After 3rd consecutive rate cut, Fed credibility on inflation could be at stake

For the third straight meeting, the FOMC in December enacted a 0.25% reduction in the federal funds rate. Those moves reflect a collective view that risks to the labor market outweigh risks to price stability. But there were three dissents, meaning this was a close call.

While there are strong arguments on all sides, I continue to view price stability as the more pressing risk.

Let me explain why.

Here’s how the employment market has changed

Credit: Stephen Nowland/Federal Reserve

Credit: Stephen Nowland/Federal Reserve

The employment market is, at best, moving sideways. Employment growth has slowed to around 17,000 new jobs a month in the six months through November, compared to 139,000 in the prior six months. It’s also taking the unemployed longer to find work. These suggest that labor demand is cooling.

Despite this, it is unclear to me whether the labor market is significantly out of balance since labor supply growth is also slowing due to changes in immigration policy and shifting demographics. The three-month average for the unemployment rate for August, September and November — the government did not release unemployment figures for October — was 4.4% compared to 4.2% in the same months a year earlier.

And careful analysis by our staff economists suggests that the labor market is likely not at a negative inflection point. Big picture, I do not view a severe labor market downturn as the most likely near-term outcome.

That said, it is difficult to divine a signal to guide policy from prevailing labor market indicators. Most notably, while labor demand is clearly declining, it is unclear whether cyclical or longer-term structural forces are responsible.

Moreover, broad-based cyclical labor market weakness would almost surely be accompanied by signs of significant economic weakening. I see indications of gradual softening, but not a pronounced slowdown.

All this tells me we need to decipher numerous dynamics to determine the labor market’s status relative to the FOMC’s maximum employment goal. Before we prescribe strong remedies for today’s labor market conditions, we should understand the root causes of the shifts, not just the symptoms.

If we are entering a cyclical labor market downturn, then a monetary policy response is probably in order. By contrast, if labor market shifts reflect more structural forces such as demographics, reduced immigration, and technological advances, then monetary policy is probably not the ideal first-level response.

Indicators suggest inflation won’t hit 2% objective soon

Turning to price stability, it is worth remembering that inflation has exceeded the 2% target for nearly five years. During this time, the price level has increased by approximately 20%, even more for necessities like food, shelter and insurance. The September reading on the all-important personal consumption expenditures price index, the latest we have, lingered well above target — at 2.8%.

Based on the data in hand and forward-looking indicators, I see little to suggest that price pressures will dissipate soon and expect inflation to remain above 2.5% at the end of 2026.

That gets me to the rub: If underlying inflationary forces linger for many months to come, I’m concerned that the public and price setters will eventually doubt that the FOMC will hit the inflation target in any reasonable time frame.

When will the public lose faith?

Nobody knows. What we do know is that credibility is a cornerstone of effective monetary policy. I’m mindful of how hard-won our credibility is and how difficult it would be to regain it should it slip away. I think a half-decade or more of missing the target could well imperil the committee’s credibility as a steward of price stability.

That would lead to higher inflation expectations. Should expectations for the medium- and longer-term climb and influence behavior in ways that produce higher long-run actual inflation, history suggests that pain in the form of higher unemployment could be required to pull inflation expectations back into the long-run target range.

I’m not immovable in my stance. We will be getting a lot of data in the coming weeks, as the federal agencies release numbers for the months when the government was closed. These data could shed light on whether weakness in labor markets and the persistence of inflation have significantly changed.

Raphael Bostic is the president and chief executive officer of the Federal Reserve Bank of Atlanta. This guest opinion column was adapted from a Dec. 16 essay published on AtlantaFed.org. Bostic intends to retire when his term ends in February.