Fed Faces Dilemma: Sticky Inflation vs. Soft Labor Market

Data has been sticky, which dulls the case for more rate cuts. The counter-argument points to a gradual but conspicuous softening of the labor market. The Fed has a dual mandate to minimize inflation and maximize employment, but sometimes conditions require the central bank to favor one over the other, if only slightly. We appear to be in one of those times.

Using a simple model of inflation and unemployment to evaluate Fed policy suggests that the current stance is modestly tight, as shown in the chart below. But the hawkish bias is relatively mild compared with recent history and is close enough to an estimate of equilibrium to leave room for debate about whether policy should be left unchanged for the moment. Inflation data provides a basis for pausing rate cuts. In the November report on consumer prices the numbers show that disinflation has stalled. Consider a measure of the inflation bias, which is based on several estimates of consumer inflation via various indices published by regional Fed banks along with the standard metrics published by the government. Taking the average of these indices indicates that the year-over-year bias has edged higher for two straight months through November – the first back-to-back increase in nine months. A third month of upside bias would further raise the reflation-risk potential. But on the employment front there are signs that the labor market is slowing. It’s modest, at least so far, while the unemployment rate remains low at 4.2% in November. But the Fed seems increasingly focused on supporting. Over the last several months, new filings for unemployment benefits have been rising vs. the year-earlier levels. The rise is relatively moderate so far, but the change gives the Fed a degree of cover for taking pre-emptive action to provide employment support. Consider, too, that the year-over-year trend in nonfarm payrolls has been slowing over much of the past year. It’s debatable if the

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Fed Faces Dilemma: Sticky Inflation vs. Cooling Labor MarketThe Federal Reserve is grappling with a decision on interest rates as inflation remains stubbornly high despite signs of a softening labor market. While recent data shows that disinflation has stalled, the unemployment rate remains low at 4.2%. The Fed has a dual mandate to control inflation and maximize employment, but the current economic conditions may require prioritizing one over the other.
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