Will Fed Rate Cuts Reduce Unemployment?

Economies spend much of their time in transition and little time at rest. When economies do reach stabilized rates, however, it reveals rare inferences regarding target levels the economy trends towards. The unemployment rate, for example, fell roughly 6 percentage points after surging during the Great Financial Crisis of 2007-2008. By 2019, it was stabilizing around 3.5%. If the fundamental dynamics of labor markets—things like the job-finding rate, job-separation rate, and the labor force entry and exit rates—remain unchanged, we would expect the economy to return to this level. Economists call this the natural rate of unemployment, and it provides a useful reference point to evaluate labor market conditions.

After spiking to nearly 15% in April of 2020, the unemployment rate quickly fell back down to its pre-pandemic trough of 3.5% in the summer of 2022. It hovered around that level for nearly a year, likely indicating that it had once again reached the natural rate of unemployment. Since then, the rate has increased to 4.3% and appears to be rising steadily. Now that the unemployment rate is nearing a percentage point above the pre- and post-pandemic low, the residual increase must either be explained by changing fundamental labor market dynamics or deteriorating macroeconomic conditions.

The pandemic restructured the economy in several ways. Consumer spending, for example, shifted towards goods and away from services. Labor markets also adjusted, as many jobs moved to remote work, increasing geographical mobility. Meanwhile, a series of fiscal and monetary packages stimulated demand, causing a corresponding surge in inflation and subsequent monetary contraction to combat inflation. Now, as the economy slows down and inflation settles near the Fed’s 2% target, the Fed will begin normalizing interest rates from highly contractionary levels. While the unemployment rate likely reflects a combination of factors, excess unemployment at this point in the business cycle likely reflects contractionary monetary policy in a weakening economy.

The Phillips Curve characterizes the inverse relationship between inflation and unemployment. The underlying economic theory suggests that the Fed can reduce unemployment by temporarily increasing inflation through expansionary monetary policy. In the wake of the pandemic, expansionary monetary policy contributed to both the reduction in unemployment, as well as a surge in inflation. As the inflation rate convergences to the Fed’s 2% target, sustained contractionary monetary policy is likely driving the residual increase in the unemployment rate.

Deviations between the unemployment rate and the natural rate of unemployment are either caused by a change in fundamental labor market dynamics or a macroeconomic shock, possibly related to policy. A natural rate of unemployment around 3.5% implies that excess unemployment is nearing one percentage point. Looking forward, given the effectiveness of monetary policy in driving economic activity, a cycle of reducing interest rates to neutral levels will—in the absence of another shock—would be expected to bring the unemployment rate back towards the natural rate of around 3.5%.