Employment Shows No Signs of Letting Off

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Can Federal Reserve (Fed) officials live with such a strong labor market and still start lowering interest rates in June or July? This question is the reason why we argued, after the latest Fed’s Federal Open Market Committee (FOMC) meeting, that the new ‘dot-plot’ showed that there was no conviction on the short-term path of monetary policy, i.e., on interest rates. That is, we said that the Fed decision was in flux. After that meeting, we have heard several Fed officials arguing for two or even just one downward move during this year.

Let’s recap for a moment. First, inflation continued to slow down, i.e., disinflate, even in the face of a still-strong labor market during the whole of 2023. This means that the strength in the labor market at the start of 2024 should not be an issue. Second, the Fed seems to be sitting pretty, just biding time for interest rates to do their job, remembering that monetary policy acts with “long and variable lags.” In this case, we continue to argue that the lags are even longer today because the post-pandemic cycle was not a monetary cycle but a fiscal cycle. This means that the Fed remains a spectator rather than a player in this game. Third, the U.S. economy continues to grow above potential output, but this has not prevented inflation from coming down, underscoring the continuous improvement in supply chains after the end of the pandemic.

Perhaps the biggest risks Fed officials are watching are related to uncontrollable events, especially issues with geopolitical risks that could threaten inflation as well as inflation expectations. Several of these risks have materialized over the last several months, with oil prices reaching $85 per barrel for the West Texas Intermediate (WTI), the recent news about cocoa prices, and increases in egg prices related to new avian flu affecting the U.S. agricultural sector.

These risks are important but not determinative of Fed policy because as long as core prices—that is, excluding food and energy prices – continue to show downward momentum, it means that the Fed can continue with its plans to start lowering interest rates by mid-year. The biggest question they have to answer is this: in this scenario, are Fed officials willing to start to lower interest rates, i.e., potentially increasing money supply, and continue to feel good about the inflationary path?