Life is about tradeoffs. And that’s also true for the Federal Reserve, which is meant to balance employment and inflation. Through 2021 and ’22, many economists saw the scales as being off. While unemployment fell dramatically, inflation spiked far higher than most experts had predicted. We can see from the Fed’s economic projections and public statements that these developments caught the institution off guard. Suddenly it shifted its focus to tamping down inflation, even if its decisions risked sparking a recession. And so last year the Fed scrambled to raise interest rates after having left them at zero throughout 2021.
But in recent months, there’s been a turnaround: Inflation broke from its high levels, and the labor market is settling into a fantastic place. Inflation is still higher than where the Fed wants it, but it should no longer be the priority. The question is again one of tradeoffs, and I believe the Fed should prioritize full employment and be patient on inflation to preserve what workers have recently gained.
Consider where we were: From December 2021 through November 2022, the Consumer Price Index—a basket of goods that consumers buy frequently—was rising at a yearly rate of between 7 and 9.1 percent. Inflation was widespread; nearly 75 percent of items saw price increases of over 3 percent. The labor market, on the other hand, was booming; wage growth was higher than it had been since the early 1980s. Policy-makers worried that this growth rate couldn’t be sustained without entrenching inflation.
But that has changed. In the final three months of 2022, core inflation—the price urban consumers pay for goods besides food and energy—fell by roughly a third. The normalization of supply chains is bringing down prices. Interest rate hikes have cooled off the housing market, which isn’t yet reflected in the inflation numbers but will be soon. And price rises in the service sector, which is labor-intensive and thus sensitive to how tight the labor market is, are starting to slow after the initial economic reopening.
Inflation isn’t at the 2 percent level the Fed wants, and there may still be bumpy months ahead. The prices of some goods, like used cars, may continue to go up; declining rents and real estate prices may take longer than anticipated to show up in the data; consumer spending may rebound with the declining costs of energy. But the medium-term trends suggest significantly lower inflation than last year.
Now think of the labor market we can preserve: The unemployment rate is down to 3.4 percent, the lowest since 1969 and among the lowest since we started keeping records in 1948. The unemployment gap between Black and white workers has been decreasing and is at a record low. Meanwhile, real wages, which began growing again in the second half of 2022, continue to rise at a rate of around 4 percent a year. That not only beats pre-Covid levels but rivals what we saw in the late 1990s. We haven’t just returned to the labor market of 2019—we are doing better.
The Federal Reserve may still be willing to push the country into a recession to wring out that last bit of inflation. Right now it is predicting an economic contraction, with its forecasts showing unemployment increasing to 4.6 percent by the end of 2023. That would be around 2 million more people unemployed. But it isn’t as simple as that. As researchers at Employ America have found, when unemployment goes up a little, it tends to keep going up. There are not a lot of tiny recessions in the history books.
Meanwhile, there are things that could happen that would further moderate inflation. After so much labor reshuffling, workers are getting fully trained in their new jobs, which could increase productivity and innovation, thereby increasing economic growth and lowering inflation. Corporate profit margins are currently near record levels, but as the economy normalizes, those margins could be competed away, pushing down prices.
Given how much room there is for upside in the economy, it’s worth taking tradeoffs seriously again. Living with inflation of a little over 2 percent for a short period would be worth it to keep the gains in the economy. If the Fed doesn’t intervene, inflation could still pleasantly surprise us and drop to the desired level. But if the Fed hikes interest rates too high, the millions who lose their jobs won’t care if inflation drops a percentage point.