Financial markets have suddenly begun to price in the risk of a U.S. recession. The S&P 500 closed on Wednesday down almost 7 percent from one month ago, with nearly all of the decline concentrated in the past few days.

Where should the Federal Reserve go from here? Given the surprise increase in the unemployment rate and the reaction of financial markets, it seems safe to assume that policymakers wish they had reduced rates at last week’s meeting. But the failure to do so need not be costly, and correcting it does not require an emergency meeting and a rate cut.

The proximate cause of the market reaction is last week’s Employment Situation report showing the jobless rate at a 33-month high, having risen 0.6 percent since January. The deeper concern is that the Fed remains behind the curve, keeping its policy rate too high as it is still overly focused on fighting the last war of inflation reduction. The new reality is becoming clearer: inflation almost back to the target rate of 2 percent and weakening in the real economy.

The facts dictate concern but not panic. Start with the latest labor market data. The July unemployment rate of 4.3 percent is not historically high. In fact, Fed policymakers have long predicted that their tightening cycle would result in an unemployment rate at the end of 2024 around 4.5 percent. If the unemployment rate peaks around its current level, the Fed will justifiably celebrate having achieved a soft landing.

The concern is the upward trend. The post-World War II historical record contains seven previous episodes when the unemployment rate stood below 5 percent, having risen 0.5 percent or more over the previous six months; on average, over the subsequent six months, the unemployment rate rose a further 1.7 percentage points. Such an increase would indeed bring the U.S. economy into a recession. Yet, past need not be prologue.

To understand the Fed’s quandary, consider why it raised interest rates and has kept them high. Inflation in the Fed’s preferred price index surpassed 7 percent in the 12 months ending in June 2022, a result of a mix of commodity price shocks and sectoral bottlenecks brought on by the Covid-19 pandemic, changing preferences in housing markets and expansionary fiscal policy, including the American Rescue Plan.

We are having trouble retrieving the article content.

Please enable JavaScript in your browser settings.

Thank you for your patience while we verify access. If you are in Reader mode please exit and log into your Times account, or subscribe for all of The Times.

Thank you for your patience while we verify access.

Already a subscriber? Log in.

Want all of The Times? Subscribe.paradise8

• How
• to
• Another
• paradise8
• Avoid