Federal Reserve Chairman Jerome Powell has previously said he wants to see more evidence that inflation is under control before lowering interest rates, and since it's far from certain where the economy is headed, it's no wonder he remains concerned that inflation could accelerate again.
But there are also risks in the opposite direction, as Chairman Powell has clearly recognized in the past. He said the Fed has an obligation to maximize employment and that this part of the Fed's mission needs to be taken as seriously as its commitment to price stability. That's why many were pleased that President Biden reappointed him as Fed Chairman. But he must take action now to demonstrate this commitment.
June job openings
Friday's June jobs report was far from bad: A survey of businesses showed the economy added 206,000 jobs, while a survey of households reported an unemployment rate of 4.1% (4.05% before rounding). These top-line numbers are healthy by almost any standard, but there are reasons for concern in both.
On the business side, the figures for the past two months were revised downward by a total of 111,000, meaning that the June figure was only 95,000 higher than the employment estimate in the May survey of businesses. This brings the average employment gain over the past three months to 177,000, a reasonable figure given current estimates of the potential growth rate of the labor force, but certainly not at a pace that would have the Fed concerned about excessive inflationary pressures.
It's also worth noting that more than a third of June's job gains (70,000) were in the government sector, almost all of which came at the state and local level. Government employment lagged significantly behind the private sector during the recovery, so this gain is mostly catch-up, but it is probably an anomaly. Many state and local governments are now facing shortages as COVID funding dries up and will likely not add jobs at this pace going forward.
Over the past three months, the private sector has added an average of 146,000 jobs, a good pace but not enough to warrant concerns about accelerating inflation.
On the household side, the unemployment rate has been gradually increasing since bottoming out at 3.4% in April last year. If this trend continues, unemployment will become a serious problem. As things stand, it should be better than 4.1%. The unemployment rate averaged 3.7% in 2019, with no clear signs of inflationary pressures.
As Chairman Powell noted, rising unemployment disproportionately affects groups that face discrimination in the labor market. This is best seen in the unemployment rate for Black workers, which hit a low of 4.8% last April (its lowest on record). It is now at 6.3%, up 1.5 percentage points.
Reducing the unemployment rate by another half a percentage point would make a noticeable difference to the prospects of the less advantaged, and this would be an important policy objective.
Other data from the household survey also provide cause for concern: The proportion of people who have been long-term unemployed (for more than 26 weeks) has risen to 22.2% of all unemployed people, up from just under 19.0% at the start of the year, suggesting that more people are having serious problems finding work.
Another indicator of labor weakness is the relatively small share of unemployment due to voluntary resignations. This share was 11.2% in June, up slightly from 10.8% in May. This is a very low figure given the overall unemployment rate. It averaged 13.1% in the two years prior to the pandemic. It peaked at 16.0% in September 2022. This suggests that workers are feeling less confident about their labor market prospects than would be expected from a 4.1% unemployment rate.
The June jobs report also showed that wage growth had slowed to a level the Fed was comfortable with: The annualized rate for the past three months was just 3.6%, just 20% higher than the 2018-2019 average. The year-over-year rate was 3.9%.
Other labor market data show similar trends. According to JOLTS data, the job openings rate has fallen from an all-time high in early 2022 to levels roughly equivalent to the pre-pandemic peak. The job separation rate has fallen to just below the 2018-2019 peak. Unemployment insurance claims and continuing claims have fallen to record lows and are now slightly higher as a percentage of the labor force than they were before the pandemic.
Non-government data tells the same story. For example, the Indeed Wage Tracker for April found that wage growth for new hires was just 3.1% higher on average than a year ago, the same as the rate of growth before the pandemic. Because this metric only looks at new hires, it tends to lead the overall labor market. This supports the view that wage growth is likely to continue to slow.
Also, keep in mind that the share of profits in income has risen by about 2.0 percentage points since the pandemic began. Unless the Fed believes the rise in the share of profits is permanent, it would need to be prepared for wages to rise somewhat above the sustainable long-run, non-inflationary rate to at least return the wage share to pre-pandemic levels. Wages would need to rise much more substantially to return the wage share to levels seen at the beginning of the century.
Inflation is approaching the Fed's target
Chairman Powell has repeatedly said that the 2.0% target is an average, not a ceiling, which should mean that an inflation rate closer to 2.0% would be consistent with the target.
