Strong labor market will lead to additional rate hikes

The U.S. central bank’s top official, Jerome Powell, said this week that interest rates could be raised further. The reason for this, he said, would be unexpected strength in the labor market and the likely persistence of upward momentum in inflation. Either of these would drive stocks back to the floor.

The statements are closely tied to the recent January jobs report. In it, officials reported that some 517,000 new payrolls were added to the market during the first month of the year. If this pace continues in the coming months, the Fed may announce further increases in the price of money.

Inflation readings would be the second aspect that financial authorities are watching closely. So far, consumer prices have been losing their mid-2022 pace. However, the lowest unemployment rate in 53 years is not the main thing helping to keep CPI cool. The number of unemployed parked at 3.4%.

The labor market becomes the main headache

The strength of the labor market is very good news in the short term for U.S. households. That scenario allows families to maintain a solid budget in the midst of complex macroeconomic conditions. However, what is good for some is not good for all. As a result, low unemployment may be the VIP ticket to recession.

The latter can be explained by the fact that keeping prices cool means tying down consumers. But if people have secure, well-paying jobs, they are likely to go out and spend. The result is that excess liquidity in the market generates a natural increase in prices. Hence, low unemployment scares the Fed as much as inflation itself.

“The reality is that if we continue to get strong reports from the labor market or reports of higher inflation, it may be the case that we have to raise rates further,” the official said. Powell’s remarks came during his participation in the Economic Club of Washington. On the other hand, the official calls for a bit of reassurance and affirms that inflation will have a remarkable setback this 2023.

Although inflation is in marked decline, the fact that the labor market remains strong may induce a dangerous revival. This is what Powell is referring to when he stresses that they are observing “the early stages of disinflation” and that there is still “a long way to go”.

Employment remains strong against hawks

The alarms created by employment among Fed policymakers stem from its strength in the face of tight monetary policies. It is noted that the U.S. central bank has been implementing the most violent rate hikes in four decades. From 4.5%, rates were raised to between 4.5% and 4.75%.

Despite these strong measures, unemployment remains shockingly low at 3.4%. As for inflation, it did mark a sharp decline from 9.1% in June 2022 to 6.5% in December 2022. But if inflation readings become strong again despite all this package of measures, the Fed would have to tighten even more.

Such a backdrop would likely push the economy into recession. So, if the vast majority of analysts now believe there will be contraction, with additional rate hikes, it could become an indisputable reality. In any case, so far, monetary policies have not been instrumental in triggering a recession. Some even dream of a “soft landing”.

Such a scenario is interpreted in many ways by stock market analysts and investors. The sharp pullback in inflation resulted in the rise of the major New York Stock Exchange indexes. But the labor market, with its strength, is keeping its shadow over stocks. The state of these two components probably keeps stocks in balance, i.e. they do not rise too much, but neither do they experience steep declines.

No improvement without pain

The retreat in inflation and the now customary improvements in the markets generate the feeling that the problems will be solved in a straight line. But Powell warns that it is a mistake to think that way. “There is an expectation that [inflation] will go away quickly and painlessly. I don’t think that’s warranted at all,” he purposely commented.

On the contrary, the official repeatedly said that pain in the economy would be a necessary step to overcome high prices. “It will take some time, and we’ll have to do more rate hikes, and then we’ll have to look around and see if we’ve done enough,” Powell reaffirmed.

The post-pandemic economic situation has left unique conditions in the United States, forcing policymakers to move carefully. For example, inflation is receding at the same rate that unemployment is also falling. This is a situation that runs counter to the conventions that experts would normally expect, even for an extraordinary situation.

Powell referred to this point of low inflation and a strong labor market and called it a scenario that confounds forecasts. Either way, as unemployment falls, that translates into labor shortages and, as a consequence, wage increases and inflation. A significant number of companies, especially in the technology sector, announced recent waves of layoffs. However, this does not seem to be translating into a fracturing of this market, at least so far.