Fed’s next challenge: the unemployment boogeyman

Looks good on paper. If the economy were just a snapshot, Federal Reserve Chair Jerome Powell should put the current one on his mantle. Strong 2.8% second-quarter economic growth and calmer inflation are the soft landing conditions that should at least temporarily win the Fed some plaudits for its handling of the current inflationary cycle. A first cut of the cycle at the Fed’s meeting in September appears to be right on time. But high rates aren’t sparing the economy—by the time the Fed starts to change course, a worsening unemployment and consumption picture could put the U.S. recovery at risk.

Throughout 2024, Powell has handled waves of skepticism from both sides of the rate debate. Those wary of resurgent prices found ammunition in spring inflation readings that showed stubborn pressures, especially in the housing sector. Others pushing for cuts sounded the alarm as unemployment ticked up to 4.1% in June from half-century lows of 3.4% in January 2023.

Particularly in recent weeks, lower inflation has helped make the case for the Fed to lower rates before September, specifically at their meeting next week. Former New York Fed President Bill Dudley penned a Bloomberg op-ed this week with the headline “I Changed My Mind," citing tamed prices. He also raised the issue of unemployment, highlighting the so-called “Sahm Rule,” an economic indicator that says that if the unemployment rate rises 0.5 percentage points from its low point in the prior 12 months, a recession is on the way.

Currently, unemployment is 0.43 percentage point from its past-year low. Crucially, when the 0.5 percentage point threshold is breached, the minimum rise has historically been around 2 percentage points. While the job market's cracks have only emerged slowly, the Sahm rule's threshold is meant to spot tipping points. Higher unemployment would lead to weaker wage growth, as employers quickly realize they have leverage. With credit card debt levels already ramping up, people may quickly pull back spending. Suddenly Powell’s perfect economic image looks blurry.

The challenge for Powell is that it is hard to find the perfect moment to zoom in on rate cuts. If the American shopper remains employed, patience is fine. If not, the summer will just be a sepia-toned memory for the Fed.