[Bloomberg Column] US Fed Must Cut Interest Rates Before It's Too Late

Since 2022, Despite GDP Decline,
Companies Facing Post-COVID Labor Shortages
Cut Overtime Hours Instead of Layoffs
Creating Illusion of a Strong Labor Market
If Central Bank Delays Easing Monetary Policy,
Recession Risk Will Increase

Jerome Powell, Chair of the U.S. Federal Reserve (Fed), recently stated that policymakers are focused on when to cut interest rates. This reflects the central bank’s confidence that inflation is being tamed. I believe the Fed should cut rates sooner rather than later. However, not for the same reasons as the Fed.

Chair Powell cautions against forcing through the ‘last mile’ of inflation by keeping borrowing costs unnecessarily high, warning that this could push the economy toward recession risk. This is because the labor market appears to be deteriorating. Do not misunderstand me. The unemployment rate is currently around 3.7%, close to historically low levels, and according to the Atlanta Federal Reserve Bank’s GDPNow index, which tracks the economy in real time, the fourth-quarter growth rate is a robust 2.68%. Nevertheless, like many other parts of the economy since the COVID-19 pandemic, the labor market’s ‘playbook’ has changed.

In particular, Okun’s Law?which describes the inverse relationship between unemployment and GDP (the proposition that as the economy grows, unemployment falls and employment rises)?has not worked as predicted over the past three years. Generally, a 1 percentage point drop in unemployment is estimated to correspond to a 1.5 percentage point increase in GDP. However, economists at the Federal Reserve Bank of San Francisco recently found in research that this correlation broke down in late 2020. GDP recovered rapidly from the initial pandemic shock, but unemployment fell much more slowly than expected.

We have some understanding of why. The pandemic-induced threat led to massive fiscal stimulus and employment benefits, which delayed workers’ return to the labor market. Companies laid off workers early in the pandemic but then scrambled to expand hiring. Despite this, the labor force participation rate currently stands at 62.8%, below the pre-pandemic level of 63.3%.

The number of job openings at companies needing labor exploded. The number of job openings per worker reached 3, surpassing record levels. Until 2021, wages for workers looking to change jobs, especially in production roles, soared. For companies, there was no choice but to expand overtime for existing workers, which pushed the average weekly working hours to levels unseen since the 1990s.

The extremely tight labor market began to ease in 2022. As rising inflation affected the broader economy, consumer demand slowed. GDP declined in the first and second quarters of 2022, meeting the general definition of a recession even if not officially declared by the National Bureau of Economic Research (NBER). According to Okun’s Law, such a decline in growth should lead to rising unemployment. Yet unemployment fell from 4% in January to 3.5% six months later. Why? Companies that had struggled after layoffs the previous year were reluctant to lay off workers again. Instead, overtime hours were cut.

Average weekly working hours have steadily decreased from a peak of 34.5 hours in January 2021 to 33.8 hours currently. This represents a 3% reduction in total working hours. Had layoffs replaced the reduction in overtime, the unemployment rate would have risen from 6.3% in January 2021 to 6.7% now. However, unemployment has remained below 4% since February 2022. Maintaining such a low unemployment rate for the longest period since 1960 has created an illusion of a strong labor market.

The problem now is that there is no more room to reduce working hours. Pre-pandemic average weekly working hours ranged from 33.6 to 33.8 hours. The current level has nearly returned to that range. With working hours normalized, if growth slows, companies are likely to resort to layoffs. Last month’s job openings data returning to long-term trends confirms this concern.

In retrospect, both the increase in working hours and record job openings clearly reflect the new playbook that has dominated the economy since the pandemic. To be clear, this new playbook has brought good results for the Fed in recent months. Even if the central bank does not fully understand it, the fact remains. More specifically, it has lowered inflation without the painful rise in unemployment or worsening recession.

Economists worry that because of this seemingly ‘free’ outcome, the Fed might fall into complacency and start cutting rates after declaring its mission accomplished (inflation easing). The real concern is that the playbook has indeed changed. If unemployment rises again and the Fed fails to recognize that the situation has changed, it will fall behind just as it did when inflation first surged. Therefore, Chair Powell’s signal that rates could be cut in early 2024 was appropriate. The Fed must not be blocked by dissenters clinging to outdated rules.

Carl W. Smith, Bloomberg Columnist

This article is a translation by Asia Economy of Bloomberg’s column ‘Fed Rate Cuts Must Come Sooner Rather Than Later.’

This content was produced with the assistance of AI translation services.