For the last three years, the Federal Reserve has been fighting to bring inflation down. Now it has boldly moved to protect the second half of its dual mandate: to keep employment strong.
On Wednesday, the Fed broke with precedent and cut its policy interest rate by 0.5 percentage point instead of the usual 0.25. The decision, which surprised many, is good for the economy and begins the last phase of the Fed’s policy response to the Covid pandemic. At the start of the pandemic, the Fed rapidly slashed rates effectively to zero to keep the economy afloat — only to drastically change course and raise rates just as rapidly in 2022, when inflation spiked. With this week’s decision, the Fed has brought the federal funds rate, now in a target range of 4.75 percent to 5 percent, a step toward pre-pandemic norms.
The Fed has now clearly signaled that it is starting to wind down its battle against inflation. And for good reason. Personal consumption expenditure inflation, its preferred measure, was 2.5 percent in July, and while that’s still somewhat elevated, it’s about a third of the peak in 2022. The data has shown inflation falling for much of the past two years. Even after this cut, the funds rate remains high enough to discourage some borrowing and spending, so the Fed is still fighting inflation by restraining demand.
Unlike many other central banks, however, the Fed has a mandate for maximum employment along with price stability, and the decision for a larger cut also signals that it is taking seriously recent signs of slowing in the labor market. That’s appropriate. Over the past two months, data has indicated that the labor market was not as strong as the Fed thought. Where things stand is largely fine — the unemployment rate is 4.2 percent, and monthly payroll gains are only somewhat below their strong pace before the pandemic — but the trend is worrisome. The labor market is cooling off.
The increase in the unemployment rate over the past year is in line with increases early in past recessions. While that indicator, the so-called Sahm rule (yes, I came up with it), has accurately forecast prior recessions, it and other economic rules of thumb are too simple for this complicated, post-pandemic time. The United States is not in a recession or even on the verge of one. G.D.P. is on track to grow about 3 percent for the second straight quarter.
Still, a larger rate cut now allows the Fed toreduce the risk. The level of the funds rate was too high given the progress on inflation and the cooling in the labor market. The Fed chair, Jerome Powell, referred to the cut as a “recalibration.”