Sept 2 (Reuters) - The Federal Reserve is seen sticking to sharp interest rate hikes in coming months to cool inflation, but rising U.S. unemployment and a slowdown in wage growth has traders betting that borrowing costs next year may not end up quite as high as previously anticipated.
That's the read from markets after the Labor Department reported Friday that employers added a more-than-expected 315,000 jobs last month, the unemployment rate rose to 3.7% from 3.5% as more workers joined the labor force, and wage growth slowed from its earlier torrid pace.
Traders still expect the Fed to deliver a third 75-basis point rate hike at its Sept 20-21 meeting, lifting the benchmark rate to 3%-3.25%, though they have pared that probability to 60% from 70% before the report, based on the CME Fedwatch tool.
Futures contracts closely linked to the Fed's policy rate for next year show traders are now pricing in a top Fed funds rate in the bottom of the 3.75%-4% range by March, down from near the top of that range earlier.
"The August employment report paints a very positive picture," wrote James Knightley, chief international economist at ING Economics. "With wage growth coming in lower than expected it points to a slower pace of rate hikes after September's expected 75 basis point move."
Fed Chair Jerome Powell a week ago said the Fed will raise borrowing costs high enough to start biting into growth, soften the labor market and bring down inflation, but said the size of September's rate hike would depend on the "totality" of the data before then.
With prices rising at more than three times the Fed's 2% inflation target and at the highest in 40 years, the jobs report will play second fiddle to data in coming weeks on consumer prices and inflation expectations, both key concerns as the Powell Fed seeks to bring demand down to meet constrained supply.
"The report was a step in the right direction, but it wasn’t a giant leap in that direction," said Brian Jacobsen, senior investment strategist, Allspring Global Investments, who saw Friday's job report as shifting the balance marginally toward a half-point rate hike in September.
"The key thing will be of course the inflation data. That will probably seal the deal as to whether it should be 50 or 75 basis points," he said.
For many Americans, the big question is less about the exact size of September's rate increases and more about whether those working will be able to keep their jobs - and for the U.S. economy to skirt recession - as the Fed bears down on inflation.
"There's been this debate about soft landing versus recession for a while that economists and investors have been wrestling with," said State Street strategist Michael Arone. "This job report supports the soft landing narrative."
Still it would take a lot of things to go right to achieve that happy outcome, most of which is beyond the Fed's control and which historically has little precedent.
Prices of futures contracts settling next year showed traders now expect the Fed to lift its policy rate to about 3.83% by March, down from the 3.9% seen before the jobs report.
The Fed is seen keeping rates in the 3.75%-4% range until after next summer, when market participants expect the central bank to ease policy slightly.
Fed policymakers have leaned against that scenario, with Cleveland Fed President Loretta Mester saying she does not expect any rate cuts next year.
The Fed will publish fresh policymaker forecasts in September when it delivers its next interest-rate decision.
