A report released by the U.S. Bureau of Labor Statistics on October 8 showed that payroll employment gains in the United States for September fell way short of expectations for a second consecutive month. Payroll employment rose by 194,000 in September versus an expected increase of 500,000.

The unemployment rate dropped to 4.76% in September from 5.19% in August and has decreased by over 1% since June. The broader U-6 unemployment rate¹ is 1.3% lower over the same period. That represents a very rapid tightening of the labor market. Household employment growth—a series that carries lesser importance because it is extremely volatile from month to month—increased by 526,000 in September. The employment-to-population ratio rose to 58.7%, just slightly below the previous cycle average of 59.3%. The previous peak of 61.1% will be difficult to match due to an aging labor force.

Meanwhile, the September data also showed that pay increases are accelerating, a signal that progress is being made towards maximum employment. The acceleration in wage inflation in 2021 stands in sharp contrast to the deceleration after the global financial crisis of 2008–09, which followed the usual dynamic from prior recessions.

The slowdown in the U.S. employment recovery—it would take another eighteen months to recover all the jobs lost during the downturn if employment growth averages 300,000 per month and three to four years to catch up to the pre-pandemic trend level of employment—implies that reopening the economy after COVID will not be smooth. Instead reopening is full of frictions that are leading to inflationary pressure on prices and wages across a broad swath of the economy.

This creates a conundrum for the U.S. Federal Reserve (Fed) since inflation is emerging from a constellation of excess demand in some sectors and insufficient demand in others. The risk is that as demand recovers more broadly, inflation picks up in sectors where it hasn’t accelerated much yet, like health care services, even as it remains higher in sectors where it has picked up already, such as food away from home.

As both inflation and inflation risk have increased, it behooves the Fed to back away from providing maximum accommodation and build in some optionality for future policy adjustments. Job growth, while still robust, is slowing and pay increases are accelerating, increasing the difficulty for the Fed to meet its objective of minimizing the shortfall from maximum employment. The problem is that labor supply appears to be increasing only gradually even as jobs remain 5 million below the pre-pandemic peak and 7-8 million below trend.

Since maximum employment may have declined and increasing wage pressure is a signal that inflation may not be transitory, we think the Fed is likely to stay on course to announce its tapering schedule at its November policy meeting and begin removing accommodation in December even if it would have preferred more robust results on the employment front.