From the lack of conviction in the previous meetings to last week’s “risk management cut,” Federal Reserve (Fed) officials continue to walk a very fine line, hoping for the effects of tariffs to be transitory while, at the same time, trusting that the recent weakness in the labor market is more of a combination of lower supply of labor (due to a declining labor force and deportations) as well as weakening demand for workers. Both of which are keeping the rate of unemployment near full employment, but in an environment of an economy that is showing signs of weakening.
Up until last week, a still historically low rate of unemployment meant that the labor market was strong and thus did not allow it to lower interest rates without risking even higher, and more lasting, inflation. However, it seems that the latest downward revisions to employment (and increased political pressure?) have convinced Fed FOMC members that they should lower interest rates just in case, or, as they called it, as a ‘risk management cut.’
The Fed Chairman argued that the revisions to the employment numbers had to do with the model the Bureau of Labor Statistics (BLS) uses to measure the ‘birth-death’ rate of new/old businesses in the US economy. He argued that the COVID-19 pandemic had messed up the accuracy of the model and that the BLS knew it and was working on improving its accuracy.
Part of the issue has to do with business formations, which is the estimate the BLS uses to account for job creation by new businesses. As the graph below shows, there was a clear structural shift in business formations after the Great Recession and another structural shift in business formations after the COVID- 19 pandemic, to which BLS statisticians are still trying to adapt their models to capture these changes.
But what the Fed Chairman did not say during the press conference and what the September FOMC Summary of Economic Projections (SEP) seems to be showing is that the NAIRU1 (the Non-Accelerating Inflation Rate of Unemployment) seems to have changed. That is, it seems that the current 4.3% rate of unemployment is higher than the NAIRU, meaning that there is slack in the labor market. This is also probably in line with Powell’s argument since early this year that wage pressures are no longer an inflation concern. If that is the case, then this is what has finally changed Fed members’ views of how much they could cut the federal funds rate without adding more fuel to the inflation fire brought by tariffs.
It is, of course, a ‘risk management cut’ because the Fed is not completely sure that the rate of unemployment is above the NAIRU and that there is slack in the labor market but is willing to cut rates if this turns out to be the case.
From the graph above, it has been clear for a while that the labor market has been weakening, and Fed members are finally, although grudgingly, getting on the economic/employment weakening bandwagon.
Perhaps the best news from the FOMC meeting and the SEP is that, although increased political pressure may have influenced the Fed’s decision, the group remains united with Stephen Miran as the only dissenter. That unity starts to dissipate when we look at the longer-term dot plot but that is understandable given the uncertainty surrounding future of economic activity and inflation.
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