Friday’s jobs report looked weak enough to make you wonder why the Fed isn’t already talking about cuts.
Look closer. The labor market isn’t deteriorating. It’s stuck.
Payrolls fell 23,000 in July. That number is smaller than the survey’s own margin of error – statistically, it is indistinguishable from zero. And most of the decline was a seasonal quirk in government education, not a broad retreat by private employers. Private payrolls actually rose 30,000.
The revisions were the softer part of the report. May and June were revised down by a combined 103,000.
On the demand side, the hiring rate is low. On the supply side, there are fewer workers too.
The labor force shrank by roughly 264,000 in July. Participation is now 61.4%, down 0.7 percentage points since January. The foreign-born labor force is down about 550,000 from a year ago, and participation among native-born workers has softened as well.
That is why unemployment can stay low with almost no payroll growth. And it means the market can stay tight in one important sense even as hiring freezes: employers need fewer workers, but there are fewer workers to be had.
This is not a healthy, expanding labor market. But it is not a collapsing one either. The labor market is frozen.
Now Comes Inflation
That is why Wednesday’s CPI matters.
June brought good news. Consumer prices fell 0.4% on the month, and core prices were flat. Core inflation slowed to 2.6% over the prior year, down from 2.9% in May. Shelter rose just 0.1% – its smallest monthly increase since January 2021.
But the problem has not gone away.
Headline inflation was still 3.5% over the year in June, held up by energy prices that remained 15.7% higher than a year earlier even after falling sharply during the month.
Households are not convinced. The New York Fed’s latest survey showed one-year inflation expectations easing to 3.6% in July. But three-year expectations held at 3.3% and five-year expectations at 3.0%. Better at the margin – not a return to the low-inflation world the Fed wants.
So Wednesday tells us whether June was the start of a genuine cooling or just a good month.
I’ll be watching three things: core goods, for tariff pass-through; energy, for the lingering Middle East premium; and shelter and services, for whether housing inflation keeps cooling.
What If the Temporary Shocks Fade?
For weeks we have focused on the obvious sources of inflation risk.
Tariffs raise goods prices. War raises oil and shipping costs. The AI investment boom is bidding up capital, computing power and energy.
Some of that will fade. Wars end. Tariff regimes change. Investment booms mature.
One pressure is harder to resolve: the federal budget.
I dug into this in my latest piece, “You’ve Got Mail: The Federal Government Is Already Sending You the Bill.” The numbers are hard to ignore.
Through June – the first nine months of fiscal 2026 – the federal government spent about $5.52 trillion and collected about $4.15 trillion. That left a deficit of roughly $1.37 trillion.
The striking part is where the new spending went. Compared with a year earlier, spending rose about $172 billion. Net interest on the debt accounted for roughly $78 billion of that – nearly half the entire increase.
Interest is now about 15% of federal spending, the second-largest function behind Social Security. Through June, Washington spent more servicing its debt than on national defense.
That is not a future problem. It is happening now.
Somebody Has to Finance It
Borrowing does not mechanically create inflation. What matters is whether investors believe the debt will be backed by future taxes, spending restraint or faster growth.
But when deficits stay large and persistent, the Treasury has to keep finding buyers – competing for the same savings that fund mortgages, factories and data centers.
Fed economist Thomas Laubach estimated that a one-percentage-point rise in the projected deficit-to-GDP ratio lifts long-term interest rates by roughly 25 basis points, all else equal.
There is an inflation channel too. Francesco Bianchi, Renato Faccini and Leonardo Melosi show that when fiscal expansions are not credibly backed by future taxes or spending cuts, the result can be persistent inflation – and monetary policy has to work harder to contain it.
That leaves an uncomfortable possibility.
Even if the war ends, oil normalizes, tariffs subside and the AI cycle cools, rates may not simply fall back to where they started. Persistent borrowing keeps pressure on the cost of capital. And if fiscal policy stays loose without a credible plan to stabilize the debt, part of the adjustment can arrive as inflation instead.
Either way, somebody pays.
Which Brings It Back to the Fed
The Fed held its benchmark at 3.50%-3.75% in July, and three officials wanted to raise. Wednesday’s CPI buys it some breathing room or takes some away – but it settles nothing larger. The Fed can suppress demand if inflation becomes entrenched. It cannot raise participation, reverse tariffs, end wars or balance the budget. And with a shrinking workforce, persistent deficits and a rising interest bill all pushing the same way, that is the real reason rates stay higher for longer – even after today’s shocks are gone.
