Fed interest rates: The Fed has now focused on the risks in the labor market, politics must now follow suit

As the Federal Reserve shifted its focus to fighting inflation in 2022, it had to raise interest rates quickly to adjust monetary policy to reflect rapidly rising prices.

Two years later, the focus has shifted again – this time to protecting the labor market, as Fed Chairman Jerome Powell outlined Friday in his speech at the Federal Reserve's annual conference in Jackson Hole, Wyoming. It seems that policymakers will have to play catch-up again – in the other direction, although probably at a less hectic pace.

With Powell's reference to upcoming interest rate cuts, the Fed reversed a course that had begun in January, when the central bank recognized the emerging risks in the labor market and now made it its top priority to counteract these risks.

The question remains: Are a weakening job market and rising unemployment rate evidence that the economy is settling at a healthy level of stable growth with little upside risk to the unemployment rate, or are they part of a downward trend that is only set to accelerate? The answer will be revealed in the upcoming employment reports and will determine how far and fast the Fed needs to cut interest rates to prevent what Powell called an “unwelcome further deterioration in labor market conditions.”

“We do not seek or welcome a further slowdown in the labor market,” Powell said. In doing so, he seemed to establish the current unemployment rate of 4.3 percent as a level he would be happy to defend. At the same time, he bitterly admitted that “conditions are less tight now than they were before the pandemic.”

When Powell became Fed chairman in 2018, the unemployment rate was 4.1 percent and continuing to decline, falling to as low as 3.5 percent in 2019 without any inflation concerns – conditions Powell said he wanted to restore after Covid-19 sent the economy into a tailspin.

The Fed's current benchmark interest rate of 5.25 percent to 5.50 percent is seen as stifling the economy and threatening jobs, and is well above officials' median estimate of 2.8 percent for the longer-term “neutral” rate. Assuming inflation continues to approach the Fed's 2 percent target, changes in the labor market will determine how quickly officials move toward that neutral level and whether they need to cut the rate even further to restore full employment. “We are definitely cooling down, but are we cooling down to a point where we stabilize … or is this just a pit stop on the way to a deeper cooling down?” Nela Richardson, chief economist at the ADP Research Institute, said on the sidelines of the Jackson Hole conference.

Richardson, like many Fed officials and other participants, argues that the economy remains strong and is likely just settling back to its underlying trends – a “normalization” after the extremes of the pandemic. But the sense of urgency around employment has increased.

The change

The Fed's two-year battle against inflation has seen interest rates rise to quarter-century highs without any significant impact on the labor market. Fed officials will next meet on September 17 and 18, and on a very different basis than they were just a few weeks ago. They are preparing to cut interest rates and debating whether the labor market is just slowing or on the brink of collapse.

The Fed's language regarding risk began to change steadily this year.

Until January, the Fed's policy statements said that policymakers were paying “close attention” to inflation risks. Then, in the same month, it said that “the risks to the achievement of employment and inflation goals are increasingly coming into balance.”

In June they said risks had “moved towards a better balance”, and in July they said risks “continue to move towards a better balance”, adding they were now “vigilant” on both the labour market and inflation.

The conversation concluded with Powell's remarks in which he said “the balance of risk for both of our mandates has changed” and that policymakers would “do everything in their power to support a strong labor market.”

Now comes the catch-up race.

In September, officials will update their interest rate forecasts and give their assessment of the pace of future rate cuts. In June, they were concerned about sluggish inflation, saw unemployment stuck at 4% and expected only a quarter of a percentage point rate cut this year.

Ian Shepherdson, chief economist at Pantheon Macroeconomics, who has predicted a contraction in the labor market, called Powell's tone “surprising” compared to the June outlook and viewed it as evidence that the Fed had “waited too long” to change course.

Meanwhile, Torsten Slok, chief economist at Apollo Global Management, fears that given persistently low layoff rates, the Fed could continue to run inflation risk if it cuts interest rates too quickly.

A COMPLETELY DIFFERENT PICTURE

The Fed is waging its own data battles.

While the July gain of just 114,000 jobs was significantly weaker than the pandemic-era average, it was in line with what was considered an appropriate pace before the pandemic to account for population growth.

Another closely watched indicator, the job openings-to-unemployment ratio, has fallen from a historic high of 2:1 during the pandemic to 1.2:1, in line with pre-pandemic levels, another sign of the economy normalizing.

Powell even downplayed the 4.3% unemployment rate on Friday, attributing it to rising labor supply and a decline in hiring rather than direct job losses.

There are “good reasons to believe that the economy will return to an inflation rate of two percent while the labor market remains strong,” he said.

Susan Collins, president of the Boston Fed, said in an interview that she felt the labor market was “generally resilient” and the unemployment rate may be close to stabilizing.

“What I've seen are some signs of stagnation,” she said, “but not a 'breakthrough.'”

Still, there are concerns that the labor market may be weaker than it appears. These risks could play out in the coming months, forcing the Fed to cut interest rates faster or more sharply to defend its “maximum employment” goal.

Fed Governor Adriana Kugler, a labor market economist, said during one of the research discussions at the conference that both sides of the job openings-to-unemployed ratio may be mismeasured – there may be fewer job openings than indicated by the monthly Job Openings and Labor Turnover Survey, and more unemployed people when alternative measures of unemployment that include, for example, discouraged workers are used.

In their estimation, the ratio of jobs to unemployed has actually fallen to 1.1 and is thus already close to the break-even point, possibly even below it.

“There are now many more layoffs leading to non-employment than the standard measures of unemployment allow,” she said. If other measures of unemployment were included, “you could get a very different picture” of the labor market.