This slowdown should be a cause for concern, because unemployment tends to be inertial: like a rock rolling down a hill, once it starts moving, it tends to keep moving in that direction. And unless someone steps in front of the rock to slow it down, the recent deterioration raises concerns that unemployment will rise again. Clearly, the Federal Reserve should be the force that slows the decline in the jobs market.
The Fed’s next steps will have a big impact on the chances of avoiding a bigger rise in unemployment. In recent years, it has raised interest rates to try to slow rapidly rising prices, but with inflation largely under control, the risks have now shifted to the labor market. Waiting too long to cut interest rates to support the economy will only increase the risks of a labor market collapse.
In short: The Fed needs to hurry up and cut rates.
The labor market is at an inflection point
The United States’ emergence from the worst pandemic lockdown in early 2020 helped usher in a historic labor market boom. From April 2020 to April 2023, the economy added 25 million jobs, an average of 674,000 new employees per month. Unemployment hit a 54-year low of 3.4% in April 2023, and hiring rates soared. The historic strength of the labor market has allowed average workers to make significant gains: wages in low-end service occupations in retail and hospitality grew the fastest.
Over the past year, that has changed. In the first six months of 2024, the unemployment rate climbed 0.4 percentage points to 4.1%, up 0.7 percentage points from its historic low. While that may seem like a small adjustment, it translates to 1.1 million more Americans unemployed than in April 2023, and about 550,000 more people out of work this year alone. It’s important to note that the unemployment rate is back to where it was before the pandemic upheaval: At 4.1%, the unemployment rate is where it was at the start of 2018.
The rise in unemployment has coincided with many other signs that times are tougher for job seekers: Job openings, a proxy for business demand for labor, have declined. Even those who do have jobs are more anxious about their prospects. After peaking at 3.3% between late 2021 and early 2022, the private-sector quit rate is lower today than it was at the start of the pandemic.
These labor market warning signs are compounded by weak economic data. Real GDP grew at a 1.2% annualized rate in the first quarter, and the Atlanta Fed’s GDPNow model estimates a second-quarter rate of 1.5%. That would bring the average for the first half of the year to a relatively sluggish 1.4%, below the Fed’s estimates for the long-run potential.
There are also two major signs that the second half of the year may not improve. First, after a strong increase in residential investment in recent quarters, the outlook for residential construction has weakened due to the decline in building permits. Any slowdown in residential investment is likely to weigh on GDP growth. Second, consumption is slowing after finishing 2023 at a strong pace. Retail and food service sales have been essentially flat over the past five months as people have started to cut back on spending.
The bleaker growth outlook matters because, even though real GDP grew by 3.1% last year, the unemployment rate still rose by 0.2 percentage points to 3.7%. Ultimately, employment follows economic growth. If 3% growth couldn’t keep unemployment from rising in 2023, why would the unemployment rate remain stable in 2024 if growth is significantly weaker?
As the economy slows, the outlook for the job market worsens. Once things start moving in one direction, they tend to accelerate and can be difficult to reverse. In other words, it is rare to see the unemployment rate increase even “slightly.” One way to visualize this phenomenon is the Beveridge curve, which plots the relationship between job vacancies and unemployment.
As the chart above shows, when unemployment is low, job openings can decline significantly without unemployment rising accordingly. But when unemployment rises, the situation intensifies and the disappearance of job openings accelerates. In the aftermath of the pandemic, it was thought that, given the strength of the labor market, job openings could decline without causing unemployment to rise significantly. But after three years of slow and steady adjustment, our current position on the curve means that any further deterioration in job openings is likely to cause unemployment to rise somewhat more.
Even a small increase in the unemployment rate would have real consequences. The Fed must balance employment and inflation. If unemployment rises, even for benign reasons such as an increase in the supply of labor, it implies that there are more people competing for a given level of employment. Thus, the more unemployed people there are looking for jobs, the more those looking for jobs can push down the wages of those currently working. This slows inflation and implies less need for less restrictive monetary policy.
There is a way to avoid this
Whether unemployment is large or not, the best way to avoid throwing more people out of work is for the Federal Reserve to step in. The Fed’s role boils down to two goals: maximizing the number of people employed while keeping inflation in check. Over the past three years, the inflation component of that equation has taken precedence: interest rate hikes have been the price to pay to slow price growth. But as inflation has slowed, the balance of risks has tipped toward unemployment. Waiting too long to start cutting interest rates risks making the labor market weaker. The Fed would be much wiser to start adjusting policy now, before more aggressive action is needed.
Given the state of the economy, there is good reason to start cutting rates as soon as possible. The 4.1% unemployment rate is already above the central bank’s consensus forecast for year-end, meaning the jobs market is deteriorating at an even faster pace than expected. At the same time, there are signs that inflation, the economic dragon the Fed has been trying to slay with its rate hikes, has been brought under control. The core personal consumption expenditures price index, the Fed’s preferred measure of inflation, is running about 2.5% compared with the same period last year. There are also signs that inflation will continue to moderate, such as the continued strength of the U.S. dollar, which will help lower prices for imported consumer goods.
In times of uncertainty, as the Fed claims, it is helpful to refer to rules of thumb to guide future actions. One such rule is the Taylor rule, a fairly crude formula that suggests the level of interest rates to set based on the unemployment rate and underlying inflation. Given current economic data, the rule suggests that the Fed should keep interest rates between 4.5% and 4.75%, which implies three or four rate cuts of 0.25%.
But instead of preparing for future cuts, Fed officials have consistently been late. From regional bank presidents to Jerome Powell, the Fed’s recent rhetoric has boiled down to this: We need to see more concrete evidence that inflation is slowing before we start cutting rates. Indeed, some policy hawks argue that easing now risks taking us back to the 1970s, when premature cuts allowed seemingly tame inflation to return. That’s a red herring. I understand that officials want to avoid a repeat of the 1970s, but living too much in the past is also a problem. Inflation is a lagging indicator. Today’s inflation data represents yesterday’s monetary policy. Since policy hasn’t changed, there’s little reason to expect inflation dynamics to change either.
Even if a small interest rate cut were to turn out to be a mistake, it would be relatively small and could be reversed quickly. After all, as Powell himself has pointed out, if one were “trying to make the case for the importance of a 25 basis point rate cut to the U.S. economy, one would have a lot of work to do.” In that case, one might as well get started!
No one disputes that the Fed should start easing aggressively, but it makes sense to readjust policy given how the economy has performed so far. The idea is to do a little now rather than having to do more when it becomes clear that action should have been taken sooner.
To sum up: unemployment is up, and there is a risk that it will continue to rise. Inflation has slowed, and there is a risk that it will slow further. And in the meantime, the Fed is adapting its rhetoric to yesterday’s problems.
Get a grip on yourself and move forward.
Neil Dutta is head of economics at Renaissance Macro Research.