Getty Images; Jenny Chang-Rodriguez/BI
For the first three years of the pandemic recovery, the labor market was one of the bright spots that helped drive America's world-leading economic boom. But increasingly, there are signs that the job market is losing some steam. Whether it's hard data like the unemployment rate or sentiment-based surveys of businesses, it's clear that the labor market has cooled off.
This cooling off should be a cause for concern because unemployment tends to be inertial — like a rock rolling down a hill, once it starts to move, it tends to keep moving in that direction. And unless someone steps out in front of the rock to slow it down, the recent deterioration raises the possibility of a further increase in unemployment. It's clear that the Federal Reserve should be the force to slow down the sliding job market.
What the Fed does next will greatly affect the chances of avoiding a larger increase in unemployment. It spent the past few years raising interest rates in an attempt to slow rapidly increasing prices, but with inflation largely tamed, the risks have now shifted toward the labor market. Waiting too long to lower interest rates to support the economy will only increase the odds of the job market breaking down.
In short: The Fed needs to hurry up and cut.
The job market is at an inflection point
The emergence of the US from the worst of the pandemic shutdowns in early 2020 helped usher in a historic boom for the labor market. From April 2020 to April 2023, the economy added 25 million jobs — an average of 674,000 newly employed people a month. Unemployment hit a 54-year low of 3.4% in April 2023, and hiring rates exploded. The historic strength of the labor market led to big gains for average workers: Wages for lower-end service occupations in the retail and hospitality sectors saw the most rapid growth.
Over the past year, that story has changed. In the first six months of 2024, the unemployment rate climbed 0.4 percentage points to 4.1% — an increase of 0.7 percentage points from its historic low. While that may seem like a small adjustment, that translates to 1.1 million more unemployed Americans than there were in April 2023 and roughly 550,000 more people out of a job this year alone. Importantly, the unemployment rate has reverted to where it was before the upheaval of the pandemic: At 4.1%, the jobless rate is where it was in early 2018.
The rise in unemployment has coincided with plenty of other evidence that times are tougher for people looking for work: Job openings, a proxy for businesses' labor demand, have declined. Even those who are employed are more nervous about their prospects. After hitting a high of 3.3% from late 2021 to early 2022, the rate at which people are quitting their jobs in the private sector is lower today than it was at the onset of the pandemic.
These warning signs in the job market are compounded by weakening data across the economy. Real GDP grew in the first quarter at an annualized rate of 1.2%, and the Atlanta Fed's GDPNow model estimates the second quarter will come in at 1.5%. This would bring the average for the first half of the year to a relatively sluggish 1.4%, below the Fed's estimates for longer-run potential.
There are also two big signs that the second half may not improve. First, after a strong run for residential investment in recent quarters, the outlook for residential construction has weakened as building permits have declined. Any slowdown in residential investment is likely to drag on GDP growth. Second, consumption is slowing after ending 2023 at a strong pace. The level of retail sales and food services has been essentially flat for the past five months as people have started to cut back on their spending.
The dimmer outlook for growth is important because even though real GDP advanced 3.1% last year, the unemployment rate still rose 0.2 percentage points to 3.7%. Ultimately, employment follows economic growth. If 3% growth could not keep unemployment from climbing in 2023, why would the unemployment rate remain stable in 2024 if growth comes in substantially lower?
As the economy slows, the outlook for the job market worsens. Once things start moving down one path, they tend to speed up and can be hard to reverse. In other words, it's rare to see the unemployment rate go up only "a little bit." One way to visualize this is the Beveridge curve, which plots the relationship between job vacancies and unemployment.
As the above chart shows, when unemployment is low, job vacancies can drop a fair amount without a corresponding increase in joblessness. But as unemployment creeps up, things get more intense, and the disappearance of job vacancies accelerates. In the aftermath of the pandemic, it was thought that given the strength of the labor market, job openings could decline without sparking much of an increase in unemployment. But after three years of a slow and steady adjustment, our current spot on the curve means that any further deterioration in job openings risks a somewhat larger increase in unemployment.
Even a small increase in the unemployment rate from here would produce real consequences. The Fed needs to balance employment against inflation. If unemployment is climbing, even if for benign reasons like an increase in labor supply, it implies that there are more people competing for a given level of jobs. Thus, the more people out of work looking for jobs, the more those seeking employment can suppress the wages of those presently working. This slows inflation and implies less of a need to run a less restrictive monetary policy.
There is a way to avoid this
Whether the increase in unemployment is big or small, the best way to avoid putting more people out of work is for the Federal Reserve to step in. The Fed's job comes down to two joined goals: maximizing the number of people who are employed while keeping inflation under control. Over the past three years, the inflation piece of this equation has taken precedence — the interest-rate hikes were the necessary cost of slowing down prices. But as inflation has cooled off, the balance of risks has tilted toward the unemployment side of its mandate. Waiting too long to start cutting interest rates risks exacerbating the weakness of the labor market. It's a much better idea for the Fed to start recalibrating policy now, before more aggressive action would be needed.
Given the state of the economy, there's a strong case for starting these rate cuts ASAP. The 4.1% unemployment rate is already above the central bank's consensus projection for the end of the year, meaning that the job market is deteriorating at an even faster pace than it anticipated. At the same time, there are signs that inflation — the economic dragon that the Fed was trying to slay with its rate hikes — has been tamed. The core personal consumption expenditures price index, the Fed's preferred measure of inflation, is running at roughly 2.5% compared with the same time last year. There are also signs that inflation will continue to cool, such as the continuing strength of the US dollar, which will help curb prices for imported consumer goods.
When times are uncertain, as the Fed claims, it's useful to refer back to policy rules of thumb to help guide actions moving forward. One such rule is the Taylor rule, a fairly rudimentary formula that suggests where interest rates should be based on just the unemployment rate and core inflation. Given the current economic data, the rule suggests that the Fed should have interest rates at 4.5% to 4.75%, which implies three or four 0.25% rate cuts.
Instead of teeing up the cuts to come, however, Fed officials have been consistently behind the curve. Whether it's regional-bank presidents or Chair Jerome Powell, the Fed's recent rhetoric has boiled down to: We need to see more realized evidence that inflation is slowing before we start bringing down rates. Indeed, some monetary-policy hawks argue that easing now might risk a repeat of the 1970s, when premature cuts allowed seemingly defeated inflation to make a comeback. This is a total red herring. I get that officials want to avoid a repeat of the '70s, but living too much in the past is a problem, too. Inflation is a lagging indicator. Today's inflation data represents yesterday's monetary policy. Since policy has not changed, there's little reason to expect the momentum behind inflation to change, either.
Even if cutting a little bit now proves to be a mistake, it would be a relatively small one that could be undone quickly. After all, as Powell himself noted, if you "try to pull out the significance to the US economy of one 25-base-point rate cut, you'd have quite a job on your hands." Well, then, you might as well get on with it!
No one is arguing that the Fed should begin an aggressive easing of policy, but recalibrating policy given the evolution of the economy to date makes sense. The idea is to do a little bit now instead of having to do more after it becomes obvious you should have acted earlier.
To review: Unemployment is up, and the risks are that it will rise further. Inflation has slowed, and the risks are that it will slow further. And all the while, the Fed is setting its rhetoric to yesterday's problems.
Get a grip and get a move on.
Neil Dutta is head of economics at Renaissance Macro Research.