For years, inflation has been the primary concern for the U.S. economy, but a new challenge is emerging: the risk of rising unemployment. As inflation continues to cool, warning signs are flashing in the labor market, raising concerns that the Federal Reserve's prolonged high interest rates may push the economy into a recession.

 

The Shift from Inflation to Unemployment

 

Inflation, once the most pressing issue for the U.S. economy, has shown signs of easing. However, the labor market, which has remained resilient, is now showing cracks. Economists are increasingly worried that the Fed’s strategy of maintaining high interest rates to combat inflation could backfire by cooling the economy too much, leading to higher unemployment.

 

“It’s time to cut rates,” says Joe Brusuelas, chief economist at RSM. “Inflation is fading as the primary focus of concern. The balance of risks is slowly tipping towards higher unemployment.”

 

Mark Zandi, chief economist at Moody’s Analytics, echoes this sentiment, warning that the labor market is straining under the weight of high borrowing costs. “The biggest danger is a policy mistake: The Fed keeps rates too high for too long,” Zandi told CNN. He suggests that a rate cut in September is appropriate, but delaying any longer could risk overdoing it.

 

Even Federal Reserve Chair Jerome Powell has acknowledged this shift in risk. “Elevated inflation is not the only risk we face,” Powell told lawmakers, pointing to a “cooling” in the labor market as a growing concern.

 

Signs of a Turning Labor Market

 

While the labor market is not in freefall, there are indications that it is losing momentum. The unemployment rate, while still historically low, has crept higher for three consecutive months, signaling that the labor market may be turning.

 

Key sectors like leisure and hospitality, which are heavily dependent on consumer spending, have seen a slowdown in hiring. Additionally, the rate of workers quitting their jobs—a sign of confidence in the job market—has dropped significantly, as has the pace of new hires.

 

Powell highlighted these changes in his recent testimony, noting that recent indicators “send a pretty clear signal that labor market conditions have cooled considerably” from the heated conditions of two years ago. This cooling is, in part, what the Fed intended when it embarked on its historic rate-hiking campaign. However, the risk now is that the Fed’s inflation-fighting measures might be overcorrecting, potentially tipping the economy into a downturn.

 

The Risk of Waiting Too Long

 

As the job market continues to cool, the risk of maintaining high interest rates becomes more pronounced. The labor market added 206,000 jobs in June, a figure that suggests the economy is neither overheating nor freezing—what Powell described as “balanced.” However, economists like Brusuelas caution that a balanced labor market may not stay that way if the Fed keeps its foot on the brake for too long.

 

KPMG senior economist Ken Kim noted that the unemployment rate is nearing a level that could trigger the Sahm Rule, a recession indicator that activates when the three-month moving average of the unemployment rate increases by 0.5 percentage points or more above its previous three-month average.

 

Additionally, Kim pointed out that the services sector, a key engine of growth, is showing signs of weakness. “No longer is inflation the predominant concern,” Kim wrote. “Equally as worrisome for the Fed should be the potential for a sharper deterioration in the labor market and economic activity. A soft landing is the goal, but a hard landing is emerging as a tail risk.”

 

 

Inflation Risks Still Loom

 

Despite the focus shifting to unemployment, inflation remains a concern. While the rate of inflation has significantly slowed from its peak of 9% in June 2022, the long-term effects of more than two years of sharp price increases continue to burden American consumers. Costs for essentials like groceries, rent, and insurance remain elevated, and there are still risks that inflation could reignite.

 

Geopolitical tensions, such as the ongoing war in the Middle East and the Russia-Ukraine conflict, pose potential threats to energy production, which could drive up prices. Moreover, the upcoming U.S. election adds a layer of uncertainty, with some economists fearing that policies proposed by former President Donald Trump could “reignite” inflation.

 

Zandi warns that cutting rates too close to the election could drag the Fed into political controversy, a situation it is eager to avoid.

 

Learning from Past Mistakes

 

The Fed’s current dilemma is reminiscent of the challenges it faced in the past. In the 1970s, the Fed rapidly increased rates but then cut them too soon, which allowed inflation to return with a vengeance, necessitating even more drastic measures later on.

 

More recently, the Fed under Powell was criticized for being slow to respond to the initial inflation surge, as officials believed it would be “transitory.” Now, the Fed faces the opposite risk: keeping rates too high for too long.

 

“They have PTSD from what happened before,” says Zandi. “They made a mistake in not raising rates fast enough. Now they run the risk of keeping rates too high for too long.”

 

As the Fed navigates these complex and competing risks, its decisions in the coming months will be crucial in determining the future trajectory of the U.S. economy.