Another very healthy employment report this morning should have taken mortgage rates above 6.5 percent, but we have been rescued by a new charm offensive from the Fed.

May payrolls gained 248,000 jobs, close to forecast, but the immensely strong, 652,000-job gain in March and April together was revised upward by an additional 75,000 workers. Employment is increasing in all sectors, in hours worked, in overtime, and in earnings.

Another very healthy employment report this morning should have taken mortgage rates above 6.5 percent, but we have been rescued by a new charm offensive from the Fed.

May payrolls gained 248,000 jobs, close to forecast, but the immensely strong, 652,000-job gain in March and April together was revised upward by an additional 75,000 workers. Employment is increasing in all sectors, in hours worked, in overtime, and in earnings.

The bond market immediately sold off, taking rates higher, then stabilized…and then recovered, mortgage prices no worse than yesterday, and some cases better. Talking economic heads have struggled all day to explain the absence of damage, like the baseball player who couldn’t figure out how the ball wound up in his glove. A common attempt held that the employment report was a “Goldilocks” deal: not to hot and not too cold – a nice line, but not true. This is not some transient hot flash leading to economic menopause: the job market is on fire, and so were all other the data this week, from the purchasing managers’ indices to retail sales.

Other salvation arguments: despite recent job growth, there is still so much slack in labor markets that inflationary growth in wages is not a risk. OK, but the Fed’s 1 percent rate is still very stimulative, and will remain so for six months to a year after the 18 months it takes the Fed to get all the way to a neutral rate (such is the inertia of monetary policy). Do we have two or three years’ of to-be-hired labor on hand, at this growth rate?

Nope.

Another everything-is-okay: excess capacity in the economy will stave off inflationary pressure. Capacity-in-use is still only about 77 percent, way under the 83 percent-85 percent worry zone; however, how much of the capacity not in use is now obsolete and in the process of being abandoned? Example: how busy is the ol’ VCR factory?

The Fed has spent the last 90 days preparing the bond market for the sustained increase in rates that will follow the expiration of its previous charm offensive, the “considerable period” one. The Fed has told us that this new regime is “likely to be “measured.”

“Measured” is preferable to hasty, scurrying, frantic, lurching or hysterical, most of which applied in 1994. “Measured” feels comfortable as to frequency (rate hikes at each Fed meeting, maybe, or most), but leaves me queasy as to distance. Perfectly precise measurements could include hikes of .5 percent (there was more than one of those in ’94), or .75 percent (Greenspan’s career record, also in ’94).

The Fed stepped in twice this week to intercept these traditional bond-market fears. The chairman, in a letter to Sen. Paul Sarbanes (D-Md.) said that the Fed’s historical approach is not a useful guide in this situation because prices are likely to increase much more slowly than in the past. Today, Fed governor Donald Kohn, very close to the chairman as a staffer, said that there was “…no major inflation threat…” and that the Fed could be “gradual” in its return to neutral.

I don’t understand why the Fed is so confident that all these inflation signals are not a problem, but I sure like “gradual” – that speaks to frequency and distance.

Bill Gross, principal deity at PIMCO, thinks the Fed is behind, and must tighten .25 percent at each of its four remaining meetings this year, and the Fed funds futures market agrees, plus a hair. The bond and mortgage markets have not paused because of Goldilocks news; they have paused because they have built in as much damage from the Fed as is possible to discount at this time.

Once the Fed gets going, the markets will begin to discount continuing measured gradualism in 2005, a process that should begin on June 30, and shortly thereafter take bond and mortgage yields up the next notch. Gradually.

Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.

***

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