Closely watch Friday's nonfarm payrolls; a key factor for a Fed rate cut in January: unemployment rate rises to 4.7%.

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The non-farm payroll report to be released this Friday has become the key variable in determining the Fed's short-term policy path. According to the latest report released by Citi Research's Andrew Hollenhorst team on Monday, if the U.S. unemployment rate rises to 4.7% in December as expected, the Fed is very likely to continue lowering the policy rate by 25 basis points this month.

Although Fed officials have recently signaled that they are "not in a hurry" to further cut rates, the continued weakness in the labor market is changing this expectation. Citi believes that, following the softness in the November data, further loosening in the labor market will force policymakers to reassess their stance. If the unemployment rate continues to rise, cutting rates to support the economy will become the inevitable choice.

Currently, the market is pricing in only 60 basis points of rate cuts for the entire year of 2026, which may underestimate the potential for policy easing. Analysts believe that balancing the risks of a weakening labor market and easing inflation, the baseline prediction for actual rate cuts this year is 75 basis points, with the possibility of exceeding 100 basis points not ruled out.

As Friday's data approaches, investors need to closely watch for specific signs of a cooling labor market, as these will directly determine whether the Fed will continue the rate cut pace since 2024.

Signs of Labor Market Loosening

Analysts point out in the report that the upcoming December employment report follows November data that showed continued loosening of the labor market. Citi's base case scenario assumes the unemployment rate will rise to 4.7%, continuing the previous upward trend, which will be a key variable for maintaining the Fed's rate cut channel.

In terms of nonfarm payrolls, Citi expects an increase of 75,000. Analysts specifically noted that Fed Chair Powell previously explained that, considering a revision down of 60,000, this level of growth essentially means employment growth has nearly stalled. Moreover, Indeed’s job posting index is generally trending downward, and although initial jobless claims fluctuate, they remain at a low level overall. These indicators together depict a cooling job market.

Policy Path and Rate Cut Expectations

Looking back at the policy path, the Fed cut rates by 100 basis points in 2024, then paused, and cut another 75 basis points in 2025. At present, though officials reiterate there is no urgency for further rate cuts, Powell has defined the current policy rate as being at "the upper end of the neutral range," which suggests room for further cuts.

The report argues that, based on the experience of the past two years, once the labor market shows obvious further weakening, the Fed will resume rate cuts. Although the meeting-by-meeting decision model makes the exact rate cut path highly data-dependent and difficult to predict, the overall trend points to easing. Beyond the volatility of monthly data, over the past two years unemployment has shown an uptrend, coupled with easing service sector inflation (especially in housing), providing a macro foundation for rate cuts.

Macro Environment Supports Deeper Rate Cuts

Besides employment data, other macro indicators also support a dovish stance. Oil prices have mainly remained below $65 per barrel, helping to ease inflationary pressure. Meanwhile, though the December ISM manufacturing index may see a slight improvement, it is still expected to remain in contraction territory.

Citi analysts note that, for 2026, the overall risk balance leans toward labor market weakness and further easing of inflation. Compared to the market's priced-in expectation of only 50 basis points or less in rate cuts, the likelihood of the Fed implementing more than 60 basis points of cuts is much higher. If unemployment data confirms the assessment of labor market loosening, the yield curve may steepen further.

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