The latest jobs report was a big surprise and may point to a labor market that has changed in the wake of the COVID pandemic.

For months, the Fed cautiously eyeing strong employment in the US economy out of concern that employers, desperate to hire, will continue to raise wages and, in turn, keep inflation high. But in January slowing job growth in tandem with the actual slowdown in wage growth. And this follows the easing of several inflation measures in recent months.

Consistently strong hiring gains last year defied the fastest increase in the Fed’s benchmark interest rate in four decades – an aggressive effort by the central bank to cool hiring, economic growth and rising prices that have angered American households for nearly two years.

Yet economists were surprised when the government reported on Friday that employers added an explosive 517,000 jobs last month and that the unemployment rate fell to a new 53-year low of 3.4 %.

“Today’s jobs report is almost too good to be true,” said Julia Pollak, chief economist at ZipRecruiter. “Like $20 sidewalk bills and free lunches, falling inflation paired with falling unemployment is the stuff of economic fiction.”

In the economic models used by the Fed and most leading economists, a job market with strong hiring and a low unemployment rate usually fueling higher inflation. Under this scenario, companies feel compelled to keep raising wages to attract and retain workers. They often pass those higher labor costs on to their customers by raising prices. Their higher paid workers have more money to spend. Both trends feed inflationary pressures.

Although hiring has been strong over the past six months, year-over-year inflation has slowed from a peak of 9.1% in June to 6.5% in December. Much of that decline reflects cheaper gas. But even excluding volatile food and energy costs, the Fed’s preferred inflation gauge has risen at about a 3% annual rate over the past three months — not much above the 2% target.

Those trends raise questions about a key aspect of the Fed’s higher rate policy. Chair Jerome Powell said that overcoming inflation requires “some pain.” And Fed policymakers predict the unemployment rate will rise to 4.6% by the end of the year. In the past, increases as large as the unemployment rate only occurred during recessions.

Yet Friday’s report suggests the possibility that the long-standing connection between a strong job market and high inflation is breaking. And that collapse has one startling possibility: That inflation could continue to decline even as employers continue to add jobs.

“Their model is that this inflation is driven primarily by wage inflation,” said Preston Mui, senior economist at Employ America, an advocacy group. “To bring that down, they think we need to bring some pain to the labor market in terms of higher unemployment. And what the last three months have shown us is that that model is wrong.

That said, it’s possible that Friday’s report could even push the Fed in the opposite direction: Steady strong job growth could convince Powell and other officials that, despite signs that the wage growth is slowing, a strong job market will inevitably change inflation. If so, their benchmark rate should remain high enough to cool the hiring pace.

With that perspective in mind, Wall Street traders are now pricing in one more Fed rate hike this year: Investors see a 52% chance the Fed will raise its benchmark rate to a quarter-point in March and May, in a range of 5% to 5.25%. That’s the same level that Fed officials themselves predicted in December.

Many economists say the pandemic has disrupted the job market, making it work differently than before.

“There are a lot of rules … that are no longer normal,” Labor Secretary Marty Walsh said Friday. “We’re seeing a lot of companies that maybe aren’t doing the layoffs in January that they normally are because they’ve been through a pandemic where they lost people and they never came back.”

In a news conference this week, Powell argued that much of the slowdown in inflation since the fall reflected falling prices for goods — things like used cars, furniture and shoes — as well as much lower gas prices. The price drops reflect a clearing of previously clogged supply chains, he suggested, and are likely to prove temporary.

And Powell reiterated one of his central concerns: That inflation in the labor-intensive service sector is still running at a steady 4% pace and shows no sign of slowing. Much of that increase is a result of strong wage growth in restaurants, hotels and transportation and warehousing companies, which have fewer workers available to fill such jobs.

“My own view,” the Fed chair said, “is that you cannot have a sustainable return to 2% inflation in that sector without a better balance in the labor market.”

Despite the strong job growth, several measures of wage growth showed a steady easing: Average hourly wages grew 4.4% in January from a year earlier, from a high of 5.6% in March.

“More attention should be placed on earnings data,” said Rob Clarry, investment strategist at Evelyn Partners, in a research note. “The high headline (jobs) reading does not appear to be translating into more inflationary pressure – an important finding for the Fed.”

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