Powell's Predicament: Inflation vs. Labor Market Stability

Federal Reserve Chairman Jerome Powell has stated that the central bank is in a "no-risk path available" predicament as the labor market shows signs of cooling while inflation remains elevated. Maintaining high interest rates to curb inflation could harm the labor market, while cutting rates to support the labor market could make inflation harder to control.

Powell appears to be leaning towards taking a risk on inflation, citing significantly increased risks facing the labor market after a sharp slowdown in hiring this summer. Signs suggest the Fed will likely implement a second rate cut this year at its next meeting later this month. September's projections also showed most officials believing there's still room for another 25 basis point cut at the final meeting of the year in December.

However, economists warn that the Fed's room for rate cuts may be limited if the labor market doesn't weaken further. Continued aggressive rate cuts could leave inflation stuck above the Fed's 2% target.

Concerns About Persistent Inflation

"Inflation remaining materially above target for a long time is a real risk for the Fed," said Matthew Luzzetti, chief US economist at Deutsche Bank. "Marginal easing leads to inflation being sustained at higher levels for longer.""

Powell's optimism on inflation stems from two judgments: First, that Trump's tariff policies would only cause a one-time increase in consumer prices, rather than triggering multiple rounds of price increases and fueling persistent inflation; second, that a weakening labor market would curb consumer price increases, especially amid weak wage growth, rising unemployment, and slowing overall spending. This optimism is shared by other members of the Federal Open Market Committee (FOMC).

So far, the impact of Trump's tariff policies – including broad tariffs on nearly all trading partners and tariffs targeting specific industries – has been more moderate than Fed officials initially expected. Not only has its impact on consumer price data lagged expectations, but increases in everyday goods prices have also been lower than anticipated.

Troubling Signals in Core Inflation Data

However, what worries some economists and even Fed officials is that core inflation indicators suggest progress towards the Fed's target has stalled.

"That suggests that the drivers behind inflation are more than just tariffs," said Loretta Mester, who stepped down as president of the Cleveland Fed last year.

One core inflation indicator, which excludes volatile items like food and energy, is currently growing at an annualized rate of 3.5%. Stephen Stanley, chief US economist at Santander, believes that an indicator that also excludes travel-related items like airline tickets and hotels better reflects true inflation – as of August, that indicator was growing at an annualized rate of 3.9%.

Stanley says this data means that "actual progress towards the 2% target is not as good as it appears on the surface, and is clearly not enough to allow the FOMC to relax about inflation.""

What If the Labor Market Stabilizes?

Another major concern is: What happens if the labor market stabilizes from here instead of deteriorating further? That possibility does exist – the recent slowdown in monthly job gains is partly due to Trump tightening immigration policies, leading to a reduced labor supply, rather than a decline in business hiring demand.

"The risk is that the labor market might not be weak enough to get inflation back to 2%," said Dean Maki, chief economist at hedge fund Point72. He added that a "full-blown recession" could eliminate all lingering concerns about service-sector inflation, but no Fed official is predicting such a severe economic downturn, and he doesn't believe it either. Instead, he expects core inflation to remain above 3% for most of next year, while the unemployment rate will rise from 4.3% in August to 4.8%.

Long-Term Inflation Expectations

What gives Fed officials some comfort is that consumer and investor expectations for long-term inflation remain within manageable bounds, suggesting people haven't lost faith in the Fed's ability to eventually control inflation.

But for Mester, the biggest worry is when that expectation will start to shift. She said that the surge in inflation after the pandemic has caused the Fed to lose some credibility in the public's eyes – it's been about 5 years since inflation last reached its 2% target.

Some current Fed policymakers have expressed similar concerns. Fed Governor Michael Barr recently said, "If it takes another two years to get back to the inflation target, that's too long, and that possibility will affect my judgment about 'appropriate monetary policy'."

Other officials have joined the "be wary of cutting rates too much" camp, including several regional Fed presidents, such as Lorie Logan, Beth Hammack, and Jeffrey Schmid.

Even Stephen Miran, the new Fed governor appointed by Trump who advocates for aggressive rate cuts, said at a CNBC event on Wednesday that he expects inflation to not reach its 2% target in the next year and a half.

"Once you lose credibility, it's much harder to get inflation back to 2% and achieve full employment – because part of the role of monetary policy is to change market behavior," Mester said.

She added: "People have to believe that inflation will return to 2%, otherwise they will act on the expectation that 'inflation will remain high', making the task of curbing inflation even more difficult."