Econ Prof: Cracks in Labor Market Signal Need for Early Rate Cut

The state of the economy is cloudy. Political tensions are high around the world. The Supreme Court is deliberating on the ability of the President of the United States to dismiss a Fed governor. And the U.S. Justice Department recently opened an investigation into Jerome Powell, the chair of the Federal Reserve.

Economics Professor Vikram Kumar shared his thoughts on the economy and how the Fed should respond to a number of the headwinds it’s facing:

The Fed’s mandate calls for it to pursue two goals that are in tension with each other: a 2% inflation rate target and maximum employment. Since the pandemic, the Fed has been chasing high inflation rates. Where does inflation stand right now? 

Inflation is pretty much where it has been recently. The headline and the core PCE (Personal Consumption Expenditures) inflation rates are both at 2.8%. Which is pretty much going sideways. 

But my feeling is that the inflation numbers are actually a little better than they appear. 

I think a good part of the price increases are due to the tariffs — which are, most likely, one-time increases. They are not going to set off a continual spiral. In other words, these prices have gone up but they are not likely to continue going up. Of course, that could change. Also, to the extent that firms reset prices at the beginning of the year, those prices would be reflected in the next few inflation readings. But inflation should moderate by the summer. 

Overall, the inflation scenario has limited downside risk at this time. 

How does the labor market, the other side of the Fed’s mandate, look?

I'm more worried about that. 

First of all, the unemployment rate is higher now than it was in July. It's ticked up to 4.4%. 

And if we look into that a bit more, a lot of that increase in unemployment is coming from people who are long-term unemployed: the proportion of people unemployed for more than 26 weeks has increased substantially. And people who are unemployed for the long term also tend to become unemployable.

Part-time workers are getting stretched as well. More workers are employed part-time for economic reasons; many workers are working part-time because they have had their hours reduced, so they may have the same job but they work fewer hours. 

Job openings have declined significantly as well. The hiring forbearance could be due to policy uncertainty or the emerging impacts of AI may be playing out on productivity. In either case, caution and concern about the labor market is indicated. 

On the other hand, fewer job openings have been balanced by a much smaller increase in the labor force, no doubt, due to changing migration patterns, especially at the Southern border. But no matter the causes, labor market vulnerability is in evidence. 

So what do you think the Fed should do this week? 

Professional forecasters and prediction markets overwhelmingly think the Fed is going to maintain its current stance of monetary policy: it will keep the Federal Funds rate in the 3.50-3.75% range. 

However, I recommend a modest easing. The Fed should cut its policy rate by 25 basis points this week. For reasons mentioned above, I perceive the downside risks to the labor market outweigh the risks of inflation. 

The Fed is likely to lower the rate two quarters from now anyway. The Fed’s December Summary of Economic Projections also suggests that the Fed is going to cut rates a couple of times this year, likely in the latter half. Given the current vulnerability of the labor market, and the fact that monetary policy works with long and variable lags, it is advisable to provide some supportive stimulus right now. 

The Fed is facing unusual political pressure at the moment. What kind of risks does that pressure bring?

The biggest casualty of the political imbroglio, potentially, would be the untethering of inflationary expectations. In addition to managing the actual interest rate, the Fed also has to manage the market expectations about rates.

Inflationary expectations basically drive the trajectory of inflation.

The latest number from the New York Fed’s survey of Consumer Expectations showed a small uptick in inflationary expectations over the next year. The 10-year Treasury bond rate also spiked the week the subpoena to the Fed chair was issued. Such changes could well be reflective of these political issues. Keeping inflationary expectations anchored is critical to managing inflation.