The US economy faces a new threat

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The biggest danger facing the American economy for years has been inflation.

Now, another problem is emerging as a credible threat on the horizon: Unemployment.

Just as inflation continues to cool, yellow lights are flashing in the still-strong jobs market. The Federal Reserve must now confront the risk that it’s making a mistake by keeping interest rates too high for too long.

That’s why some economists are pleading with the Fed to ease up its inflation fight—before high interest rates, which it’s used to tame surging prices, grind the US economy into a recession.

“It’s time to cut rates,” said 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, said 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 in a phone interview. “Right now, the Fed is signaling a September cut. I think that’s okay, but if they wait any longer than that, I fear they are going to overdo it.”

Even Fed Chair Jerome Powell is acknowledging a significant shift in the risk calculus.

“Elevated inflation is not the only risk we face,” Powell told lawmakers on Tuesday, pointing to easing inflation and “cooling” in the labor market.

To be clear, the jobs market is by no means imploding.

Jobs are still being created at a healthy pace — faster than many thought possible just a year ago.

Yet just beneath the surface, cracks have begun to emerge.

The unemployment rate remains historically low, but it has noticeably crept higher three months in a row — “a sign the labor market may be turning,” according to economists at KPMG.

Hiring has slowed in leisure and hospitality, a key sector that is powered by consumer spending. The pace of workers quitting their jobs has dropped significantly. So has the rate of workers getting hired.

Powell highlighted these changes, telling lawmakers that recent indicators “send a pretty clear signal that labor market conditions have cooled considerably” from two years.

“This is no longer an overheated economy,” Powell said.

Of course, that’s exactly what the Fed wanted to accomplish when it began its historic rate hiking campaign.

The fear in 2022 was that the jobs market was so hot that it would add fuel to white-hot inflation growth and keep prices dangerously high, forcing the Fed to start a recession just to put the inflation fire out.

Overheated inflation and a historically over-abundant job market are no longer viewed as major concerns.

The current risk is that the Fed is injecting inflation-fighting medicine into an economy that no longer needs it. And that could turn a cooling job market into one that’s frozen—leading to job losses.

The job market added 206,000 positions in June, according to the latest government figures released Friday. In other words, it’s not too hot, and not too cold—it’s “balanced,” the Fed Chair said on Tuesday.

“A balanced labor market with too restrictive rates from the Fed will not remain balanced for long,” Brusuelas said. “That means higher unemployment.”

Brusuelas clarified that doesn’t necessarily mean “skyrocketing” unemployment is on the horizon, but a premature recession may be, nonetheless, if the Fed waits too long to cut rates.

In a Monday report, KPMG senior economist Ken Kim noted that the unemployment rate is close to triggering the Sahm Rule, which signals a recession has started when the three-month moving average of the unemployment rate increases by 0.5 percentage points or more above the three-month average.

Kim also pointed to how the services sector — a key engine of growth for the US economy — is suddenly 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.”

Of course, the high cost of living remains a major concern for Americans.

Although the rate of inflation has slowed sharply from 9% in June 2022, there is a painful snowballing effect from more than two years of sharp price gains. Americans are paying much more for groceries, rent and insurance than before Covid-19.

And there are still risks on the inflation front.

The war in the Middle East continues, posing a potential threat to energy production in the region. The same is true of the Russia-Ukraine war, where oil refineries deep inside Russia have been hit by drone attacks.

The upcoming US election also creates significant uncertainty — and complications.

Some mainstream economists are concerned that former President Donald Trump’s economic agenda — tax cuts, immigration crackdown and tariff hikes — would “reignite” inflation.

Plus, cutting rates just before the US election could cause the Fed to be “thrown into the political cauldron—a place it doesn’t want to be,” said Zandi, the Moody’s economist.

If the Fed cuts rates prematurely, it could stimulate demand from consumers and businesses. That could boost inflation and make matters worse.

Powell and his colleagues face a difficult decision—and they don’t want to repeat mistakes of the past.

In the 1970s, the Fed rapidly spiked rates but then lowered them before inflation was defeated. Inflation roared back and forced the Fed to take even more drastic steps.

More recently, the Powell-led Fed was slow to the inflation fight, waiting too long to respond to price spikes because officials (and many economists) thought inflation was “transitory,” and would dissipate on its own.

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

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