All eyes on the U.S.: The dollar and labor market

Commentary by Adam Schickling, Vanguard Senior Economist

Key points

• A fragmented U.S. labor market is strong for some and strained for others.
• A low unemployment rate and a muted pace of layoffs mask underlying weakness.
• The labor market’s mixed signals may make the Federal Reserve less reactive to the unemployment rate alone, as policymakers weigh a broader set of indicators before adjusting interest rates.

The health of the U.S. labor market, which is a primary consideration for the Federal Reserve when setting interest rates, can be a matter of individual perspective right now:

• If you’re a registered nurse, you may believe the job market’s health to be excellent. The unemployment rate for experienced health care practitioners is currently below 2%.
• If you’re young and just entering the labor force or you’re older and seeking to reenter it, prospects may seem bleak. The number of unemployed in these two categories has been rising, as it did during the global financial crisis and the COVID-19 pandemic.
• If you already have a job and aren’t looking to switch, the labor market’s health may not matter at all. Hiring is down, but so are layoffs, and your wages are still growing faster than inflation.

Taken together, such contrasts suggest a subtle weakening that isn’t apparent from the 4.1% unemployment rate. And there’s one more important vantage point to consider:

• If you’re a Federal Reserve policymaker concerned with setting a key interest rate, the labor market may appear just strong enough to wait for greater clarity about another potential development—the prospect of a tariff-induced reacceleration in inflation.

Historically, a decline in hiring has been accompanied by a swift rise in layoffs, a one-two punch that drives up the unemployment rate. Today’s labor market is defying that pattern. Firms are pulling back on hiring without shedding existing workers in significant numbers. The result is a labor market that is softening gradually, not collapsing.
 

The lack of layoffs can be traced to two sectors that have historically driven periods of job losses when hiring has slowed: manufacturing and construction. Today, both sectors are benefiting from long-term trends that have muted cyclical behavior.

Manufacturing now constitutes a much smaller share of the U.S. labor force than it did in decades past, so there is simply less headcount to cut. Moreover, the sector is adapting to structural forces, including onshoring and a shrinking labor supply, which is helping to stabilize employment levels even amid broader economic uncertainty.

Construction reflects a similar situation. High demand amid a persistent shortage of residential housing construction, particularly acute since the global financial crisis, has generally helped insulate construction activity and employment even as elevated interest rates have challenged affordability.

Other less-cyclical industries, such as professional and business services, are following their historical playbook of achieving desired staffing levels through attrition and reduced hiring. 
 

Although layoffs are low, the hiring slowdown is exacting a toll, especially on younger workers entering the labor force and older workers reentering it after a hiatus. These groups depend on job creation to gain traction, and in today’s environment, that traction is elusive. Sentiment data show a growing level of frustration, with job seekers experiencing longer searches and fewer opportunities.

There are worrisome signs that the labor market is in for a more difficult second half of the year. In the construction industry, which has contributed to the overall low-layoff environment, home prices and the number of planned housing construction projects are now falling as the prolonged higher mortgage rates have priced many would-be buyers out of the market. We anticipate these headwinds will curb construction employment in the coming months.

And while the private sector has added an average of almost 110,000 new jobs per month since the start of the year, roughly 60% of those have been in the health care and social-assistance sector.

The lack of breadth in job growth raises questions about the sustainability of the current 4.1% unemployment rate. Other measures of private-sector employment reported more modest growth in the first half of 2025. 
 

The labor market matters not only as a barometer of the broader economy’s health, but also because of its critical function in determining monetary policy. Congress requires the Fed to promote price stability and maximum sustainable employment. This is known as the Fed’s “dual mandate” in setting its key interest rate target.

If the unemployment rate creeps higher in the second half of the year, as we expect it to, the Fed may be in position to respond with the rate cuts that markets have been eagerly awaiting. (Vanguard anticipates the equivalent of two quarter-percentage-point rate cuts this year.)

That assumes, of course, that the Fed doesn’t have its hands full with a continued inflation fight.

Key points

• The dollar has fallen more than 9% this year on the back of a global reconsideration of U.S. dollar-denominated assets amid heightened trade tensions, rising fiscal concerns, and institutional uncertainty.
• Dollar depreciation this year has driven international equity outperformance compared with U.S. equities for U.S. investors. The recent shifts and the speed with which they occurred underscore the value of global diversification for long-term investors.
• Over the long term, the U.S. dollar appears fairly valued. While we continue to expect international equity to outperform, the gains are likely to come from corporate fundamentals rather than dollar weakening.
   

For the past three years, the U.S. dollar stood tall—overvalued and seemingly defying its fundamental gravity. But in recent months, it’s come back down to a level that we assess to reflect long-term fair value compared with a basket of developed-market currencies. 

The downward shift has been a gift to globally diversified U.S. investors. As the dollar weakened—triggered in part by a global reconsideration of appetite for U.S. assets amid tariff upheaval—international equity returns surged when translated back into dollars, giving portfolios a meaningful lift.

International returns also benefited from depressed valuations that reflected very pessimistic sentiment at the start of the year. This, along with the weakening dollar, led international equities in U.S. dollar terms to return 17.9% in the first six months of 2025. International equities returned 8.8% in local currency, while the dollar contributed the remaining approximately 9%. (U.S. equities, by comparison, returned 6% in the first half of 2025.)¹ Looking ahead, the degree to which corporate fundamentals abroad can rise to meet this renewed optimism will be key for further international equity gains.

With the dollar now firmly back within our estimated fair-value range, we view the risks as more balanced than at any time during the last three years. Over the short term, an easing of trade tensions and greater certainty around U.S. policy may lead to dollar appreciation. Alternatively, a continued reconsideration of dollar-denominated assets among global investors could result in further declines. Longer term, however, we see higher U.S. productivity and persistently higher (but sustainable) U.S. interest rates as supportive of the current dollar valuation.

The shift reinforces the case for global diversification. With U.S. equity valuations still stretched and international markets offering more historically grounded return prospects, spreading risk across regions remains a cornerstone of a sound long-term strategy.²

—Kevin DiCiurcio, Head of Vanguard Capital Markets Model Development

Although uncertainty remains around U.S. tariff policy, we’re likely to see modest economic growth along with further rate cuts by a number of major central banks in the second half of 2025.