Concerns about the labor market have become more serious in recent months. In July, the unemployment rate hit 4.3 percent, a 0.6 point increase from the end of last year. Had fiscal and monetary policymakers not committed grievous errors in 2021 and 2022 and helped unleash the worst inflation spell in four decades, they would be much better positioned today to address risks that the labor market might further deteriorate.
There’s no doubt that the job market is weaker than it was six months ago. True, the rise in unemployed workers recorded in July was driven by temporary layoffs. Since furloughs, often caused by disruptions such as weather, usually end, they’re not as worrisome as unemployment increases caused by permanent layoffs. But a risk always remains that temporary layoffs could become permanent. Since the Bureau of Labor Statistics insists that Hurricane Beryl isn’t to blame for the recent surge in unemployment, we can’t be sure what’s causing it, but record heat in California might be to blame, particularly because that’s where the greatest number of temporary layoffs occurred.
While no evidence has appeared of widespread permanent layoffs, the labor market is showing other troubling signs. Hiring is down, for example, and the number of people who have been unemployed for half a year or more has increased.
The jobs market is not in crisis, but it would soothe concerns if the Federal Reserve could provide some insurance—interest-rate cuts, based on the changing balance of risk—to make sure that the deterioration doesn’t accelerate. The Fed’s scope of action is limited, however, by inflation. Core inflation in the price of Personal Consumption Expenditures, the Fed’s preferred gauge of price pressures, ran at 3.3 percent in the first half of the year.
For much of the last decade, this measure of inflation ran closer to 1.5 percent than to the Fed’s target of 2 percent. Relatively low inflation freed the central bank to pursue monetary easing to cushion the job market. If stimulus drove prices a bit higher, this was not a bad thing, from the Fed’s perspective, since inflation was already below target. (Extended periods of monetary easing can present financial stability risks, but the Fed does not pre-empt them—sometimes to our peril.)
But inflation has run far too high since the pandemic, putting the Fed in a much tougher spot. If its stimulus prevents inflation from falling—say, because housing markets or labor markets re-tighten, or because the dollar weakens—then inflation will stay beyond the Fed’s target.
For the Fed, insurance cuts to protect the labor market went from being essentially free to being quite costly. Inflation has restrained the agency’s ability to underwrite the labor market. Had these developments occurred in 2014, say, the Fed would have eased many months ago, and by several percentage points.
Now, however, the agency has been forced to wait for the labor market to weaken sufficiently before providing insurance, to ensure that stimulus won’t push inflation higher. Moreover, the support that the agency can provide is limited. The Fed—and by extension, the American people—must tolerate the risk that the job market will transition from mild weakness to a more severe state.
The Fed’s actions helped cause this problem by pursuing foolishly accommodative policies in 2021. The agency insisted on continuing its large-scale purchases of mortgage-backed securities, even as home prices nationally had surged. It injected more and more credit into an already red-hot housing market and helped drive rents up nearly 50 percent in some regions. The resulting inflation has been with us ever since, since rent increases are felt gradually over time as tenants renegotiate their leases or move.
Equal blame is due, of course, to Congress’s expansive fiscal policy. After adjusting for accounting technicalities from President Biden’s attempts to forgive student loans, deficits soared beyond 7 percent of GDP during a peacetime economic boom. America now has less fiscal room to respond to more dire events, such as the outbreak of a major war or a genuine recession.
Prudence demands that policymakers use emergency tools like fiscal stimulus and large-scale central bank asset purchases only when truly needed. By throwing caution to the wind in 2021 and delivering far too much stimulus through today, government policy created an inflation problem, still with us, that has narrowed the Fed’s options.
Were inflation in recent quarters 1.8 percent instead of 3.3 percent, the Fed would have eased aggressively by now. Instead, its hands have been tied. While the labor market today is not suffering an extended downturn, the increased cost of delaying rate cuts serves to raise that risk—and that policymakers will be late to respond when it happens.
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