Jerome Powell’s prized labor market is back. Can he keep it?

Federal Reserve Chairman Jerome H. Powell used the early pandemic to lament something America had lost: a labor market so historically strong that it empowered marginalized groups, expanding opportunities for people and communities that had long lived without them.

“We’re so eager to get back into the economy, get back into a tight labor market with low unemployment, high participation rates, rising wages — all the good factors we had as recently as last winter,” Mr. Powell said in an NPR- interview in September 2020.

The Fed chair got his wish. The labor market has picked up by almost all major measures, and the employment rate for people in the most active working years has surpassed the 201[ads1]9 high, reaching a level last seen in April 2001.

Yet one of the biggest risks to the strong recovery has been Mr. Powell’s Fed itself. Economists have spent months predicting that workers won’t be able to hang on to all of their recent labor market gains because the Fed has aggressively attacked rapid inflation. The central bank has raised interest rates sharply to cool the economy and labor market, a campaign that many economists have predicted could push unemployment higher and even plunge America into a recession.

But now a tantalizing possibility emerges: Can America both tame inflation and retain its labor market gains?

Data last week showed that price increases are beginning to slow down in earnest, and that the trend is expected to continue in the months ahead. The long-awaited cooling has occurred even though unemployment has remained at a low level and employment has remained healthy. The combination raises the prospect — still not guaranteed — that Mr. Powell’s central bank could pull off a soft landing, with workers largely keeping their jobs and growth slowing, even as inflation returns to normal.

“There are meaningful reasons why inflation is falling, and why we should expect to see it fall further,” said Julia Pollak, chief economist at ZipRecruiter. “Many economists argue that the last mile of inflation reduction will be the hardest, but that is not necessarily the case.”

Inflation has fallen to 3 percent, just a third of the peak of 9.1 percent last summer. While an index that strips out volatile products to give a cleaner sense of the underlying trend in inflation remains higher at 4.8 percent, it is also showing notable signs of falling — and the reasons for that moderation appear potentially sustainable.

Housing costs are falling within inflation targets, something economists have been expecting for months and which they widely predict will continue. New and used car prices are cooling as demand slows and dealer lot inventory improves, allowing item prices to moderate. And even services inflation has cooled somewhat, although some of that is due to a decline in airfares that may look less significant in the coming months.

All of these positive trends could make the path to a soft landing — one Mr. Powell has called “a narrow path” — a little wider.

For the Fed, the incipient cooling may mean there is no need to raise interest rates as much this year. Central bankers are poised to raise borrowing costs at their July meeting next week, and had predicted another rate hike before the end of the year. But if inflation continues to moderate in the coming months, it could allow them to delay or even remove that move, while also indicating that further increases may be warranted if inflation picks up again — a signal economists sometimes call a ” tightening bias.”

Christopher Waller, one of the Fed’s most inflation-focused members, suggested last week that while he might favor raising rates again at the Fed’s September meeting if inflation data came in, he could change his mind if two upcoming inflation reports show progress toward a slower pace price increases.

“If they look like the last two, the data would suggest they might stop,” Waller said.

Interest rates are already elevated – they will be in the range of 5.25 to 5.5 percent if they are raised as expected on July 26, the highest level in 16 years. Keeping them steady will continue to weigh on the economy, discouraging home buyers, car buyers or businesses hoping to expand on borrowed money.

So far, however, the economy has shown a surprising ability to absorb higher interest rates without bursting. Consumer spending has slowed, but it has not fallen. The interest-rate-sensitive housing market cooled sharply at the beginning when mortgage interest rates rose, but it has recently shown signs of bottoming out. And the labor market is just tough.

Some economists believe that with so much momentum, it will prove difficult to completely stop inflation. Wage growth fluctuates around 4.4 per cent by one popular measure, well above the 2 to 3 per cent that was normal in the years before the pandemic.

With wages rising so quickly, the logic goes, companies will try to charge more to protect profits. Consumers who earn more will have the means to pay, keeping inflation hotter than normal.

“If the economy does not cool down, companies will have to build bigger wage increases into their business plans,” said Kokou Agbo-Bloua, a global head of research at Société Générale. “It’s not a question of whether unemployment has to go up – it’s a question of how high unemployment should go for inflation to return to 2 percent.”

Still, economists within the Fed themselves have raised the possibility that unemployment may not need to rise much at all to lower inflation. There are a lot of vacancies across the economy at the moment, and wage and price growth may be able to slow as these fall, a Fed Board economist and Mr. Waller argued in an article last summer.

While the unemployment rate may creep higher, the paper argued, it may not rise much: perhaps one percentage point or less.

So far, that prediction is playing out. The number of vacancies has decreased. Immigration and higher labor force participation have improved the supply of workers in the economy. As balance has returned, wage growth has cooled. Unemployment, meanwhile, is at a similar level to when the Fed started raising interest rates 16 months ago.

A big question is whether the Fed will feel the need to raise rates further in a world of wage gains that — while slowing — remain significantly faster than before the pandemic. It may be that they don’t.

“Wage growth often follows inflation, so it’s very difficult to say that wage growth is going to lead inflation down,” Mary C. Daly, president of the Federal Reserve Bank of San Francisco, said during a CNBC interview last week.

The risk to the outlook still looms, of course. The economy could still slow more sharply as the effects of higher interest rates mount, reducing growth and hiring.

Inflation could come roaring back due to an escalation of the war in Ukraine or some other unexpected development, prompting central bankers to do more to ensure that price rises are quickly brought under control. Or price increases may simply prove painfully stubborn.

“One data point does not make a trend,” Mr. Waller said last week. “Inflation eased briefly in the summer of 2021 before getting much worse.”

But if price increases continue to slow — perhaps to below 3 percent, some economists speculated — officials may increasingly weigh the costs of bringing down price increases against their other major goal: promoting a strong labor market.

The Fed’s tasks are both price stability and maximum employment, what is called its “dual mandate.” When one goal is truly out of whack, it takes precedence, based on the way the Fed approaches policy. But when they are both close to the goal, pursuing the two is a balancing act.

“I think we need to get a firm grip on core inflation before they’re ready to put the dual mandates next to each other,” said Julia Coronado, an economist at MacroPolicy Perspectives. Forecasters in a Bloomberg survey expect the inflation measure to fall below 3 percent — what economists call a “2-handle” — by spring 2024.

The Fed may be able to walk the tightrope to a soft landing, preserving a labor market that has benefited a range of people — from the disabled to teenagers to black and Hispanic adults.

Mr. Powell has regularly said that “without price stability, we will not achieve a sustained period of strong labor market conditions that benefits everyone,” explaining why the Fed may need to hurt his prized labor market.

But at the press conference in June he sounded a little more hopeful – and since then there has been evidence to bolster that optimism.

“The labor market, I think, has surprised many, if not all, analysts over the last couple of years with its extraordinary resilience,” Powell said.