The labor market continues to be a thorn in the Federal Reserve's side because it just won't cooperate with expectations.
The Federal Reserve has been pretty consistent in saying that it needs to see some deterioration in the remarkably tight labor market in order to know that it is winning its war on inflation and can stop its aggressive interest rate-hiking campaign.
But despite signs of easing inflation, the labor market continues to look quite strong, with unemployment at historic lows. The January jobs report has only made the Fed's task of combating inflation more difficult. Here's why.
It just doesn't make sense
In late 2021 and a large chunk of 2022, a strong labor market fueled wage growth. While normally a good thing, wage growth has enabled consumers to keep spending despite high consumer prices, which drove inflation to some of the highest levels seen in four decades.
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Sensing that it was behind the curve on inflation, the Fed has moved quickly and aggressively, raising its benchmark overnight lending rate (the federal funds rate) from practically zero last March to inside of a range of 4.50% to 4.75% now. It's the fastest the Fed has moved in this short of a time period.
Toward the end of 2022, the Fed started to see some success, which has continued into this year. The Consumer Price Index (CPI), which tracks the prices on a market basket of consumer goods and services, peaked at 9.1% in June on a year-over-year basis. In December, the CPI was only up 6.5% year over year. By the end of this year, some economists think the number might be in the 3% to 4% range.
But during this downward trend in inflation, the labor market has remained puzzlingly strong. The labor market is a lagging indicator and economists have not exactly done the best job of forecasting monthly job numbers, but they missed big time in January. Economists had only expected the U.S. economy to add 185,000 jobs and the number came in at 517,000. Meanwhile, the unemployment rate fell from 3.5% to 3.4%, hitting the lowest level seen since 1969.
Economists found the number surprising because many large tech and finance firms have announced layoffs lately. The growth was led by 128,000 new jobs in leisure and hospitality, showing that different industries are in different places right now. The labor force participation rate also moved up slightly in January and wage growth came in higher than expected but lower than in December.
The rate picture got cloudier...again
The big question here is: What does this mean for the trajectory of interest rates? Many had assumed the Fed was almost done raising rates and numerous banks, economists, and analysts had been factoring rate cuts into their 2023 models this year.
But at a recent economic conference, Fed Chair Jerome Powell said that while the process of disinflation has begun, he thinks it's likely to be a long one and that the Fed will not hesitate to act if it doesn't see progress.
On one hand, the strong labor market could suggest that the economy is not going to tip into a recession this year. On the other hand, many believed the economy needed to see a mild recession in order for the Fed to cut rates.
All of this makes the outlook murkier. We know Powell and the Fed do not want a repeat of the runaway and persistent inflation seen in the 1970s and are going to be thinking about longer-term goals. The strong labor market may at the very least push them to keep rates higher for longer.
The next big data point will be the release of the CPI for January, which is due out next week. If it's in line with expectations, that will be good reassurance for the Fed and the market. If it bounces up and surprises investors, then it could push the market lower.
