A 4.3% Unemployment Rate Hides a Fragmenting Labor Market

Jobseekers wait in line to speak to recruiters in Chicago. The private sector shed 32,000 jobs last month, according to a report released by ADP this week. (Jim Vondruska/Bloomberg)

About the author: Marcello Estevão is the managing director and chief economist at the Institute of International Finance. He teaches macroeconomics at Georgetown University.

Many observers saw the Federal Reserve’s quarter-point rate cut in September as merely a technical adjustment, rather than the start of a new downward rate trajectory. Inflation isn’t spiraling, unemployment is still low, and growth is sluggish but not collapsing. Why cut now?

The answer lies beneath the surface. Demand is cooling, hiring is slowing, and the labor market is sending mixed signals. Rather than wait for a downturn to become undeniable, the Fed has chosen to act pre-emptively. This isn’t a panicked response but a recalibration—an effort to balance risks in an economy that looks stable on the surface but is fragile underneath.

Fed Chair Jerome Powell and his colleagues know monetary policy works with a lag. By easing now, they hope to cushion the economy against what could become a sharper slowdown later this year. They are betting that the danger of faltering growth and rising unemployment outweighs the risk of inflation reigniting.

That is the key message of this cut: The Fed is shifting its weight to guard against risks it believes are gathering momentum.

The most revealing part of this story is the labor market. The unemployment rate looks fine on the surface. But our research at the Institute of International Finance shows the labor market is far more fragmented than those headline numbers suggest.

At 4.3%, the unemployment rate might seem tight. But that isn’t driven by booming demand across the board. Instead, reduced supply in specific corners of the workforce is reducing the labor force. Immigration has slowed, especially of workers who typically filled lower-skilled jobs. That has left shortages in construction, agriculture, and some services.

Created with Highcharts 9.0.1Immigration Crackdown Blunts Labor Force ParticipationIn many of the states that are most reliant on immigrant labor, the labor force​participation rate is falling faster than the nationwide average.Change in LFPR, in percentage pointsSource: BLS, IIF

Created with Highcharts 9.0.1U.S.CAAZTXNVFLNCGAILVAWA-1.2-1-0.8-0.6-0.4-0.200.20.4

Meanwhile, overall demand for labor is weakening as businesses face uncertainty and disruptions from tariffs and global trade frictions. The result is an uneven pattern of wage pressures. Wages are rising in sectors and states that relied heavily on immigrant labor and are vulnerable to changes in immigration policy. They are decelerating elsewhere.

Created with Highcharts 9.0.1Uneven Wage GainsSupply shock fuels wage gains in vulnerable statesLabor-weighted average hourly earnings, year-over-year percentage growthSource: BLS, IIF

Created with Highcharts 9.0.1Jan-​10Jan-​12Jan-​14Jan-​16Jan-​18Jan-​20Jan-​22Jan-​240123456VulnerableLess vulnerable

Historically, a low unemployment rate meant strong demand, tight labor markets, and rising inflation risks. But the playbook has changed. Identical rates may reflect a very different reality. A shrinking labor supply makes unemployment rates appear low even if demand is weak.

This nuance is critical. Tight unemployment can mean either stronger or weaker inflationary pressures depending on which situation applies. A low unemployment rate driven by a shrinking workforce in a specific sector won’t necessarily mean higher inflationary pressures, while low unemployment driven by roaring demand everywhere will. Powell’s emphasis on labor supply signals that the Fed is adapting its framework. Aggregate jobless rates alone are no longer enough to serve as a basis for judgments about inflation. The central bank is looking harder at participation trends, immigration, and where wage pressures are actually building.

Markets need to adjust to this shift. The equilibrium unemployment rate is likely lower, although it is too early to prove that. Moreover, inflation data point to localized pressures in items more sensitive to higher tariffs, not to broad-based inflationary pressures, although service price inflation is quite sticky, contributing to around 3% core inflation at the moment. The jury on future inflationary pressures is still out. It is a judgment call that inflation risks are smaller than the risk of significant worsening in labor market conditions.

Fed moves have global implications. Lower U.S. yields usually weaken the dollar, driving capital into higher-yielding markets. Brazil, Mexico, and Indonesia are already seeing inflows.

But the story is mixed for emerging markets. Easier Fed policy is positive in the short term, but inflows can be fickle if they are driven mainly by carry trades, where traders seek to profit off interest-rate differentials. Large part of the inflows to Brazil, for instance, is explained by its high rates, but without credible fiscal reform those inflows will remain volatile. And U.S. fiscal deficits are pushing up long-term yields, even as the Fed cuts short-term rates. That steepens the yield curve and complicates funding conditions for emerging markets.

All this adds up to a quarter-point cut with outsize significance. The Fed is signaling that headline inflation, growth, and unemployment no longer provide a sufficient guide for policymaking. Structural shifts in the labor force—especially around immigration and low-skilled work—now matter as much as cyclical dynamics.

Central banking has entered a new era—one where flexibility, nuance, and structural awareness are as important as the traditional focus on aggregate statistics.

Guest commentaries like this one are written by authors outside the Barron’s newsroom. They reflect the perspective and opinions of the authors. Submit feedback and commentary pitches to ideas@barrons.com.