Fed's fear meter may be pointing to stagnation, rather than stagflation

Adam

Summary:

The Fed is set to cut rates next week, shifting focus from inflation to a weakening job market. Officials may opt for 25 bps but debate 50 bps, as employment revisions show sharp slowdown.

Federal Reserve officials, already expected to cut interest rates next week, may also be closer to settling a months-long debate over the risks of stagflation after recent data showed longstanding weakness in hiring and easing inflation concerns.

The shift in tone began this summer, led by dissents in July from two Fed governors who wanted to cut rates at that time based on risks to the job market, and continuing as other officials began downplaying inflation and focusing more on an economy that was slowing and at risk of shedding jobs.

As the U.S. central bank's September 16-17 meeting nears, the latest batch of data shows the unemployment rate rose in August to 4.3% and the economy actually lost jobs in June following a revision. Had that data been available in the initial June estimates, it could have influenced the Fed's decision on July 30 to hold its benchmark interest rate steady in the 4.25%-4.50% range, where it has been since December.

In addition, a benchmark revision of employment this week indicated nearly a million fewer jobs were added in the year through March than originally reported.

Consumer prices in August did rise faster than in the prior month, but initial jobless benefits claims jumped in the latest week, in another sign of labor market cooling.

The situation resembles last summer when slowed hiring and downward revisions to prior estimates prompted a half-percentage-point rate cut at the Fed's meeting that September. While market analysts, including 105 of 107 economists in a recent Reuters poll, expect only a quarter-percentage-point cut next week, the latest data could lead officials to project a quicker and steadier drop in rates as they move from guarding against inflation to defending the job market.

"The Fed should cut 50 basis points next week ... Labor market conditions are cooling more rapidly than they were to start the year. Underemployment has been rising more quickly than the ... unemployment rate. Tariff-related pass-through has not been as large as anticipated. Inflation expectations look benign," Neil Dutta, head of economics at Renaissance Macro Research, wrote in a note.

But Dutta added that he expected the central bank's policy-setting Federal Open Market Committee to compromise on a 25-basis-point cut "with a stronger commitment to backstop the labor market."

That commitment may be seen in policymakers' updated economic projections for inflation, unemployment and the Fed's policy rate through the end of this year and into 2028. Those quarterly projections, which will be released with the latest policy statement on Wednesday, are an important mark-to-market exercise at a time when President Donald Trump is demanding rate cuts and taking steps to gain influence over the central bank, including attempting to fire Fed Governor Lisa Cook.

The last quarterly projections in June showed Fed officials anticipated two quarter-percentage-point rate cuts this year, but seven of the 19 anticipated no moves as they mulled how Trump's tariffs might complicate efforts to return inflation to the central bank's 2% target.

There was even talk within the central bank and in financial markets of a risk of stagflation, a phenomenon marked by high inflation and unemployment and stagnant economic growth. It last reared its head in the U.S. in the 1970s and early 1980s.

But data this summer has tended to ease that concern while raising uneasiness about the direction of the job market.

EMPLOYMENT DATA SETTING OFF ALARMS

The pass-through of tariffs to consumer prices has been more tempered than expected. Though inflation is expected to accelerate this year, and could end 2025 a percentage point or more above the Fed's target, policymakers have become more comfortable with the idea that any tariff-driven boost would be a one-time price shock they could largely ignore.

Fed Chair Jerome Powell called that view "a reasonable base case" in remarks last month at a Fed research conference in Wyoming, with the most recent data bolstering the sense that the combination of higher import taxes and curbs on immigration may be slowing the economy more than it is boosting consumer prices.

The recent benchmark employment revision, meanwhile, points to substantially fewer job gains at the start of 2025, a key moment when officials decided to pause what had been an expected series of rate cuts this year on concern that tariffs could rekindle inflation.

Based on the estimates available at the time, the job market was not a concern. But, excluding two months at the end of 2024 when hiring jumped in a bout of business exuberance following Trump's election in November, the revised data show job gains from April 2024 through August 2025 may have averaged just 40,000 a month, virtual stall speed for the U.S. economy.

The unemployment rate has remained relatively low, but only because immigration curbs have also slowed growth in the number of available workers.

Other warning signs are growing. The breadth of hiring across industries has narrowed to levels seen ahead of a recession, and data released alongside the latest employment revisions showed the number of large U.S. counties adding jobs hit the lowest level in 14 years outside of the COVID-19 pandemic.

The unemployment rate for Blacks, typically the first to increase as the economy slows, has jumped from 6% in February, Trump's first full month back in the White House, to 7.5% in August. The rate for whites by contrast edged down to 3.7% from 3.8% in February.

The Fed won't declare victory over inflation next week, given the expectations for faster price increases this year, or even make a firm commitment to the pace of rate cuts, said Vincent Reinhart, a former Fed staffer who is now chief economist for BNY Investments.

Fed officials are willing to make a quarter-percentage-point cut, he said, but "I think they frame it as a recalibration" after concluding tariffs will have less of a price impact than feared and likely won't trigger persistent inflation. But "signing on to a succession of rate cuts? They're not there yet ... I don't read the macroeconomy as needing that. I don't read the committee (members) as wanting that, or at least most of them."

Indeed, consumer spending has held up better than anticipated, while investment gains around artificial intelligence have boosted output.

But the jobs slowdown is real.

Francesco Renna, an economist with Chmura Economics & Analytics, said the firm's JobsEQ database showed openings were down more than 7% from a year ago and off a "striking" 27.1% from 2023. "Employment growth in the U.S. is indeed losing steam," he said.

source : Reuters

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