Three Questions

Given large concurrent changes to trade, immigration, and tax policies as well as mixed signals from the economy, it is challenging to assess with confidence which side of our dual mandate is at greater risk: price stability or maximum employment. In this essay I describe potential answers to three important questions that I am wrestling with and explain how they inform my current view of the optimal path for monetary policy.¹

Question 1: How can I reconcile mixed signals from the labor market and from financial markets?

The labor market appears to be weakening. The last four payroll employment numbers have been especially weak, even before incorporating the benchmark revision to the data series (Figure 1). Some of this slowdown is inevitable given the sharp decline in net immigration we have seen, but Minneapolis Fed economists estimate that lower immigration can only explain one-third to at most one-half of the observed decline in job creation. Weak labor demand is likely also an important driver of lower job growth.

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And nominal wage growth continues to moderate, confirming that the labor market is cooling (Figure 2).

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At the same time that the labor market appears to be slowing, risk markets seem exuberant. The equity market continues to hit all-time highs. And this is not limited to large-cap technology stocks. Broader indices, such as the Russell 2000, are also near all-time highs (Figure 3).

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Even speculative markets, such as bitcoin and meme stocks, are once again in fashion. Meanwhile, credit spreads continue compressing to historically low levels. It is hard to look at many U.S. financial markets and see evidence of restrictive monetary policy.

Who is right-the labor market or financial markets-and are there ways to reconcile the two?

One explanation is that any sign of new economic weakness could pop risk markets' exuberance, and they would then come into alignment with signals from the labor market.

Another explanation is that financial markets are pricing in two important forecasts: (1) Tariff inflation truly is transitory and will fall back towards our 2 percent target starting next year, and (2) The Federal Open Market Committee (FOMC) will recognize that and thus deliver a series of rate cuts this year and next. Perhaps if these forecasts of transitory tariff inflation and commensurate rate cuts prove true, the markets' optimism will be validated.

A third explanation that I have focused on is the possibility that the neutral rate of interest, R*, is higher, at least in the near-term, and that capital is being reallocated away from labor-intensive industries to less labor-intensive industries. We have seen a remarkable investment boom in technology-building data centers for AI, for example. While it takes a lot of people to build a new data center, it takes relatively few to operate one. The markets fund those investments via a higher R*, which makes building new apartment buildings, for example, less economically attractive, and instead capital flows to higher return investments in Silicon Valley. Thus the labor market and the stock market could both be right: Technology is driving rapid growth of industries that don't require as much labor, resulting in a booming stock market and sluggish hiring environment. In addition, while we've focused extensively on the price effects of tariffs on imported goods, we shouldn't forget the other side of that coin is that capital from abroad would be more expensive, nudging R* up. In this view, monetary policy might not be particularly tight, and even if the FOMC embarks on a number of policy cuts, long-term interest rates might not fall much in response. The housing market might not actually experience much relief from rate cuts.

I look at long real rates, such as the 10-year TIPS, as a proxy for the overall rate environment that households and firms are experiencing. As shown in Figure 4, 10-year TIPS yields have essentially moved sideways over the past couple of years, even though the policy rate dropped 100 basis points last fall. Their relative insensitivity to changes in the federal funds rate suggests to me the neutral rate may be higher than it was prior to the pandemic.

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Of course, it could be a combination of all three explanations: Markets are vulnerable to a correction, markets are pricing in transitory tariff inflation, and R* has increased.

Question 2: Are we at risk of losing control of long-term inflation expectations?

After several years of highly elevated inflation and with inflation moving sideways near 3 percent and likely climbing (Figure 5), I worry that the longer inflation remains elevated the greater the risk of unanchoring long-run inflation expectations. So far, that hasn't happened (Figure 6).

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What are the specific mechanisms that could cause inflation expectations to rise?

Central bankers traditionally focus on a wage price spiral as the primary risk to losing our inflation anchor: Workers demand wage increases to keep up with inflation. Employers pass those increased wage costs on to their customers, who then demand further raises of their own. This traditional overheating dynamic seems highly unlikely at the moment with a weakening labor market and declining wage growth. We'd need to see the labor market tighten a lot before a wage price spiral became a meaningful risk.

A second risk to long-run inflation expectations is one of some political development that damages Fed independence and reduces confidence that the FOMC will set rates appropriately to try to achieve our dual mandate goals. While a serious potential issue, managing it is outside of the control of the FOMC.

The final risk to long-run inflation expectations is if people believe our reaction function has changed. After several years of elevated inflation, cutting rates in a time of high and rising inflation could lead people to conclude that we are satisfied with 3 percent inflation.

I believe the FOMC is strongly committed to returning inflation to our 2 percent target. Whether tariffs lead only to a one-time increase in the price level or to more persistent inflation, I am confident the FOMC will do what it needs to do in order to restore price stability.

Question 3: Which is the more likely risk, a large upside inflation surprise or a rapid further weakening of the labor market?

For me the more likely risk is a rapid further weakening of the labor market. We know from past economic cycles that when labor markets weaken, they can weaken quickly and non-linearly.

In terms of inflation, there remains tremendous uncertainty about tariffs: Where will headline tariff rates settle, where will actual collected tariff rates settle, and how much spillover will there be from increasing goods inflation to the rest of the economy? It is becoming increasingly clear that we won't know these answers for several quarters or even a few years. But these concerns suggest to me a risk of inflation persistence-3 percent or slightly higher inflation for a year or two-rather than a significant jump in the level of inflation to, say, 4 or 5 percent. Unless there is some large increase in tariff rates from here or some other supply side shock, it is hard for me to see inflation climbing much higher than 3 percent given announced tariff rates and the relatively small share of imported goods in overall U.S. consumption.

Putting these questions and their potential answers together led me to support cutting the federal funds rate at this week's FOMC meeting. I believe the risk of a sharp increase in unemployment warrants the committee taking some action to support the labor market. In my previous submissions to the Summary of Economic Projections (SEP), I had indicated that two 25-basis-point rate cuts would likely be appropriate this year (Figure 7). I nudged that up to three in my most recent SEP but also nudged up my long-run equilibrium funds rate by 25 basis points to 3.1 percent. Over the past few years, I have continued to increase my assessment of the neutral rate of interest. The implication of this reassessment is that monetary policy has likely not been as tight as I previously understood. Most importantly, I do not believe we should be on a preset course for a series of rate cuts. If the labor market proves more resilient than it seems at the moment or if inflation surprises to the upside, we should be prepared to pause and hold our policy rate. I even remain open to raising the policy rate further if economic conditions warrant it. Of course, if the labor market weakens more quickly than we currently expect, we could always move more quickly to support economic activity.

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