The Federal Reserve is set to begin cutting interest rates next month for an unusual reason: Not out of fear that the economy is tipping into recession, but because officials now believe it can generate more jobs than they thought.
In other words, Chairman Jerome Powell and company are acknowledging they made a mistake in the past few years by assuming that sub-5% unemployment rates would yield rising inflation and thus tighter monetary policy was warranted.
“I think we really have learned, though, that the economy can sustain much lower unemployment than we thought without troubling levels of inflation,” Powell said in an exchange with Rep. Alexandria Ocasio-Cortez last week in congressional testimony.
In the same Capitol Hill appearance, Powell made clear that the Fed anticipates lowering its target interest rate at its monetary policy meeting scheduled for next month. By the end of his testimony, bond market prices indicated that investors expected at least one and possibly even two rate cuts.
Usually, Fed officials only start cutting rates too late, as the economy has already begun a slide into recession.
For instance, the last time the Fed entered a rate-cutting cycle, in September 2007, the nation was just three months from the official start of the Great Recession. Unemployment had already been rising for months, and the labor market had shed jobs in July and August.
Similarly, when the Fed began cutting rates in January 2001, job growth had stalled out several times the year before, and the economy would tip into recession two months later.
The situation is not the same today.
To be sure, recessions can hit at any time, and Fed officials have said that they see some warning signs of economic risk, such as the trade wars causing uncertainty for business executives looking to invest.
But just as large a factor in their thinking is that the labor market has more capacity for expansion than they thought. They are coming to grips that they have, for years, underestimated the potential for job growth.
Over the past three months, employers have added 171,000 jobs a month, nearly twice the rate needed to keep unemployment trending down. Furthermore, claims for unemployment insurance have remained stuck at historically low levels, suggesting that layoffs are infrequent. Those are signs of a strengthening labor market, not a deteriorating one.
The brightest signal that the jobs recovery has not yet run its course is that wage gains, while improving, are still not what they would be in a fully mature economy. Only in recent months have average hourly earnings eclipsed a 3% annual rate of growth, which is healthy but below what was seen in the mid-2000s or, earlier, in the years of the dotcom boom.
Powell noted during last week’s testimony that wage growth is the proverbial dog that didn’t bark.
In response to a representative’s question about whether the Fed risked pushing the economy too “hot,” Powell responded that while 3.7% is a low unemployment rate, “To call something hot, you need to see some heat. And while we hear lots of reports of companies having a hard time finding qualified labor, nonetheless we don’t see wages really responding, so I don’t really see that as a current issue.”
In the Fed’s view of the economy, inflation is not a major risk if wages aren’t rising quickly and there are still workers available to hire. In other words, Powell was depicting an economy that still hasn’t reached the end of the business cycle, even 11 years into the recovery.
In portraying the economy as one still with spare capacity, Powell was bringing himself into alignment with President Trump and his economic advisers, supply-siders like Larry Kudlow who have called on the Fed to keep money loose to boost Trump’s tax-cutting and regulation-lifting agenda.
Powell was also breaking with his past assessments. When President Trump nominated him to chair the Fed in November of 2017, Powell hinted that the economy was at the peak of the business cycle.
“By many measures, we’re close to full employment and inflation has gradually moved up toward our target,” Powell said then, nearly 4 million jobs ago.
Nor was he alone in that view.
As far back as four years ago, for example, then-Fed Vice Chairman Stanley Fischer, a central banking veteran and eminent academic, declared in an interview with Bloomberg that the country was at “nearly full employment.” At the time, unemployment was at 5.1%.
More examples: As far back as February of 2015, San Francisco Fed president John Williams, now the head of the New York Fed and accordingly one of the most prominent economic officials in the U.S., said that “we’re going to reach full employment by the end of the year.” Around the same time, with unemployment around 5.5%, a number of Fed officials issued official projections that unemployment was already around the rate it would be if the economy were fully healthy.
In other words, Fed officials expected for years that higher inflation was right around the corner. Yet inflation has failed to break above the Fed’s 2%, and today is running at around 1.5% even with much lower unemployment.
Altogether, those indicators signal more job growth to come. And, now, a Fed more willing to accommodate it.
