Federal Reserve – Time for Interest Rate Cuts as Unemployment Rate Reaches 4.3%

Federal Reserve Chair, Jerome Powell, announced the time for interest rate cuts is now and the fight against inflation is over. The US central bank will begin cutting interest rates in mid-September, signaling the Fed’s fight against inflation is over and focusing on safeguarding employment as a top priority.

Powell and his team are working towards a consensus interest rate cut at next month’s meeting, citing economic data showing inflation is decreasing and increased labor market risks. With the unemployment rate rising from 3.4% to 4.3% over the past year, Powell believes the Federal Reserve has seen enough.

Powell stated the Federal Reserve will not tolerate further labor market cooling, as the inflation measure used for its 2% target is currently at 2.5%. With price pressures easing and hiring measures weakening, Powell will support a strong labor market, potentially leading to an initial interest rate cut of half a percentage point.

Inflation surged in 2021 and 2022, leading to the Federal Reserve raising its benchmark policy rate to its highest level in 25 years. Powell warned of rising joblessness and higher credit costs, causing “pain” for workers and families. The average interest rate on a 30-year fixed-rate home loan rose from less than 3% in 2021 to nearly 8% last October.

Powell predicts the economy will return to 2% inflation with a strong labor market, provided policy restraint is adjusted.

The Rise of Inflation

The COVID-19 pandemic led to economic shutdowns worldwide, causing uncertainty and risks. Americans adapted and innovated, with the U.S. Congress passing the CARES Act and the Fed using its powers to stabilize the financial system and prevent an economic depression.

The US economy began to recover in mid-2020 after a brief recession, but faced the risk of repeating the slow recovery after the Global Financial Crisis. Congress provided substantial fiscal support in late 2020 and early 2021, and spending recovered strongly in the first half of 2021. The ongoing pandemic shaped the recovery pattern, with pent-up demand, stimulative policies, and constrained services spending contributing to a historic surge in consumer spending on goods. The pandemic also impacted supply conditions, with eight million people leaving the workforce and the labor force remaining 4 million below pre-pandemic levels in early 2021.

Inflation spiked in March and April 2021, primarily due to short supply goods like motor vehicles. Despite the pandemic-related factors being temporary, the sudden inflation increase was expected to pass quickly without monetary policy response, allowing central banks to weather a temporary inflation rise.

Inflation Required Strong Policy Response

The transitory economic model, favored by mainstream analysts and central bankers, was initially supported by data showing a slow decline in core inflation from April to September 2021. However, by October, inflation rose and expanded from goods to services, indicating that high inflation was not transitory and required a strong policy response.

In early 2022, headline inflation exceeded 6%, with core inflation above 5%. Supply shocks, such as Russia’s invasion of Ukraine, increased energy and commodity prices. The global nature of inflation was unlike any period since the 1970s, with high rates becoming entrenched. The labor market was extremely tight, with employment increasing by over 6-1/2 million from mid-2021. However, labor supply remained constrained, and labor force participation remained well below pre-pandemic levels. There were nearly twice as many job openings as unemployed persons from March 2022 through the end of the year, signaling a severe labor shortage. Inflation peaked at 7.1% in June 2022.

The Fall of Inflation

The Federal Reserve demonstrated its commitment to price stability by raising its policy rate by 425 basis points in 2022 and 100 basis points in 2023. The 4-1/2 percentage point decline in inflation from its peak two years ago has occurred in a context of low unemployment, a welcome and historically unusual result.

Pandemic-related distortions to supply and demand, as well as severe
shocks to energy and commodity markets, drove the high
inflation. The restrictive monetary policy contributed to a moderation in aggregate demand, reducing inflationary pressures and allowing growth to continue at a healthy pace. The labor market has normalized, reducing vacancies relative to unemployment and reducing inflationary pressures.

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