Lower Growth Suddenly Worries the Fed

The Federal Reserve, now worried about slow economic growth, shifted its focus from inflation to the labor market.

The unique feature of the current economic cycle is growth wasn’t fueled by private sector borrowing. Instead, government borrowing and spending powered the economy.

That’s why the rapid increase in interest rates beginning in 2022 didn’t trigger a recession and slowed growth only moderately.

The labor market remained strong. Compensation increased faster than the average of the last few decades, supporting spending increases by households.

But signs of a weaker labor market emerged in recent months. Unfilled job openings declined, and the unemployment rate increased. Compensation increases still exceed the pre-pandemic average but are below the recent highs.

Unlike in past cycles, the labor market isn’t cooling because of faltering growth. Businesses aren’t engaged in widespread layoffs.

One reason the labor market is softer is a sharp increase in the labor supply, due largely to a surge in immigration. In a sharp change from just a few years ago, there are more than enough new workers to replace retiring Baby Boomers and those who took part in the Great Resignation during the pandemic.

Another factor is the decline in government stimulus.

Most state and local spending programs initiated during the pandemic are ending. Federal stimulus programs also ended or shifted to more targeted spending, such as the subsidies for electronic vehicles.

Though federal budget deficits and spending still are high, they are below their pandemic peaks. The reduction in government spending hasn’t been replaced by higher private sector borrowing, investment and spending, so household income isn’t rising as rapidly.

Real interest rates, which are nominal rates minus inflation, are key to economic growth. The Fed held nominal interest rates steady while inflation fell, so real interest rates are high. They need to fall.

The labor market usually is the laggard among economic indicators. But, because this cycle has been different, employment is likely to be more of a leader, and the Fed is using it to guide monetary policy.

The labor market is about at the lower point of the Fed’s comfort level, because a cooler labor market could lead to an economic downturn.

A weak labor market means households have less money to spend. They’ll also feel less secure and will increase savings.

As spending declines, businesses reduce their hiring and investing. A steady drop in spending could cause a reinforcing spiral of layoffs and compensation decreases.

The Fed hasn’t been subtle. Its officials clearly stated that their focus is on employment, and they don’t want to see further weakening in the labor market.

Inflation is much less of a concern to the Fed than even a few months ago.

The Fed has been cautious about easing monetary policy since it mistakenly thought higher inflation in 2021 and 2022 was transitory. But it is confident now that economic forces are bringing inflation steadily toward the 2% target rate.

This gives the Fed more freedom to make bigger-than-expected rate cuts and implement multiple cuts, if it thinks that’s what the economy needs.

The Fed wants to stimulate the private sector enough to replace the government programs and maintain a desirable growth rate.

The risk of the Fed’s approach is that inflation could be reignited quickly, but it’s a risk the Fed will take at this point.

It is also probably a modest risk and easier to deal with than a reinforcing downward spiral.