Federal Reserve officials held off on cutting interest rates this week because they want slightly more data to feel confident that inflation is truly coming under control. But while that approach is cautious when it comes to price increases, it could prove to be risky when it comes to the labor market.
High Fed interest rates help to cool inflation by slowing demand in the economy. When it costs more to borrow to buy a house or expand a business, people make fewer big purchases and companies hire fewer workers. As economic activity pulls back, businesses struggle to raise prices as quickly, and inflation moderates.
But that chain reaction can come at a serious cost to the job market. And as inflation comes down, Fed policymakers are increasingly attuned to the risk that they might overdo it, tipping the economy into a severe enough slowdown that it pushes unemployment higher and leaves Americans out of work.
Those concerns were not enough to prod central bankers to cut interest rates at their meeting this week. For now, Fed officials think that the ongoing slowdown in hiring and a recent tick up in joblessness signal that labor market conditions are returning to normal after a few years of booming hiring. But policymakers are sure to carefully watch the July jobs report set for release on Friday for any sign that labor conditions are cracking — and have been clear that they will be quick to react if they see evidence that the job market is taking a sudden and unexpected turn for the worse.
“A broad set of indicators suggests that conditions in the labor market have returned to about where they stood on the eve of the pandemic,” Jerome H. Powell, the Fed chair, said during a news conference this week. He later added that “I would not like to see material further cooling in the labor market.”
Mr. Powell said the Fed stood prepared to react if the labor market weakened more than expected.
While the central bank is already widely expected to lower rates in September, economists think that officials could move them down faster than they otherwise might if the job market is cooling notably. In fact, investors expect the central bank to cut rates by three-quarters of a point — equivalent to three normal sized rate cuts — by the end of the year.
Some critics of the Fed have argued that the central bank is making a mistake by waiting until its next meeting on Sept. 18 to cut interest rates. Unemployment has already crept up slowly but substantially over the past year, and lingering risks that could cause inflation to get stuck at an uncomfortably high level are fading from view.
Fed rate moves take time to work, so if the central bank only starts to cut borrowing costs when the job market is showing serious signs of strain, it could be moving too late.
“Until the Fed begins cutting, they are going to look behind the curve,” Neil Dutta, head of economics at Renaissance Macro Research, wrote in a research note following the Fed’s meeting this week. “This is a small policy mistake that can be undone very quickly.”
But economists often point to a reason the Fed is tiptoeing rather than running toward rate cuts: The central bank was slow to react when inflation shot up in 2021, something it has faced widespread criticism for, and then was overly optimistic when price pressures began to cool last year. Officials are wary of another head fake.
That is why Friday’s jobs report, along with the August employment numbers, will be so important in shaping the Fed’s thinking ahead of their next meeting. Already, jobless claims shot up to a one-year high in a report on Thursday, the day after the Fed’s meeting.
Now, central bankers are likely to watch for any sign that the unemployment rate has risen further, along with evidence that hiring is slowing and wage growth is cooling. If the report shows signs of a meaningful deterioration, it could put central bankers on alert.
“We’re balancing the risk of going too soon against the risk of going too late,” Mr. Powell said this week. “It’s a very difficult judgment.”