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The writer is an FT editor and director of economic policy studies at the American Enterprise Institute
Markets, economists and Federal Reserve officials appear to believe that the U.S. labor market has weakened for most of last year, that inflation will return to the Fed’s inflation target and that the central bank will continue to cut interest rates in 2026. On each of these three points, the conventional view is probably wrong.
The holes in the consensus narrative were already apparent before last week’s jobs report, which surprised many analysts on the upside. In January, the economy added a net 130,000 new jobs and the unemployment rate fell 10 basis points to 4.28 percent.
But the unemployment rate of 4.38 percent in December was already very low. And the unemployment rate – which stood at 4.3 percent or higher for six months last year – did not show a worrying upward trend. In addition, there is the pace at which employers fire employees has been flat since 2023. And according to my calculations, so is the total supply and demand for labor approximately in equilibrium and have been relatively stable over the past year.
The monthly wage increases – which showed a downward trend in 2025 – apparently tell a different story. But this decline is mainly due to a large drop in net migration.
The conventional view of the weakening labor market has struggled to cope with robust economic growth. Real GDP grew with an annual interest rate of 3.8 percent and 4.4 percent in the second and third quarters of last year respectively, and at the time of writing that is expected of the Atlanta Fed will grow 3.7 percent in the fourth quarter. Growth in real consumer spending and gross fixed capital formation was strong and stable in the middle quarters of last year.
Disinflationary pressures may seem inconsistent with solid GDP growth and low and stable unemployment. And, contrary to the conventional view of analysts and the Fed, inflation shows no signs of slowing. Core PCE inflation grew at an annual rate of 2.8 percent in November, the last month for which data is available. In January 2025, the index was growing at exactly the same annual rate.
Moreover, this lack of progress does not appear to be driven by the 2025 tariff increase. Tariffs should not have a first-order effect on the price of services, and my preferred measure of underlying inflation in the services sector – which relies on observed market prices and excludes housing and energy services – also shows no disinflation by 2025.
It is fair to say that the conventional view of the labor market has some empirical support. The pace at which employers are hiring is slower than it has been since 2013. Still, the risk of inflation accelerating this year is greater than the risk of a spike in unemployment.
Tailwinds that will boost demand and inflationary pressures include strong spending on AI and data centers, rising stock prices that will boost consumer spending, and a declining drag on trade policy uncertainty. On the supply side, it seems likely that there will be at least some inflationary pressure from the lagged effects of last year’s rate increases and from the decline in the number of foreign-born workers.
The federal funds rate was 4.33 percent from January to September. The policy rate at this level was apparently not high enough to curb a rise in stock prices, prevent GDP growth from accelerating, or trigger a worrying rise in unemployment. Nevertheless, the Fed lowered its policy rate at its meetings in September, October and December.
It would be a mistake if the Fed were to cut rates again in 2026. While the Fed thinks it has its foot on the brake pedal on the economy, it is actually stepping on the accelerator. Partly because of this, even if the central bank keeps policy rates at current levels, they may have to raise rates in the second half of this year.
Because inflation psychology may become more fragile, the Fed should place more weight on the inflation side of its dual mandate. Medium term of households inflation expectations peaked last year and remains high. Over the past five years, companies have come to believe that consumers are more willing to put up with price increases than they were before the pandemic. Because of President Donald Trump’s efforts to win over the Fed, the impending change in leadership has many concerned about the strength of the continued commitment to the inflation target.
But first the Fed – along with investors and economists – must see the economy’s strength more clearly.
