This cooling is worrisome because the unemployment rate tends to be inertial; like a stone rolling down a hill, once it starts moving, it tends to keep moving in that direction. And unless someone steps in front of the stone and slows it down, the recent deterioration makes it more likely that the unemployment rate will rise further. Clearly, the Federal Reserve should be a force to slow down a declining job market.
What the Fed does next will have a major impact on the chances of avoiding a further rise in unemployment. The Fed has been raising interest rates over the past few years to tame price spikes, but inflation has been largely contained and the risk has shifted to the labor market. Waiting too long to lower interest rates to support the economy will only increase the chances of a job market collapse.
In short, the Fed needs to cut rates quickly.
The job market is at a turning point
As the United States emerged from the worst of the pandemic shutdowns in early 2020, the labor market experienced a historic boom. Between April 2020 and April 2023, the U.S. economy added 25 million jobs, equating to an average of 674,000 new jobs per month. The unemployment rate hit a 54-year low of 3.4% in April 2023, and the employment rate soared. The average worker benefited greatly from the historic strength of the labor market. Low-income service jobs in retail and hospitality saw the fastest wage growth.
Over the past year, the situation has changed dramatically. In the first six months of 2024, the unemployment rate rose 0.4 percentage points to 4.1%, up 0.7 percentage points from its all-time low. While this may seem like a small adjustment, it means 1.1 million more people are unemployed than in April 2023, and about 550,000 more people unemployed this year alone. Importantly, the unemployment rate is back to the level it was before the pandemic disruption: at 4.1%, the unemployment rate is back to the level it was at in early 2018.
The rising unemployment rate comes at the same time as plenty of other evidence that things are tough for jobseekers. The number of job openings, a measure of business demand for labor, is falling. Even those who are employed are growing increasingly nervous about their future prospects. After reaching a high of 3.3% in late 2021 and early 2022, the private sector turnover rate is now lower than it was at the start of the pandemic.
These warning signs in the job market are exacerbated by weak data from the broader economy: Real GDP grew at a 1.2% annualized rate in the first quarter, and the Atlanta Fed's GDPNow model projects second-quarter growth at 1.5%. This would bring the first half of the year to a relatively sluggish 1.4% average, below the Fed's longer-term potential growth forecast.
There are two big signs that the second half of the year may not improve either. First, after strong residential investment in recent quarters, the outlook for home construction is weakening as building approvals fall. A slowdown in residential investment is likely to drag on GDP growth. Second, after finishing 2023 on a strong pace, consumption is slowing. Retail sales and food service levels have remained roughly flat over the past five months as people have begun to cut back on spending.
The gloomy growth outlook is important because unemployment rose 0.2 percentage points to 3.7% last year, even though real GDP grew 3.1%. After all, employment follows economic growth. If 3% growth was not enough to prevent unemployment from rising in 2023, why is it likely to remain stable in 2024 when growth slows significantly?
As the economy slows, the job market outlook worsens. Once things start moving in one direction, they tend to accelerate and are difficult to reverse. In other words, it's rare for the unemployment rate to rise “just a little.” One way to visualize this is the Beveridge Curve, which plots the relationship between job openings and the unemployment rate.
As the graph above shows, when the unemployment rate is low, job openings can fall considerably without a corresponding increase in the unemployment rate. But as the unemployment rate gradually rises, the situation becomes more severe and the decline in job openings accelerates. In the aftermath of the pandemic, given the strength of the labor market, it was thought that job openings could fall without causing a significant increase in the unemployment rate. But after three years of slow and steady adjustment, the current position of the curve means that there is a risk of some increase in the unemployment rate if job openings worsen further.
Any increase in unemployment from here would have real consequences. The Fed needs to balance employment and inflation. If unemployment is rising, even for something as innocuous as an increase in labor supply, it means there are more people competing for a given level of work. So the more unemployed people there are looking for work, the more job seekers can suppress the wages of those currently employed. This slows inflation and reduces the need for loose monetary policy.
There is a way to avoid this
Whether the increase in unemployment is large or small, the best way to prevent more people from losing their jobs is for the Federal Reserve to step in. The Federal Reserve's job is to achieve two goals together: maximizing employment while keeping inflation in check. Over the past three years, the inflation part of this equation has taken precedence. Raising interest rates was a necessary cost to keep prices rising. But as inflation has subsided, the balance of risks has shifted toward unemployment. Delaying to start lowering interest rates too long could exacerbate labor market weakness. It would be much wiser for the Federal Reserve to start recalibrating policy now, before more aggressive action becomes necessary.
Given the state of the economy, there is a strong case to start cutting rates sooner. The 4.1% unemployment rate is already higher than the central bank's forecast for the end of the year, meaning the job market is deteriorating at an even faster pace than expected. At the same time, there are signs that inflation, the economic dragon the Fed was trying to slay with interest rate hikes, has been tamed. The Fed's preferred inflation measure, the core personal consumption expenditures price index, is running at about 2.5% compared to the same time last year. There are also signs that inflation will continue to subside, including continued strength in the U.S. dollar, which should help keep prices of imported consumer goods in check.
As the Fed argues, in times of uncertainty, it's useful to revert to policy rules of thumb to guide future actions. One such rule is the Taylor Rule, a fairly basic formula that tells us where interest rates should be set based solely on unemployment and core inflation. Given current economic data, this rule suggests the Fed should set interest rates at 4.5% to 4.75%, which would mean three or four 0.25% rate cuts.
Yet, rather than preparing for future rate cuts, Fed officials have been consistently playing catch-up. Recent Fed comments, whether from regional bank presidents or Chairman Jerome Powell, have essentially said that they need to see more concrete evidence that inflation is slowing before they begin to cut rates. In fact, some monetary hawks have argued that easing now risks a repeat of the 1970s, when premature rate cuts reignited inflation after it was seemingly defeated. This is completely off the mark. While it is understandable that officials would like to avoid a repeat of the 1970s, there is also the problem of being too fixated on the past. Inflation is a lagging indicator. Today's inflation data represents yesterday's monetary policy. And since policy has not changed, there is little reason to expect inflation to change momentum.
Even if cutting rates a little now proves to be a mistake, it would be a relatively small mistake that could be quickly reversed — after all, as Powell himself pointed out, “trying to tease out the impact of a single 25 basis point rate cut on the U.S. economy is a daunting task.” So better to just do it now.
No one is arguing the Fed should begin aggressive easing, but given how the economy has developed so far, it makes sense to recalibrate policy — doing a little now, rather than doing more once it becomes clear that they should have acted sooner.
In summary, unemployment is rising and there is a risk of it getting higher. Inflation is slowing and there is a risk of it getting higher. And all the while, the Fed is applying rhetoric to yesterday's problems.
Stay calm and move on.
Neil Dutta Chair of the Economics Department at Renaissance Macro Research.
