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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is an FT contributing editor and director of economic policy studies at the American Enterprise Institute
Markets, economists and Federal Reserve officials seem to believe that the US labour market spent most of last year weakening, that inflation is trending back to the Fed’s inflation target and that the central bank will continue cutting interest rates in 2026. On each of these three points, the conventional view is probably wrong.
The holes in the consensus narrative were clear before last week’s jobs report, which surprised many analysts on the upside. In January, the economy added 130,000 net new jobs and the unemployment rate declined by 10 basis points to 4.28 per cent.
But December’s 4.38 per cent unemployment rate was already very low. And the jobless rate — which was 4.3 per cent or higher for six months last year — had not been displaying a worrying upward trend. In addition, the rate at which employers are laying off workers has been flat since 2023. And according to my calculations, aggregate labour supply and demand are roughly in balance and have been relatively stable over the past year.
Monthly headline payroll gains — which trended down throughout 2025 — ostensibly tell a different story. But this reduction is mostly due to large declines in net migration.
The conventional view of labour market weakening has struggled to contend with robust economic growth. Real GDP grew at annual rates of 3.8 per cent and 4.4 per cent in the second and third quarters of last year, respectively, and at the time of this writing is expected by the Atlanta Fed to grow at 3.7 per cent in the fourth quarter. Growth in real consumer spending and gross fixed investment was strong and stable in the middle quarters of last year.
Disinflationary pressure might seem inconsistent with solid GDP growth and low and stable unemployment. And, contra the conventional view of analysts and of the Fed, inflation does not seem to be decelerating. Core PCE inflation grew at a 2.8 per cent annual rate in November, the last month for which data is available. In January 2025, the index grew at exactly the same annual rate.
Moreover, this lack of progress does not seem to be driven by the 2025 increase in tariff rates. Tariffs should not have a first-order effect on the price of services, and my preferred measure of underlying service-sector inflation — which relies on observed market prices and excludes housing and energy services — also shows no disinflation in 2025.
To be sure, the conventional view of the job market has some empirical support. The rate at which employers are hiring workers is lower than it has been since 2013. Still, the risk of inflation accelerating this year is greater than the risk of a spike in the unemployment rate.
Tailwinds that will boost demand and inflationary pressure include strong spending on AI and data centres, rising stock prices that will fuel consumer spending and a fading drag from trade policy uncertainty. On the supply side, at least some inflationary pressure seems likely to come from lagged effects of last year’s tariff increases and from reductions in the number of foreign-born workers.
The federal funds rate was 4.33 per cent from January into September. The policy rate at this level was apparently not high enough to restrain an increase in stock prices, prevent GDP growth from accelerating, or induce a worrying increase in the unemployment rate. Despite this, the Fed cut its policy rate at its September, October and December meetings.
It would be a mistake for the Fed to cut rates again in 2026. Though the Fed thinks it has its foot on the economy’s brake pedal, it is actually hitting the gas. In part because of this, even if the central bank keeps the policy rate at its current level, it may need to raise rates in the second half of this year.
Because inflation psychology may be becoming more fragile, the Fed should be putting more weight on the inflation side of its dual mandate. Households’ medium-term inflation expectations spiked last year and remain elevated. Over the past five years, businesses have come to believe that consumers are more willing to live with price increases than they were prior to the pandemic. Because of the lengths President Donald Trump has gone to capture the Fed, the upcoming leadership change has led many to worry about the strength of its ongoing commitment to its inflation target.
But first, the Fed — along with investors and economists — needs to see more clearly the strength of the economy.