How can the Fed be cutting interest rates again with inflation running so high?
The labor market is now more worrying than high inflation
The big change to the economy this year has been President Donald Trump’s decision to implement widespread tariffs, or taxes on imported goods.
For the Fed, this is known as a supply shock — something that causes a scarcity of goods that impacts the economy. Supply shocks, like tariffs or the 1970s oil embargo, raise prices and also slow economic growth.
The Fed has been watching these two conditions, and for much of the year, inflation seemed the bigger concern. There were consistent warnings from economists that the tariffs would cause inflation to surge. But, at least so far, inflation from tariffs has been relatively muted.
So, even though inflation was at 3% in September, it is better than Fed policymakers were worried about.
Fed officials now think that any increase from tariffs will be transitory and will fade, putting inflation on a downward path to 2%. While inflation might come in hotter than they expect, they believe that it won’t last.
At the same time, the U.S. labor market is now much weaker than anyone at the central bank expected at the beginning of the year.
A series of revisions and surprises over the summer have shown that private-sector job growth has slowed to a crawl. The economy only averaged 29,000 net new jobs over the three months ending in August. This compared with three-month average job gains of 209,000 in the final three months of last year.
“There has been a clear stalling out in employment gains,” said Kathy Bostjancic, chief economist at Nationwide, in an interview. Uncertainty has caused businesses to slow hiring. And if businesses are not passing the costs of tariffs to consumers, they need to find ways to save costs — and that often leads to job cuts.
On Friday, General Motors announced that it had laid off 200 salaried workers.
In the back of their minds, Fed officials are aware of past downturns, when small initial declines in job growth suddenly ballooned into a recession. There is also the “Sahm rule,” which shows that a deep economic downturn usually follows a half-percentage-point increase in the unemployment rate.
So many on the Fed want to move rates lower now as risk management to avoid that outcome.
“It is less damaging to workers to correct a policy move that is too easy than to correct one that is too tight,” explained James Glassman, a former economist with J.P. Morgan, in an email.
