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Despite jobs bombshell, Fed could still hike rates in July

“June just doesn’t seem at all possible in the context of this report,” says one chief economist, who then added, “It just feels very flukey. I don’t know if I would read anything into it at all.”

There's next to no chance the Federal Reserve will raise rates this month after Friday's shockingly weak jobs report for May, but strategists say the central bank could still find a way to hike in July if other economic data shows that the U.S. economy is not toppling over.

The 38,000 nonfarm payrolls reported for May and the dramatic 59,000 downward revisions to March and April jobs, plus a series of miserable elements, like a 0.2 point drop in the participation rate, all raise warning flags.

Economists had expected 164,000 nonfarm payrolls and had included an estimated decrease of about 35,000 striking Verizon workers. But the number was worse all around, aside from the 0.2 percent increase in average hourly wages which was as expected.

May's job creation was the smallest in more than 5½ years, and the three-month average, with revisions, is now 116,000, about half the rate of late last year. The report found a reduction of 34,000 information workers, which would reflect telecommunications workers. Goods producing jobs declined by 36,000, while construction fell by 15,000 and manufacturing was off by 10,000.

"June just doesn't seem at all possible in the context of this report. It just feels very flukey. I don't know if I would read anything into it at all. Job growth has slowed since the beginning of the year but no other data suggests that it would fall to this extent," said Mark Zandi, chief economist at Moody's Analytics. "You can't dismiss it. It's an important report, but there are times when the data, for whatever reason, are not representative of the reality of what's going on."

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Economists said the weak May data could mean there would be a bounce back in June. But on a negative note, May ISM nonmanufacturing data, which measures the service economy, fell Friday to 52.9, below expectations and a 28-month low. The jobs component of that number fell to 49.7, showing contraction and well below the 53 in April.

"When you take the entire report as a whole I get two main messages," said Luke Tilley, chief economist at Wilmington Trust. "One is that Verizon is throwing off a lot of the numbers here, but there is also structural weakness when we look at construction, manufacturing and wholesale trade."

Goldman Sachs economists said in a note Friday that there's now zero chance of a June rate hike, but still a 40 percent chance the Fed could raise rates in July. "Although the report lowers the odds of near-term action, in our view, it also arguably raises the range of possible outcomes. If employment growth rebounds next month but the unemployment rate remains low, the case for hiking after June would become quite strong," they wrote.

The unemployment rate fell in May to 4.7 percent from 5 percent, in large part due to drop in labor force participation.

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Economists pointed to other positive anecdotes in employment-related data, like unemployment claims, which fell to a low 267,000 Thursday. The latest Challenger layoff data also showed a drop of 30,157 job cuts in May, for the lowest monthly total since December.

The latest job openings data from the government also showed that the level of openings rose by 149,000 in March to an eight-month high, while 2.98 million Americans quit their jobs, a sign of confidence in the job market. Finally, ADP's private sector hiring data this week also showed a solid gain of 173,000 jobs in May.

The weak jobs report, however, will carry weight with the Fed.

"This gives them room to wait until the July meeting even though I believe you'll end up seeing underlying wage pressure," said Tilley.

Average hourly wage gains of 0.2 percent, or 2.5 percent annualized, were as expected for May, even with the elimination of so many telecommunications workers. April's gains were revised higher to a surprising 0.4 percent.

There were only five occasions where the average hourly wage gains were higher in the past 10 years. One of those was in January, when wage gains were up a 0.5 percent. The other occurrences were in 2008 or earlier.

Tilley noted that it may be that the wage gains would have been higher if not for the Verizon strike so wage gains could be higher still in June when those workers return. He noted that wages of workers in the information sector, which includes telecommunications, are among the highest in the country — at $36.59 per hour. That compares with an overall $25.59 per hour.

"It's a disappointing jobs report with regards to net hiring," said Tilley. He said it needs to be put in context of the still high level of hiring in the Job Openings and Labor Turnover Summary report and the fact that a number of Fed regions are reporting labor tightness.

"If it's that companies saw something that gave them pause, we would have seen it in the JOLTS data. The JOLTS data for April is reported Wednesday.

JPMorgan economists said they are still sticking with their call for a July rate hike for now even though they note the slowdown in job growth raises questions about the durability of gains in unemployment and wages.

"The simplest explanation is that job growth tends to respond with a lag to GDP growth, and GDP growth was rather weak around the turn of the year. This would suggest job growth should recover along with overall growth in economic activity, but even if that does occur we think the days of steady 200,000-plus payroll figures are probably behind us," they wrote in a note.

For a July rate hike, strategist say the Fed will have to see a sharp turnaround in other data. Fed Chair Janet Yellen speaks Monday, and markets have been anticipating clues from her on policy.

"We expect upcoming communications will play up the "data dependence" aspect and play down the "coming months" rhetoric," the JPMorgan economists wrote.

Zandi said another factor that may have affected that payrolls number was the low response rate in the establishment survey for the employment number. "It was only 74 percent. In the past several years, it's been well over 80 percent. That was a very low response rate. I have no idea why that would be the case. That means there will be, in all likelihood, bigger revisions next month. It feeds into the narrative that this is a fluke report," he said.