Lost amid the Federal Reserve’s recent decision to reduce its policy rate was the publication of the employment cost index that we expect to have implications for the direction of monetary policy and the estimation of the neutral level of the federal funds rate.
Long-term trends in the cost of labor and core inflation continue to move in sync, but the gap has widened since 2023.
While the employment cost index grew at a yearly pace of 3.6% in the third quarter, the core personal consumption expenditures index, the Federal Reserve’s preferred measure of inflation, increased at a 2.7% average yearly rate.
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In our view, the widening gap between the two rates coincides with the pandemic-era labor shortage, which prompted employers to raise wages to induce workers back into the labor force.
Over the same period, the rebuilding of the global supply chain allowed for an easing in inflation growth with the core PCE moving from over 5% in 2022 to within range of the Fed’s 2% target in 2024 and at 2.8% through September 2025.
The 3.6% cost of labor accounts directly or indirectly for some portion of the 2.8% increase in core inflation.
The impact of the cost of labor on the neutral setting for the federal funds rate requires more information for central bank policymakers.
Policymakers need more time to observe the response of the economy and prices to the dwindling supply of domestic labor because of changes in immigration and an aging population.
Both demand and supply in the labor market face real constraints. Hiring, as a result, has downshifted to a range between 20,000 and 50,000 new jobs a month, with the latter being the minimum amount necessary in our estimation to keep labor market conditions stable.
Finally, if the economy is expected to weather the trade disruptions and changes in the labor market, and with fiscal stimulus taking effect in 2026, then a neutral federal funds rate in the range of a 3% to 3.5% nominal rate is more appropriate than the zero real (inflation-adjusted) terminal rate now being called for in some quarters.
Expectations are of 2% real GDP growth and headline inflation of 2.5%, which implies nominal GDP growth of 4.5%.
The current futures market is pointing to the federal funds rate in a 3% to 3.25% range from September 2026. That figure is modestly too low in respect to economic growth, which in our view would apply upward pressure on prices and the demand for labor.
As a new Federal Open Market Committee and a new Federal Reserve chair take over in 2026, we think inflationary risks around dovish policy decisions will become clear.
