Fed Walks Rate Cut Tightrope Amid Labor Market Strength
At the press conference following the Federal Reserve's (Fed) January meeting, Chair Powell downplayed the possibility of a March rate cut while acknowledging inflation had been contained for the previous six months. Powell noted that a rate cut was not the base case, with the Fed preferring to have more confidence that inflation would hold at its 2% target.
Powell reiterated those comments during a televised 60 Minutes interview, confirming that the Fed was still on track for three rate cuts in 2024, as had been signaled in the Summary of Economic Projections following the December meeting.
With the annual pace of inflation falling significantly in 2023, why does the Fed need more confidence before getting aggressive with rate cuts?
The answer may be related to ongoing labor market tightness, particularly following January's Employment Situation report, which was consistent with a robust labor market: payrolls rising more than expected, favorable revisions, unemployment holding at historically low levels, and solid nominal earnings growth.
Recent economic literature1 has focused on an alternative to the unemployment rate that adjusts for labor demand as a measure of labor tightness. This indicator is calculated as the ratio of job openings to unemployed. A value greater than one means that more employers are trying to fill jobs than there are workers available and willing to fill them. Conversely, a value less than one means that there are more workers seeking employment than there are jobs available.
Source: FactSet, Barnichon (2010)2, NBER, Author's Calculation. Data from 1/31/1950-12/31/2023
This labor tightness indicator was below one for much of the post-World War II period as the increase in labor market participation provided firms a plentiful supply of employees. Before this indicator flipped to more than one in 2021, we saw just a few instances when the labor market was as tight as it is today - primarily during the Korean and Vietnam wars. Another common thread between those periods and the labor landscape today is the combination of monetary easing, expansionary fiscal policy, and financial repression, with funds channeled from the private sector to reduce government debt.
More recently, the economy slowly worked off the backlog of labor market slack induced by the 2007-8 Great Financial Crisis. With baby boomers beginning to retire en masse in the late 2010s, the US labor market became tighter. While there was a temporary step-down during the COVID recession, expansionary fiscal policy and monetary stimulus, along with the end of COVID restrictions, contributed to record-high labor tightness. The Fed's rate hikes and the fading impact of COVID has caused some pullback, but the labor market remains historically tight.
Ongoing labor market tightness has helped keep upward pressure on wages and incomes, which has fed through to inflation. While wages have increased significantly in the post-COVID period, Fed rate hikes have helped the economy avoid a wage-price spiral, unlike in prior inflationary episodes. Nevertheless, the Fed may want to see further labor market cooling before initiating rate cuts.
By keeping rates too high for too long, the Fed sets up the risk of a recession. However, in the post-war period for which we have data, the labor market was never as tight before a recession started as it is today. Only two of the 11 recessions that our data covers began amid labor market tightness as defined by this measure. Both of those were also associated with wars during which the government initially eased monetary policy and expanded government spending, but needed to course-correct to constrain inflation. Today, while heightened geopolitical risk driven by wars in Ukraine and the Middle East, and unsustainable levels of debt in the US could be catalysts for a potential US recession, this is not our base case.
1 Benigno, P. & Eggertsson G.B. 2023. It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve. NBER Working Paper 31197.
2 Barnichon, Regis. 2010. Building a Composite Help-Wanted Index. Economics Letters 109(3): 175-178.
