The Case for Front-Loaded Rate Cuts
Why the Fed Must Act Boldly as the Labor Market Cools
The labor market is cooling down at a fast pace, as recent JOLTS data shows. Over the last three months, the unemployment rate moved from 4.0% in May to 4.1% in June, then to 4.3% in July, before falling back to 4.2% in August. Note that due to rounding, the unemployment rate appears to have decreased by 0.1%, but in practice, it has only slightly changed from 4.25% to 4.22%. More significantly, the ratio of job vacancies to unemployed individuals has dropped sharply, from a historically high value of 2 in March 2022 to 1.07 in July 2024. This drop has been rapid in recent months, as the ratio was 1.4 at the beginning of the year.
The sharp adjustment in vacancies relative to the unemployment rate is consistent with a steep Beveridge curve. Indeed, the Benigno-Eggertsson Beveridge curve, shown above, consistently depicts the decline in vacancies and the rise in unemployment from September 2022 to the most recent observation in July 2024.1 The Beveridge curve has remained remarkably stable during this period, with the intermediate points tracking closely.
The labor market has definitely entered a state of neutrality, no longer being tight and moving away from inflationary risk. However, the main issue is that it is rapidly approaching the Beveridge-threshold (BT) inflection point, i.e., when the number of vacancies equals the unemployed people, after which the dynamics reverse: the Beveridge curve becomes relatively flatter, and adjustments occur more through an increase in the unemployment rate rather than a further decline in vacancies.
Note also that the Beveridge curve has shifted to the right compared to the pre-COVID period, indicating a worsening of matching efficiency. Before COVID, a 4% vacancy rate corresponded to 4% unemployment; now, it would imply a 5% unemployment rate. There are 1.3 million more unemployed individuals now than before COVID.
The inflection point in the Beveridge curve identifies the BT unemployment rate, which can be interpreted as a reasonable approximation of maximum employment conditions for the U.S. economy, one of the Federal Reserve's dual mandates. The BT unemployment rate has remained relatively stable over the last few months, currently at 4.4%, compared to 4.42% the previous month, reflecting stability in the labor market's structural parameters. It is likely to drop slightly next month, given the newly released unemployment data.
With unemployment nearing the BT unemployment rate and the policy rate’s upper limit still at 5.5% for over a year, along with relatively high real interest rates, the policy stance is clearly contractionary. As shown in the above Figure, the real interest rate has moved from a trough of -2.9% when the Fed began raising rates to 3.8% in June 2023. It now stands at 3%, signaling a persistently contractionary stance, even as inflation and the labor market are cooling down.2 Considering the delays in the transmission of monetary policy, this raises the risk of undershooting maximum employment and further worsening labor market conditions.
In March 2022, when the labor market was extremely tight, as indicated by a vacancy-to-unemployment ratio of 2, the Fed initially raised rates by only 25 basis points, then moved more aggressively with 75 basis point hikes. Now, rate cuts should not be as cautious. A 50 basis point cut would be a reasonable starting point, aiming for a total of 150 basis points in cuts by the end of the year, followed by smaller cuts next year. This would bring the real interest rate to a more neutral level, around 1%, helping to sustain the current favorable labor market conditions without risking inflation. Normalizing rates soon would also provide the Fed with greater flexibility in the future to adjust policy upward or downward as needed.
References
Pierpaolo Benigno and Gauti Eggertsson. 2024. Revisiting the Phillips and Beveridge Curves: Insights from the 2020s Inflation Surge. Jackson Hole Economic Policy Symposium, August 2024.
The curve is calibrated to pass through the most recent data point of July 2024 and, interestingly, also aligns with the observation from September 2022.
The real rate is computed as the Fed funds rate minus 1-year expected inflation from the Federal Reserve of Cleveland.