Why the Federal Reserve Needs to Hike Rates Despite Lower Unemployment

The recent strong job growth and relatively low unemployment rates in the U.S. have left many puzzled as to why the Federal Reserve continues to hike interest rates. The prevailing narrative is that with more jobs and economic growth, prices should naturally decrease. However, the relationship between employment and inflation is more complex than it appears. This article explores why the Fed raises interest rates in the context of a strong job market and discusses the underlying economic mechanisms at play.

The Federal Reserve's Dual Mandate

The Federal Reserve operates under a dual mandate to promote stable prices and full employment. In recent years, the unemployment rate has steadily decreased. This suggests that reducing unemployment was one of the Fed's main goals, and it appears that they have succeeded in this area. However, the Fed's actions are not solely driven by employment levels. They must also consider inflation to fulfill their dual mandate.

For instance, Howard Schneider reported, 'Solid US jobs data keeps Fed on track for rate hike in May' (Thomson Reuters, April 7, 2023). This indicates that even with a healthy job market, the Fed recognizes the need for maintaining price stability through regulatory measures such as higher interest rates.

How Labor Shortages Drive Up Prices

Even with a strong labor market, the idea that more jobs would lead to lower prices is a misconception. In a labor shortage, companies often raise wages to attract workers. This increased cost of labor is often passed on to consumers through higher prices. According to Nik Popli, ‘It Could Be Harder to Find a Job and Get a Pay Raise if the Fed Gets Its Way’ (Time, February 8, 2023), underscores the difficulty of increasing wages and prices simultaneously without government intervention.

When there is a scarcity of labor, businesses may face higher costs, which they often attempt to recover through increased pricing. This mechanism can lead to inflation, which is why the Fed is required to intervene by raising interest rates, even when unemployment rates are low.

Interest Rates as the Price of Credit

Interest rates are essentially the price of credit, and they can fluctuate based on market demands and supply. The Federal Reserve can significantly influence these rates, but they cannot always ignore market signals. For example, businesses seeking credit to innovate can drive up interest rates. The Fed often reacts to these market signals to manage economic stability.

While the Fed does not always completely align with market forces, it must consider the broader economic implications. Pushing interest rates too high can lead to deflation or hyperinflation, both of which are detrimental to employment. Instead, the Fed aims to find a balance that helps maintain stable prices without causing significant economic upheaval.

A Countercyclical Approach to Monetary Policy

The Federal Reserve employs countercyclical monetary policy, a strategy that adjusts interest rates in response to economic cycles. When the economy is contracting and unemployment is high, the Fed typically lowers interest rates and increases the money supply to stimulate economic growth. Conversely, when the economy is growing strongly and inflation is a concern, the Fed raises interest rates to tighten the money supply and slow down inflation.

Recent data shows a labor market that is far from contracting, yet inflation remains a pressing concern. Unemployment has dropped to levels not seen in decades, meaning businesses are competing more intensely for workers. This competition can drive up wages, leading to increased production and service costs. As a result, consumers face higher prices, which directly counteracts the benefits of increased employment.

To address this issue, the Fed has undertaken several rate hikes. The strategy is to increase the cost of borrowing to reduce spending and mitigate inflationary pressures. This approach is designed to stabilize prices without causing a recession. Ideally, the Fed tightens monetary policy slightly, allowing the economy to maintain growth while staying within a normal range of around 4-5% inflation.

Given this context, the Fed's actions are not merely reactions to employment levels but are part of a broader strategy to balance economic growth and price stability. While the job market is robust, the underlying issues of inflation and labor market dynamics necessitate a measured approach to interest rate hikes.

Conclusion

The Federal Reserve's decision to hike interest rates, despite lower unemployment rates, reflects a nuanced understanding of the economy. By balancing employment and price stability, the Fed aims to maintain a healthy economic environment. Understanding the mechanics behind these decisions can help us comprehend why even a strong job market does not necessarily result in lower prices. The Fed's actions are informed by a complex interplay of economic indicators and the overarching goal of a stable and growing economy.