Year-over-year inflation is still significantly higher than 2.0%, but this is mostly due to rent. For the Consumer Price Index (CPI), the year-over-year inflation rate is 3.3%, but just 2.1% without housing. For PCE, the year-over-year inflation rate is 2.6%, but less than 1.9% without housing.
The removal of housing is reasonable. This is due to leases signed one to two years ago. Rent inflation for housing units on the market is very low, likely below zero. Housing inflation will converge to inflation for new units, even if the timing of that convergence is uncertain. But the key is that the Fed can be confident that in the near term, the direction of inflation is downward and toward the Fed's goal.
We also find that many measures of inflation expectations are back or nearly back to pre-pandemic levels. The Atlanta Fed's business expectations index for one-year-out inflation is at 2.3%, a rate seen several times in 2018 and 2019. Other regional Feds' indexes of manufacturers' expectations for prices paid and received are also back to pre-pandemic levels.
The breakeven inflation rate for 5-year inflation-linked bonds is currently just over 2.2%, roughly where inflation was at some point in 2018. It's also important to note that the index used for these bonds is the CPI, which is 0.2-0.3 percentage points higher than the Fed's target PCE, meaning that the bond market expects inflation to be at or slightly below the Fed's target.
The key takeaway here is that the risk of a 1970s-style inflationary spiral is now virtually nonexistent. Wage growth has stabilized at roughly the same pace as it was pre-pandemic and will likely slow further going forward. Moreover, inflation has been gradually slowing over the past two years and will almost certainly continue to do so.
Trade-offs for Federal Reserve rate cuts
Many reports have suggested that the decision to cut rates comes because the Fed must worry about embarrassing itself by cutting rates too soon and letting inflation accelerate again. The argument is that the Fed made an error in 2022 by delaying rate hikes too long, which resulted in higher inflation than would have happened if the Fed had been more cautious. Having made this error, the Fed does not want to cut rates too soon and embarrass itself again by letting excessive inflation take hold.
While this may be what some observers say, there is little logic to the argument. The Fed has a dual responsibility to maintain low inflation and maximize employment. If the Fed makes a mistake now by allowing unemployment to rise unnecessarily, that is not erased in any way. This mistake is not made worse by the fact that the Fed made an error in the opposite direction three years ago. The Fed must now strive to make the right decision based on the data it has.
In that respect, it seems hard to argue that excessive inflation is a bigger threat than a weakening labor market. The unemployment rate has risen by 0.7 percentage points over the past 14 months. This is 0.3 percentage points higher than the average over the past two years before the pandemic. This means that an additional 510,000 people who would have been employed if the labor market had been stronger are now unemployed. If current trends continue, this figure will rise further over the next 12 months. This should be taken seriously.
Others point out that high interest rates are hitting the housing market hard. Sales of existing homes are down more than 30% from their 2021 peak, before the Fed began raising interest rates. As a result, hundreds of thousands of potential first-time buyers are being locked out of the housing market. Millions of homeowners who could have sold their homes are now locked out of the market and unable to take the action they would prefer.
While interest rates probably won't fall far enough to see a return to the 3.0% mortgage rates of 2021, it's reasonable to assume that the Fed's low rates will push mortgage rates back below 6.0% and eventually closer to 5.0%, which would be a game changer for the housing market.
Higher interest rates also increase financial instability. While another Silicon Valley Bank collapse in 2023 is unlikely, banks will be hit by impairments on commercial real estate loans in the coming months and years. Lower interest rates would make it much easier for banks to weather a surge in defaults and bankruptcies in this sector. Housing market and financial stability may not be as high on the Fed's priority list as maximum employment and low inflation, but they are factors to consider in setting interest rates.
There are events in the world that could lead to a resurgence of inflation. Houthi attacks on ships in the Red Sea would send shipping costs soaring, which would be passed on to higher prices. A major war in the Middle East could disrupt oil supplies and send gasoline prices soaring again. Many other disasters could be added to the list.
But these events always carry risks. The Fed can't design monetary policy with the idea that it will suppress inflation if some crisis occurs. The Fed has to respond to the prevailing economic conditions, and right now, the economy is demanding lower interest rates.
This originally appeared on Dean Baker's Beat the Press blog.