The Federal Reserve’s fight against inflation was going almost unbelievably well. Price increases were coming down. Growth was holding up. Consumers continued to spend. The labor market was chugging along.
Policymakers appeared poised to lower interest rates — just a little — at their meeting on Sept. 18. Officials did not need to keep hitting the brakes on growth so much, as the economy settled into a comfortable balance. It seemed like central bankers were about to pull off a rare economic soft landing, cooling inflation without tanking the economy.
But just as that sunny outcome came into view, clouds gathered on the horizon.
The unemployment rate has moved up meaningfully over the past year, and a weak employment report released last week has stoked concern that the job market may be on the brink of a serious cool-down. That’s concerning, because a weakening labor market is usually the first sign that the economy is careening toward a recession.
The Fed could still get the soft landing it has been hoping for — weekly jobless claims fell more than expected in fresh data released on Thursday, a minor but positive development. Given the possibility that everything will turn out fine, central bank officials are not yet ready to panic. During an event on Monday, Mary C. Daly, the president of the Federal Reserve Bank of San Francisco, suggested that officials were closely watching the job market to try to figure out whether it was cooling too much or simply returning to normal after a few roller-coaster years.
“We’re at the point of — is the labor market slowing a lot, or slowing a little?” Ms. Daly said, as she pointed to one-off factors that could have muddled the latest report, like Hurricane Beryl and a recent inflow of new immigrant workers that left more people searching for jobs.
“It’s clear inflation is coming down closer to our target, it’s clear that the labor market is slowing, and it’s to a point where we have to balance those goals,” she said.
For now, officials appear ready to watch incoming data reports closely as they try to figure out the answer. They will receive payroll revisions data on Aug. 21, a fresh jobs report on Sept. 6 and two Consumer Price Index inflation reports before their meeting on Sept. 18, along with several more weekly unemployment claims reports.
How the data come in will most likely inform just how aggressively central bankers cut interest rates in September. Will they lower borrowing costs by the sharp half-point reduction that many investors have come to expect, or will they stick with their more traditional quarter-point rate cut? Will they make back-to-back reductions, or wait and cut interest rates at every other meeting?
What is clear, at this point, is that the final stretches of the Fed’s fight against inflation are going to be more of a nail-biter than previously expected. While the economy’s cooling seemed calm and gentle, there is clearly a growing risk that policymakers have waited too long to lower interest rates, increasing the possibility of a more painful crash landing.
The Fed’s policy rate is now set at 5.3 percent, a high level that economists think is tapping the brakes on economic growth. Officials decided just last week — immediately before weak labor market data came out on Thursday and Friday — to hold borrowing costs at that level. They wanted just slightly more evidence that inflation was under control, and they thought that the labor market was strong enough to hold up as they took a patient approach.
Policymakers were widely expected to lower interest rates at their meeting in September, even before the jobs report last week. But after its release, investors sharply increased their bets for bigger reductions in borrowing costs.
That’s because interest rates are thought to be weighing on the economy pretty heavily at their current level. If incoming data in the weeks and months ahead suggest that the economy is in fact slowing sharply, officials may want to return rates to a more normal level rapidly to avoid further hitting the brakes on growth. By essentially taking their foot off the brake pedal, officials may be able to avert a more painful stop.
“The totality of the data — to quote how the Fed likes to talk about it — is definitely shifting toward one where growth concerns are more elevated,” said Michael Feroli, the chief U.S. economist at J.P. Morgan. “We’re in a process of labor market slowing, and it doesn’t feel like we’re in the final innings of that process, so I think that’s the concern here.”
Mr. Feroli expects the Fed to cut interest rates by half a point in September and half a point in November and then lower rates by a quarter point at every meeting after that.
There are still reasons to think the Fed could pull off a soft landing, even if officials do not end up slashing rates in the months to come. Labor market data could still be revised, and both consumer spending and overall growth data have held up OK. Incoming data may suggest that the recent jitters are a false alarm.
But if the economy does weaken to the point that it tips into a downturn because interest rates have been so high for so long that activity is pulling back in a cycle that will begin to feed on itself — fewer jobs leading to less spending, less spending leading to less hiring — it will not be the first time that the Fed has caused a recession in its quest to lower inflation.
The most famous instance came in the early 1980s, when Paul A. Volcker’s central bank pushed rates to punishingly high levels in order to wrestle price increases under control.
In fact, there was a time at the start of the Fed’s fight against inflation when Jerome H. Powell, the Fed chair, specifically invoked Mr. Volcker’s experience.
Mr. Powell used his 2022 speech at the Jackson Hole symposium, a closely watched Fed conference that takes place each year in late August, to explain that fighting inflation would come with “unfortunate costs.” His walk-off line invoked Mr. Volcker’s memoir “Keeping at It,” published in 2018.
“We will keep at it until we are confident the job is done,” Mr. Powell said.
As recently as a few weeks ago, it seemed the central bank might have managed to wrangle price increases without the unfortunate side effects Mr. Powell once warned America about.
But as this year’s Jackson Hole conference approaches, the recent data suggest there is a risk that the Fed will be faulted for keeping at it a little too long.