For years, inflation has been the primary concern for the American economy. Now, another significant threat is looming: unemployment. As inflation continues to cool, warning signs are appearing in the job market. The Federal Reserve now faces the challenge of avoiding the mistake of maintaining high interest rates for too long. Some economists are urging the Fed to ease up on its fight against inflation before high interest rates, used to curb rising prices, push the US economy into a recession.
“It’s time to cut rates,” said Joe Brusuelas, chief economist at RSM. “Inflation is no longer the primary concern. The balance of risks is slowly tipping towards higher unemployment.” Mark Zandi, chief economist at Moody’s Analytics, noted that the labor market is struggling under high borrowing costs. “The biggest danger is a policy mistake: The Fed keeps rates too high for too long,” Zandi told CNN. “The Fed is signaling a September cut, which is acceptable, but waiting any longer could lead to overdoing it.”
Even Fed Chair Jerome Powell acknowledges a shift in risks. “Elevated inflation is not the only risk we face,” Powell told lawmakers, pointing to easing inflation and a “cooling” labor market.
Signs of a Shifting Labor Market
The job market is not collapsing, but there are signs of stress. Jobs are still being created at a healthy pace, yet cracks are forming beneath the surface. The unemployment rate, though still low, has crept higher for three consecutive months, suggesting a potential shift in the labor market, according to KPMG economists.
Hiring has slowed in key sectors like leisure and hospitality. The pace of workers quitting their jobs and the rate of new hires have both dropped significantly. Powell highlighted these changes, stating that recent indicators “send a pretty clear signal that labor market conditions have cooled considerably” from two years ago. “This is no longer an overheated economy,” Powell said. This cooling is exactly what the Fed aimed for with its rate hikes, intended to prevent a hot job market from fueling inflation.
Risks of Waiting Too Long
The current risk is that the Fed might be applying anti-inflation measures to an economy that no longer needs them, potentially freezing a cooling job market and leading to job losses. In June, the job market added 206,000 positions, maintaining a balanced state. However, Brusuelas warned that restrictive rates from the Fed could disrupt this balance, leading to higher unemployment.
Brusuelas emphasized that this doesn’t mean “skyrocketing” unemployment, but it could trigger a premature recession if the Fed delays cutting rates. KPMG’s senior economist Ken Kim noted that the unemployment rate is nearing a point that could signal a recession, as defined by the Sahm Rule. Kim also pointed out weaknesses in the services sector, a major growth engine for the US economy.
“No longer is inflation the predominant concern,” Kim wrote. “Equally concerning should be the potential for a sharper deterioration in the labor market and economic activity. A hard landing is becoming a risk.”
Inflation Risks Remain
Despite improvements, the high cost of living remains a significant issue for Americans. Although inflation has dropped from 9% in June 2022, prices for essentials like groceries, rent, and insurance remain high. There are still risks on the inflation front, including geopolitical tensions in the Middle East and the ongoing Russia-Ukraine war, which threaten energy supplies. The upcoming US election adds uncertainty, with concerns that former President Donald Trump’s policies could reignite inflation. Additionally, cutting rates before the election could drag the Fed into political controversy.
Learning from the Past
If the Fed cuts rates too soon, it could stimulate demand and boost inflation. Powell and his colleagues aim to avoid repeating past mistakes, such as those in the 1970s when premature rate cuts led to a resurgence in inflation. Recently, the Fed was criticized for being slow to respond to inflation, which officials initially considered “transitory.” “They have PTSD from past mistakes,” Zandi said. “They were slow to raise rates before. Now, they risk keeping rates too high for too long.”
