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A hot job market is usually good news for workers. When the unemployment rate is low, people can easily switch jobs and negotiate better pay from employers. Workers have more money to spend, which drives economic growth.
But low unemployment and strong jobs growth have a downside: A robust job market can drive higher inflation, setting the Federal Reserve on a course to try to reduce it — which can mean a longer wait before interest rates come down.
How are inflation and the jobs market connected?
A strong job market can drive inflation higher, but high inflation can also reverberate through the U.S. labor market.
A tight labor market is typically defined by low unemployment rates, an increase in job openings, and faster-than-usual wage growth. Businesses need to hire more workers to keep pace with surging demand. As businesses are forced to compete for workers, they’re more likely to offer wage increases and higher pay. After all, if your boss refuses to increase your pay, you can easily take your services to a different employer.
Workers have more money to spend, which pushes prices higher. Inflation, after all, is often described as too much money chasing too few goods.
Meanwhile, higher labor costs add to the cost of doing business, said Christopher Decker, a professor of economics at the University of Nebraska-Omaha. “Businesses either have to reduce production [which] typically involves cutting costs elsewhere, increase prices, or both.”
But high inflation also influences the job market, often drawing more people into the workforce in the short run.
“High inflation will usually lead to an increase in the number of workers to take advantage of the higher wages being paid,” said Thomas Stockwell, an assistant professor of economics at the University of Tampa, who studies monetary policy. “However, as workers realize their purchasing power has been eroded by inflation, they will be less willing to work.”
Most consumers generally can’t absorb higher prices forever, though. So, eventually, they’ll have to cut their spending in response to rising prices.
“Higher prices will eventually slow, or even reverse, demand growth,” Decker said. “With less demand, the need for more labor is reduced. This, by the way, is what the Fed is really trying to do with higher interest rates. By reducing demand for goods, services, and business investments, there’s less pressure on both wages and prices, so inflation slows.”
“Sadly, the timing of all of this is impossible to predict,” he added.
How do interest rates factor in?
Fed policymakers have a dual mandate from Congress to promote stable prices and maximum employment. Lately, though, the Fed has been laser-focused on inflation, which is why it has raised interest rates 11 times since March 2022.
When inflation is high, the Federal Reserve raises the federal funds rate with the goal of cooling off spending. The federal funds rate is the amount banks charge one another for overnight loans. When banks pay more to borrow money, they pass the cost on to consumers in the form of higher interest rates, making it more expensive to borrow money.
The idea is to tame price increases by getting consumers to scale back on spending. If fewer people are making big purchases, theoretically, prices will grow at a slower pace.
Read more: What the Fed rate decision means for bank accounts, CDs, loans, and credit cards
But the Fed walks a delicate tightrope when it hikes interest rates. In response to a drop in consumer demand, businesses may reduce hiring, causing the unemployment rate to spike. If consumer spending is weak and the unemployment rate is high, the central bank will often cut interest rates in response. For example, the Fed slashed interest rates to nearly zero in response to the financial crisis of 2007-09 and the COVID-19 pandemic.
The Federal Reserve’s target inflation rate is pretty clear-cut: Since 2012, it has aimed for a 2% inflation rate as measured by the price index for Personal Consumption Expenditures, or PCE. The PCE price index rose 2.7% in March compared to the previous year, making it pretty clear that the economy hasn’t simmered down quite enough for the Fed’s liking.
The definition of maximum employment, on the other hand, is a lot murkier.
“There is not an explicit target for unemployment like there is for inflation,” said Stockwell. “But to keep inflation steady, it is important to keep the unemployment rate as close to the natural rate of unemployment as possible. This is the unemployment rate that would exist if there were no shortages or surpluses in the labor market.”
Maximum employment isn’t 0% unemployment, Stockwell said, because some unemployment is healthy. There will always be what economists call frictional unemployment, which is driven by people in transition, i.e., you quit your job to find new opportunities or you’re a recent college grad searching for employment. Some structural unemployment, which is when workers lose jobs due to factors like technological developments, globalization, or widespread changes in consumer demand, will always exist as well.
“Full employment is when the only people unemployed are those who are frictionally or structurally unemployed,” Stockwell said.
As inflation cools off, many observers wonder when the Fed’s goal of full employment may come into greater focus. The latest jobs report from the U.S. Bureau of Labor Statistics (BLS), released May 3, showed that employers pulled back on hiring in April, adding just 175,000 jobs compared to the 233,000 jobs economists forecasted.
Federal Reserve Chair Jerome Powell said recently (prior to the April jobs report) that a weakening in the job market “would have to be meaningful and get our attention and lead us to think that the labor market was really significantly weakening for us to want to react to it.” Though he declined to get specific, he noted that an increase of a couple of tenths of a percentage point in the unemployment rate probably wouldn’t be significant enough to prompt cuts.
With interest rates at a 23-year high, why is the job market still so hot?
Back in 2022 when the Fed first started hiking interest rates, many economists believed a recession and higher unemployment were ahead. Thus far, though, neither has materialized. Instead, the U.S. economy actually grew by 3.1% in 2023.
So what gives?
Economists are quick to point out that current interest rates aren’t that high by historical standards. The economy experienced about 15 years of unusually low interest rates before rates started rising, Stockwell said.
“We don’t have high interest rates right now,” Stockwell said. “We have returned to more normal interest rates.”
It’s also important to note that not all industries are experiencing a sizzling job market. For example, sectors like healthcare, education, and state and local government tend to be relatively inflation-proof and aren’t sensitive to interest rates. These sectors have been hiring in large numbers. Meanwhile, Big Tech, which tends to be more interest-rate sensitive, has been hard-hit by layoffs.
One potential reason higher interest rates haven’t slowed consumer spending as much as the Fed might have hoped: Higher interest rates don’t affect everyone equally. If you’re looking to buy a home and lock in a low mortgage, you’re struggling with credit card debt, or you’re a business owner seeking financing to expand, high interest rates are painful. But someone who locked in a low-rate mortgage in 2020 or 2021 and doesn’t carry revolving debt may be largely unaffected by high interest rates, so they can afford to keep spending, even if prices continue going up.
Decker, though, worries that higher spending and interest rates will have a broader impact over time. For example, he worries that credit is fueling some consumer spending.
“Eventually those debts will have to be paid down,” he said. “That will slow demand, and eventually the job market.”