Stagnation Is Lulling The Fed To Sleep: The Disconnect Between Growth and Labor

The economic picture is sending mixed signals. On one side, the headline numbers are robust. The economy grew at a red-hot 4.3 percent in the third quarter, far outpacing most forecasts. Looking ahead, Goldman Sachs projects the US will accelerate to 2.6% growth in 2026, a figure that substantially outperforms the consensus. This is the story of strong, resilient growth.

On the other side, the labor market tells a different tale. Job creation has fallen well below the rates prevailing in 2019, with the monthly net gain in nonfarm payrolls plunging from a peak of 139,000 to just 17,000. This sharp slowdown points to a labor market that is stagnating, not expanding. At the same time, the underlying cost of living has been rising steadily, with the price level having risen by about 20 percent over the past five years. This inflicts real pain on households, particularly those with lower incomes.

The disconnect is clear: sturdy headline growth is not translating into a healthier job market. This creates a dangerous illusion of economic strength. For the Federal Reserve, this false sense of security is a major risk. It can lull policymakers into complacency, making them less likely to act decisively to address the underlying pressures in the labor market. As Atlanta Fed President Raphael Bostic noted, the central bank faces a "tough spot" where softening labor conditions coexist with inflation that remains above target. When growth looks good but jobs are not following, the Fed's dual mandate becomes harder to navigate.

The Fed's Lullaby: Why Stagnation Is Being Ignored

The Federal Reserve's focus on headline growth is not merely a statistical oversight; it is a response to a complex, high-stakes dilemma. The central bank's primary mandate is price stability, and the persistent inflation overshoot creates a powerful gravitational pull on its policy calculus. As of October, the cumulative gap between actual and target inflation has reached 10.4 percentage points, marking the longest and largest such period since the Fed gained independence. This is a structural overhang that demands attention. For many officials, the immediate imperative is to close this gap, which can overshadow the more ambiguous signals from the labor market. The core of the Fed's hesitation lies in uncertainty. Atlanta Fed President Raphael Bostic, in his final quarterly message, explicitly frames the challenge: it is unclear whether the labor market is significantly out of balance because the forces at play are a mix of cyclical cooling and deeper structural shifts. Labor supply growth is slowing due to changes in immigration policy and shifting demographics. This ambiguity makes it difficult to assess the true state of "maximum employment." When policymakers cannot distinguish between a temporary soft patch and a fundamental rebalancing, they are less likely to act aggressively. The Fed's dual mandate becomes a tug-of-war between a clear, persistent inflation problem and a labor market where the diagnosis is still in question.

This environment has fostered a notable complacency. Despite the record inflation overshoot, only a few Fed officials are expressing an urgency to get inflation back to target. This quietude is a red flag. It suggests a broader committee comfort with the current trajectory, where the fight against inflation is seen as ongoing but not yet critical enough to warrant a policy pivot. This complacency likely extends to labor market risks. If the inflation fight is perceived as the dominant concern, then the stagnation in job creation may be viewed as a secondary issue, perhaps even a necessary byproduct of cooling demand.

The result is a policy stance that is, by some accounts, only modestly restrictive. This leaves the Fed vulnerable to being lulled into inaction by the illusion of strong growth. The disconnect between robust GDP and weak labor is a classic setup for a delayed reaction. The Fed may be prioritizing the inflation fight because it is the clearer, more immediate threat. But by doing so, it risks allowing structural labor market pressures to deepen, setting the stage for a more painful adjustment later. The central bank's focus on headline growth, therefore, is a rational but dangerous choice in a world where the true risks are obscured by uncertainty.

The Risk of Complacency: A Policy and Market Vulnerability

The Fed's current stance, lulled by strong headline growth and focused on the inflation journey, is building a set of concrete vulnerabilities. The first and most direct risk is a delayed policy response that allows labor market stagnation to deepen. The Atlanta Fed's president has acknowledged that it is unclear whether the labor market is significantly out of balance, a view that may be shared across the committee. This uncertainty is a luxury the economy cannot afford. As long as policymakers hesitate, the underlying pressures-slowing labor supply, demographic shifts, and persistent cost-of-living pain-can fester. The result is a potential for a more severe and costly correction later, where the Fed is forced to act decisively to support employment, potentially at the expense of its inflation fight.

The bond market's complacency amplifies this risk. Investors are focusing on the journey back to the Fed's 2% target, with market expectations now pushing the timeline into 2027. This assumes the Fed's credibility and control remain intact. But that assumption is fragile. If deteriorating labor data-such as a sharp drop in job creation or a rise in unemployment-were to emerge, it could force the Fed into a difficult trade-off. The central bank might then be compelled to pivot toward easier policy to support jobs, directly challenging the inflation narrative that has anchored bond yields. This would create a volatile environment where the market's long-dated inflation expectations could unravel, leading to a sharp repricing of risk.

Finally, the policy tailwind for growth may be underestimated, potentially masking deeper structural weaknesses. Goldman Sachs projects the US will accelerate to 2.6% growth in 2026, a figure driven by tax cuts and fiscal stimulus. This front-loaded boost could provide a powerful cushion, making the economic picture look stronger than it is at a fundamental level. The danger is that this stimulus masks the stagnation in the labor market, reinforcing the Fed's complacency. In reality, the growth is being fueled by policy, not organic expansion. When that fiscal impulse fades, the economy's true underlying health-particularly its ability to generate broad-based job creation-will be laid bare. The current setup is a classic case of a policy-driven growth story that may delay the reckoning, but does not eliminate it.

Catalysts and Watchpoints: What Could Break the Lull

The thesis of Fed complacency hinges on a fragile equilibrium. It will be tested in the coming months by a series of data releases and policy decisions that must clarify the true state of the economy. The first major signal arrives in March, when the Federal Open Market Committee meets again. The market will be watching for any shift in tone. A dovish pivot, perhaps a second consecutive rate cut, would confirm the committee's prioritization of the labor market, validating the stagnation narrative. Conversely, a pause or even a hike would challenge the complacency thesis, suggesting that the Fed remains anchored by its inflation fight and views the current stance as "only modestly restrictive" as it should be.

Beyond the next rate decision, the critical watchpoint is inflation's composition, particularly in the services sector. The Atlanta Fed's president has noted that it is unclear whether the labor market is significantly out of balance, a view that underscores the need for clearer data on supply and demand. This is where core services inflation becomes a key divergent signal. While official PCE data may show a gradual decline, the underlying pressures may not be fully captured. For instance, the PCE shelter index is known to lag market rents, and recent data suggests it has overshot new rents. This means the official measure may still reflect past imbalances rather than current conditions. Similarly, the cost of other services like portfolio management fees may be moving differently than the broad index. Monitoring these granular components will be essential for the Fed to assess whether inflation is truly cooling or merely being smoothed by statistical lags.

Finally, the data that will most directly challenge or confirm the Fed's uncertainty is that which clarifies the state of labor supply and demand. The Atlanta Fed's president has pointed to slowing labor supply growth due to changes in immigration policy and shifting demographics. Future reports on job openings, quits, and wage growth will need to disentangle cyclical cooling from these deeper structural forces. A sharp drop in job creation or a rise in unemployment would force the committee to confront the risk of a labor market that is indeed out of balance. Until that data arrives, the Fed's cautious stance will likely persist. The coming months are a period of high-stakes data dependency, where the missing benchmarks are being filled by regional insights and forward-looking analysis. The lull will end when the evidence compels a clearer policy choice.