stocks

Despite the hollowing-out of the old economy, it remains a marginal swing factor for growth. In an economic soft patch like the one we’re currently experiencing, the downside volatility of goods-producing industries can be a disadvantage for overall growth and jobs. In contrast, services are generally more stable and resilient when the economy decelerates, a quality that’s helping to keep growth in positive territory at this maturing stage of the business cycle.

In our view, U.S. growth is quite modest and the economy isn’t strong enough for the Fed to raise policy rates. In Exhibit 3, we display the year-over-year percentage change in total nonfarm payrolls (see the green line on the left axis) versus the year-over-year change in the effective federal funds rate (see the black line on the right axis) since 1990. Given the ongoing deceleration of payroll growth, we think it’s unlikely that the U.S. central bank will restrict monetary policy settings in 2016.

U.S. Employment, Federal Reserve, U.S. Stocks

U.S. Dollar Weakness Could Boost the Economic Outlook and Stocks

The bottom line is that it’s difficult to be the only developed country raising interest rates when other major central banks around the world are still easing, and inflation remains below-target. The Fed wants to raise rates, but will have a tough time escaping the strong downward pull of planetary economic gravity.

If we’re right, a Fed that refrains from hiking rates in the foreseeable future would translate into a stable or slightly weaker U.S. dollar, which could give the economy and stock market a lift via exports, corporate revenues, and earnings.

Stay tuned.

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