The Federal Reserve’s Pause Could Go Terribly Wrong

The US Federal Reserve thinks it can take a break. As Fed officials see it, they need only sit back and wait while the monetary tightening they’ve already done gradually takes hold, slowing the economy and pushing inflation back down to the central bank’s 2% target.

They could be making a big mistake.

Officials can offer various arguments for keeping interest rates on hold, which is what markets fully expect them to do at this week’s meeting of the policy-making Federal Open Market Committee. Considerable progress has been made in restoring balance in the labor market and in bringing down inflation. Monetary policy has reached a restrictive setting. The full effects of past interest-rate increases have not yet been felt, and the recent rise in bond yields is tightening financial market conditions, negating the need for further short-term rate hikes.

I see four potentially fatal flaws in this thinking.

First, the labor market — albeit in better balance — is still too tight for the Fed to reach its 2% inflation objective. Non-farm employers have been adding about 275,000 jobs a month, far outpacing sustainable growth of the labor force. The ratio of unfilled jobs to unemployed workers remains at 1.5, well above the 1-to-1 ratio that Fed Chair Jerome Powell considers appropriate. Wage inflation remains above 4%, which — barring unexpectedly fast productivity growth — isn’t consistent with 2% overall inflation.

Second, the economy’s performance strongly suggests that monetary policy isn’t sufficiently restrictive. Gross domestic product increased at an inflation-adjusted annualized rate of 4.9% in the third quarter of 2023, far exceeding the 20-year annual average of 2.1%. Even if growth slows sharply in the fourth quarter, it’s far from certain that the economic slack will be enough to push inflation lower.