Financial markets have suddenly begun to price in the risk of a U.S. recession. The S&P 500 closed on Wednesday down almost 7 percent from one month ago, with nearly all of the decline concentrated in the past few days.
Where should the Federal Reserve go from here? Given the surprise increase in the unemployment rate and the reaction of financial markets, it seems safe to assume that policymakers wish they had reduced rates at last week’s meeting. But the failure to do so need not be costly, and correcting it does not require an emergency meeting and a rate cut.
The proximate cause of the market reaction is last week’s Employment Situation report showing the jobless rate at a 33-month high, having risen 0.6 percent since January. The deeper concern is that the Fed remains behind the curve, keeping its policy rate too high as it is still overly focused on fighting the last war of inflation reduction. The new reality is becoming clearer: inflation almost back to the target rate of 2 percent and weakening in the real economy.
The facts dictate concern but not panic. Start with the latest labor market data. The July unemployment rate of 4.3 percent is not historically high. In fact, Fed policymakers have long predicted that their tightening cycle would result in an unemployment rate at the end of 2024 around 4.5 percent. If the unemployment rate peaks around its current level, the Fed will justifiably celebrate having achieved a soft landing.
The concern is the upward trend. The post-World War II historical record contains seven previous episodes when the unemployment rate stood below 5 percent, having risen 0.5 percent or more over the previous six months; on average, over the subsequent six months, the unemployment rate rose a further 1.7 percentage points. Such an increase would indeed bring the U.S. economy into a recession. Yet, past need not be prologue.
To understand the Fed’s quandary, consider why it raised interest rates and has kept them high. Inflation in the Fed’s preferred price index surpassed 7 percent in the 12 months ending in June 2022, a result of a mix of commodity price shocks and sectoral bottlenecks brought on by the Covid-19 pandemic, changing preferences in housing markets and expansionary fiscal policy, including the American Rescue Plan.
The Fed eventually responded with a historically rapid tightening cycle, raising the policy rate by 5 percentage points from March 2022 to August 2023. Accounting for the decline in inflation expectations over that time, the real interest rate — which more closely affects business investment decisions — rose even more. Typically, higher interest rates discourage borrowing, leading to fewer new homes purchased by households and less new investment by businesses. The decline in spending means businesses need fewer workers, starting a cycle that causes unemployment to rise.
Yet, as late as the end of 2023, the unemployment rate did not appear much affected — contrary to some economists’ expectations. Perhaps reflecting this thinking, the upcoming Jackson Hole Symposium, the flagship research conference of the Federal Reserve system, has the theme “Reassessing the Effectiveness and Transmission of Monetary Policy.”
With hindsight, the labor market response to monetary policy tightening looks less atypical. The recent rise in the unemployment rate is one manifestation. More strikingly, the number of unemployed job seekers for each job opening has risen by 60 percent since the tightening cycle started, suggesting that companies have indeed reduced their need for new workers. At least three other factors have also worked to offset some of the Fed’s tightening: high business and infrastructure investment following the Bipartisan Infrastructure Law, the CHIPS and Science Act, and the imprecisely named Inflation Reduction Act; a large increase in immigration and the rapid provision of temporary work permits; and consumer spending buoyed by continued labor market strength and the strong stock market.
Even as the stock market has fallen, so, too, have borrowing costs as financial markets price in expected future Fed action. The interest rate on a 10-year Treasury bond has fallen more than three-quarters of a point from its high at the end of April, and the rate on a 30-year mortgage has followed it down. Expect mortgage rates to fall further. As rates come down, households and businesses may step in with additional spending.
At the moment the Fed needs only to acknowledge and validate expectations of future rate cuts. The Jackson Hole symposium, starting Aug. 22, offers a convenient opportunity to reiterate that data dependence means paying attention to both sides of the Fed’s dual mandate — inflation and full employment. But the Fed should not wait to put the message out.
Recent history underlines the risks of waiting too long to lower rates. When the Federal Open Market Committee met in December 2021, the most recent available data showed an unemployment rate of 4.1 percent and 12-month inflation at 6 percent. Looking ahead, policymakers forecast the unemployment rate to decline to a median 3.5 percent by the end of 2022 and remain there while inflation would fall gradually to reach 2.1 percent by the end of 2024.
Despite this optimism, the F.O.M.C. left its main policy rate at essentially zero percent and projected it would reach only 2.1 percent by the end of 2024. The thinking was that the inflation was transitory and would fall of its own accord, and that recovery from the Great Recession had been unnecessarily slowed by the Fed prematurely tightening policy in expectation of inflation that never materialized. The mantra was: wait until the Fed saw “the white of inflation’s eyes.” But waiting for bad data to arrive means waiting too long, and three months later the Fed began its course correction.
The comparison to December 2021 offers additional perspective. Even a three-quarter-point reduction at the next F.O.M.C. meeting would leave monetary policy much more restrictive than it was three years ago, despite a comparable unemployment rate and much lower realized inflation. The Fed has room to cut interest rates without jumping immediately to a policy of easy money that would risk losing the last mile of the disinflation campaign.
Why not wait a little longer to see what other data say, reducing the risk of having to flip-flop and raise rates again if warranted? After all, perhaps last week’s report will turn out to be a blip — other recent data releases have come in stronger. Such a policy would risk much, as financial markets, businesses and households will not wait to react to the incoming data.
The Fed’s credibility rests instead on following its declared strategy of data dependence, lowering expectations of future rates now and preserving the option to pivot in either direction as new developments arise.
Gabriel Chodorow-Reich is a professor of economics at Harvard and a visiting scholar at the Federal Reserve Bank of Boston.
The Times is committed to publishing a diversity of letters to the editor. We’d like to hear what you think about this or any of our articles. Here are some tips. And here’s our email: letters@nytimes.com.
Follow the New York Times Opinion section on Facebook, Instagram, TikTok, WhatsApp, X and Threads.