Getting back to normal

Fed Chair Jay Powell is on the Hill this week with the latest employment numbers fresh in everyone's minds.

Fed Chair Jay Powell will be in Congress on Tuesday and Wednesday for the twice-annual Humphrey Hawkins hearings. Fittingly, given the Fed’s dual mandate, those two days are sandwiched between last Friday's employment report and the CPI report on Thursday. Unlike the past several hearings, the labor market, particularly its cooling, will likely raise questions. Expect to hear Powell counter that the US labor market is “strong," allowing the Fed to be patient in cutting interest rates. Expect to hear some pushback.

I agree that the labor market looks very good, even remarkable. Unemployment was just above 4% in June, which is historically low. Payroll gains were a solid 200,000. The unemployment rate might be even better than it looks (pushed up by a bigger labor force), though payrolls are probably not as good as they look (measurement issues). On balance, across a host of metrics, today's labor market remains the success story of the recovery. This is not the reason why the Fed should begin cutting interest rates. Nothing about June (including the Sahm rule) on Friday sounded alarms.

My pushback is that the labor market by June has cooled enough that it no longer fits the “luxury of time” mindset. Waiting several months for more data to gain “confidence” about inflation will come at a cost. The FOMC may decide that’s a cost worth incurring, but their assessment of the risks to the labor market appears too optimistic and has not kept up with the cooling in the labor market. Finally, today’s labor market is not the primary concern for the Fed; it’s the one that is six or twelve months from now. That’s when any monetary policy decisions soon would have their peak effect on the economy. There were signs in the June employment report that those future labor markets could be weak if the Fed keeps rates high.

Cooling back to normal.

We are almost back to something that might feel normal in the economy, including the labor market. Though not perfect, pre-Covid is a relatively good comparison. And it was a strong labor market until the Covid struck. The deep recession was followed by a very rapid recovery.

In the recovery, especially after the Covid vaccines became available, the US economy went through a period of very low unemployment rates and large job gains. The cooling that followed was gradual, and we are now back to the pre-pandemic levels.

Labor shortages, a surge in job switching, and fast wage growth were hallmarks of the early recovery. It was too strong to be sustainable—too disruptive and inflationary. Here, too, as the Monetary Policy Report explains, there has been normalization:

With cooling labor demand and rising labor supply, the labor market became gradually less tight over the first half of this year, although it nevertheless remains strong. The balance between demand and supply in the labor market appears similar to that during the period immediately before the pandemic.

A variety of labor market indicators support this assessment. The ratio of job openings to unemployment has fallen notably from its peak of about 2.0 in spring 2022 to 1.2 in May, the same as its average in 2019. Similarly, the gap between the number of total available jobs (measured by employed workers plus job openings) and the number of available workers (measured by the size of the labor force) has also moved down markedly from its peak of 6.1 million in spring 2022 to 1.4 million in May and is only a bit above its 2019 average of 1.2 million (figure 14).

The labor market has cooled to the point that Fed officials should rethink the argument that the “strong” labor market allows them to wait for more inflation data.

Get the risks right.

The Fed says that it approaches monetary policy as risk management, but it is worth asking if its assessment of the risks is drifting out of sync with the degree of cooling in the economy. In the latest Summary of Economic Projections, most Fed officials saw larger risks of an upside surprise to inflation than a downside surprise. At the same time, they saw the risks around the unemployment rate as balanced between higher- and lower-than-expected outcomes.

Notably, those risk assessments were for an inflation forecast that was already “conservative,” as Powell described it, expecting the progress made so far in 2024 to mostly reverse by the end of the year. In contrast, the unemployment rate was expected to hold at 4% for the rest of the year. After more than a year of increases in the unemployment rate and the federal funds rates well above pre-pandemic levels, it’s hard to tell the story of the risks of a lower unemployment rate for the balanced assessment. A misalignment of risks reinforces the Fed’s view that the strong labor market provides a buffer to holding rates high. It also shows how high the bar might be for good inflation data.

A warning, not alarm bells.

Being attuned to risks is especially important in monetary policy, as changes in interest rates take time to affect the economy. As Powell said at the last press conference in June, the Fed is watching the labor market carefully:

You know—you know, when I say “unexpectedly,” the first thing is more than, kind of, is in our forecast or in common forecasts—so, something more than that. But we’ll be looking at everything. You know, we’ll—the, the labor market, you know, has the ability—has, has the tendency sometimes to, to weaken quickly. So waiting for that to happen is, is not what we’re doing. You know, we’re watching very carefully; we’re looking at the balance of risks. I always point out the balance of risks, so—and, and also the fact that we look at, at all of it—the whole situation. So, you know, a decision to begin to—you know, to loosen policy could have several reasons associated with it at a given time. But I, you know, I would just— you know, we monitor all the—all the labor market data. And if we saw troubling—weakening more than—more than expected, then that would be something we’d consider responding to. But we’d look at the—we look at the broader context of what’s going on, too.

Since then, the unemployment rate has risen unexpectedly to 4.1%, putting the Sahm rule, my recession indicator, at 0.4. That’s near the 0.5 “trigger” level that, since 1970, has been consistent with the early months of a recession. That alone probably wouldn’t meet Powell’s “something troubling” definition. Some of the rise in unemployment appears to be due to more people entering the labor force, who often take longer to find jobs, rather than due to just reduced worker demand. In early November 2023, I wrote in Bloomberg Opinion about why the recession signal might be weaker this time:

After more than two years of severe labor shortages, workers are still coming back at a somewhat faster pace than new jobs being created. The labor force participation of prime-age women is at an all-time high after an outsized decline in 2020 in what was dubbed a “she-cession.” Workers with disabilities and Black men made historic gains this year, too. After a stoppage during the pandemic, immigrants on work visas are entering the country. Taken together, economist Julia Coronado, the president and founder of MacroPolicy Perspectives, argues that the rising supply of workers is good for the rebalancing of the labor market, even if it shows up initially in somewhat higher unemployment rates.

That’s not to say it’s all supply or that the Sahm rule should be dismissed. The signs of cooling go beyond the labor market, such as slowing growth in consumer spending. Most importantly, waiting until the economy is clearly in recession is far longer than the Fed would want to wait. Avoiding a recession is not the low bar we should shoot for. A weak economy is more vulnerable to shocks than a strong one.

In closing.

When Powell says the labor market is “strong,” listen carefully to the context; it matters. The labor market is strong relative to its longer history and aligns with the pre-pandemic period. That normalization is remarkable. Wage growth has slowed considerably, and labor shortages have eased, so the labor market’s strength is not the threat to inflation of even a year ago. Strong now is not sufficient for forward-looking monetary policy. The cooling and signs of weakness are ones that the Fed should heed. Inflation at 2.6% in June has come a long way back to normal; it is time for the Fed to begin normalizing its policy, too.

Bonus clip: my interview at Bloomberg Surveillance: