Back in May of this year, we discussed “stagflation,” a term that combines the words stagnant and inflation. Now, five months later, CR Economist Henry Willmore revisits the concept.
The Federal Open Market Committee (FOMC) cut interest rates by 25 basis points in mid-September and indicated that it would likely ease by another 50 over the course of the fourth quarter. However, the committee is closely divided, with a large minority of its members indicating that one more 25 basis point easing might be all that is needed. FOMC Chair Jerome Powell indicated that the move in September was needed to reduce downside risks to job growth.
These downside risks can be seen in the trends for job growth in 2024 and the first eight months of 2025. Non-farm payrolls have grown by an average of 27,000 per month in the past four months. This marks a sharp deceleration from 123,000 per month in the first four months of 2025, which itself is a deceleration from 168,000 per month in 2024.
In spite of decelerating job growth, the unemployment rate has shown little change. It stood at 4.3% in August, up 0.1% from a year ago. This reflects weaker labor force growth as net immigration slowed sharply.
Over the rest of this year and early 2026, the FOMC’s decisions are likely to be strongly influenced by their assessment of whether weakening job growth is mainly a reflection of slower labor force growth. If that is the case, then they will have to be cautious about easing too much. Fortunately, the unemployment rate is an excellent statistic for balancing the relative growth rates of jobs and the labor force. Its movements in coming months will be closely scrutinized.
Additional increases in the unemployment rate can be expected to trigger the 50 basis points of easing projected by the FOMC for the fourth quarter. If the unemployment rate stabilizes at current levels, it will be difficult to justify more than 25 basis points of easing.
Does the Fed Have a “Crystal Ball?”
Which scenario is more likely? There are signs the economy is starting to stabilize after being rocked by uncertainty generated by the erratic rollout of tariffs policy. Retails sales data were strong in the third quarter and point to real consumption growth of about 3.5% for the quarter.
The consumer is being supported by a powerful wealth effect being generated by the stock market. The gains in household wealth have encouraged and enabled spending above and beyond income growth. One manifestation of this has been an ongoing decline in the savings rate, which has dropped for four consecutive months and stood at 4.6% in August, its lowest level this year.
These developments come against a backdrop of slowly accelerating inflation. Excluding food and energy, the Consumer Price Index continues to rise at a pace slightly over 3%. The tariffs can be expected to have their strongest effect on goods rather than services. Not surprisingly, the index for goods other than food and energy has been accelerating. Usually such prices fall, but in the past year they have risen 1.5%, with one of largest monthly increases during the past year coming in August. Some additional tariff-related price increases can be expected over the next few months.
However, the members of the FOMC appear confident that this uptick in inflation will not carry over into 2026 and beyond. Their latest projections call for a gradual deceleration in inflation and a return to their 2% target by the end of 2027. This relaxed view regarding inflation means that the movements in the unemployment rate really hold the key to the near-term path of monetary policy. The strength of the stock market and related resilience in consumer spending suggest that there may be enough momentum in the economy to keep the unemployment rate from rising further and to limit additional easing by the FOMC to a single 25 basis point move in the fourth quarter.
