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Risks of labor supply restraints and implications for the Fed

July 31, 2025
Christian Floro, CFA, CMT
Market Strategist
Magdalena Ocampo
Market Strategist
Seema Shah
Chief Global Strategist
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Amid an already softening labor market, the Trump administration’s aggressive immigration stance is likely to dampen U.S. labor supply. This combination of cyclical weakness and structural restraint could lead to conflicting labor market signals, distorting the traditional indicators that markets—and the Federal Reserve—have historically relied upon. Importantly, it could also trigger an inflationary impulse, further complicating the Fed’s policy outlook in the latter half of 2025.

Cyclical slowdown in employment clashes with structural trends

Though job layoffs remain subdued, measures of labor demand have continued to soften in 2025. Company surveys reveal that lingering policy uncertainty has prompted small and large businesses to scale back hiring, and the number of job openings per unemployed worker is now sitting at 1.1—a stark contrast to labor market conditions in early 2022, when there were two job openings per unemployed person. Unsurprisingly, according to the Conference Board’s labor consumer confidence survey, household sentiment towards finding a job declined to a cycle low in June.

Yet, these signs of cooling labor demand sit at odds with a muted unemployment rate, which even declined in June. What appears to be at least partially at play is a tightening of immigration policy. This emerging structural force is leading to a decrease in labor supply and is working against the prevailing trend of a cyclical labor market slowdown. While the timing and the magnitude of immigration policies’ impact on the labor market remain unclear, anecdotes from the Fed’s latest Beige Book provide early indications of increased stress in finding workers amid changes in immigration policy.

As risks associated with labor supply constraints have gained traction, the issue has not gone unnoticed by the Federal Reserve. In fact, in a speech by Fed Governor Waller on July 17, he acknowledged that this year’s slowdown in net immigration could play a part in reduced hiring in the private sector. Waller, however, expressed more concern about weaker payroll gains driven by ongoing weakness in labor demand, specifically among new college graduates looking for employment.

Overall, the conflicting signals between labor supply and labor demand contribute to an economic backdrop that is already difficult to interpret. Going forward, if labor demand weakens more than supply, it may indicate economic distress, and the economy would probably need rate cuts. Conversely, if a smaller workforce tightens the labor market, inflation could remain sticky, strengthening the case for further restrictive monetary policy.

Macro effects of an immigration-induced smaller workforce

Throughout his election campaign, President Donald Trump praised Eisenhower’s immigration raids in 1954, which allegedly deported almost 1.2 million Mexicans in response to rising unemployment and depressed wages. Trump promised mass deportations totaling about 1 million undocumented immigrants in the first year of his presidency.

In today’s context, the administration’s strong stance on both legal and unauthorized immigration can lead to labor supply shortages, particularly in sectors that rely more on immigrant workers. This year, U.S. immigration case backlogs hit record highs under the Trump administration, slowing the rate of legal immigration. Furthermore, increased funding for border protection and immigration enforcement challenges not just the inflows of foreign-born labor, but also its existing stock.

If labor force participation declines meaningfully, the number of new jobs needed to maintain a stable labor market—often referred to as “breakeven employment”—could fall in the year ahead. Breakeven employment isn’t fixed; it fluctuates based on demographic trends, participation rates, and the broader economic environment. Outside of extreme periods like the pandemic, monthly job growth below 100,000 would typically signal weakening labor demand and raise recession concerns. However, even though breakeven employment has largely returned to pre-pandemic norms, restrictive immigration policies could push it lower. In that case, slowing payroll growth might not indicate a demand-side problem, but rather reflect structural constraints on labor supply.

Potential paths for immigration

Three different scenarios can be considered to understand to what extent immigration enforcement policies could potentially shrink the labor supply and affect breakeven employment.

  1. Base case scenario: assumes continued immigration inflows and the rate of deportations staying close to longer-term trends. In this scenario, the breakeven employment level would sit at around 120,000 per month, largely matching the average pace of non-farm payroll gains so far this year.
  2. Moderate risk scenario: assumes a tightening of immigration policy, no unauthorized immigration inflows, and a modest increase in deportations. This could see breakeven employment fall to around 70,000 per month.
  3. Severe risk scenario: assumes a significant tightening of immigration policy and enforcement and would see deportations surging to match President Trump’s stated goals. This would see breakeven employment fall further to only 35,000 per month. Though the severe risk scenario may seem unlikely, the increasing immigration backlog, visa and work authorization delays, increased raids, and the expansion of immigration enforcement make this scenario difficult to dismiss entirely.

Under each scenario, tighter immigration policies would likely slow foreign-born population growth, reduce labor supply, and weigh on breakeven employment. In the moderate risk scenarios, even job gains of just 70,000 per month—a notable downshift from this year’s gains—and broadly in line with consensus expectations for the remainder of 2025, would be broadly in line with breakeven employment. As such, sub-100,000 payrolls would not necessarily indicate severe weakness in labor demand but rather reflect tight labor supply.

Inflationary risks of tighter immigration policies shrinking the labor force

If immigration policies pan out to be more severe than expected in the base case scenario, the falling labor supply would likely eventually impact the inflation outlook (provided economic conditions remain robust).

An inflationary pulse could materialize in:

  1. Wage growth: worker shortages could accelerate wage growth in certain sectors, driving additional stickiness in the core services ex-shelter category of inflation.
  2. Goods prices: if labor shortages drive product shortages, for example in agriculture, there could be upward pressure on the food category of inflation, as well as core goods inflation.
  3. Shelter prices: wage growth in the construction industry, cleaning, and maintenance could lead to renewed firmness in shelter inflation, though potentially offset by reduced housing demand.

Given little historical precedent, the magnitude of a potential inflationary impact as a byproduct of lower immigration inflows is unclear. Some economic studies suggest that it can range anywhere from 0.15ppt to 0.5ppt. However, these factors could become especially problematic to the disinflationary objectives when combined with tariff-induced price increases.

Though unauthorized labor is typically associated with low-skilled labor, high-skilled occupations should not be dismissed, as tighter legal immigration policies that target visas for higher education, arts and science could also shrink the pool of available and qualified high-skilled workers. For companies already struggling with attracting and retaining talent, high-skilled wage increases may result.

Occupational distribution

Foreign-born vs. Native-born workers
Occupation Foreign Native
Cleaning and food prep 31% 69%
Agriculture, construction, and maintenance 30% 70%
Computer and math 27% 73%
Production and transportation 24% 76%
Architecture, engineering, and sciences 21% 79%
Healthcare, personal care and services 19% 81%
Management, business, and financial 14% 86%
Arts, education, and social services 12% 88%
Legal and protective service 9% 91%

Source: Bureau of Labor Statistics, Principal Asset Management. Data as of December 31, 2024.

Implications for the Fed and financial markets

Under all three immigration scenarios, enforcement of tighter immigration policies can distort traditional labor market signals, creating more uncertainty for the Fed and elevating the risk of a policy misstep. There could be two key implications:

  1. If payrolls descend substantially lower, markets (or even the Fed) may initially misinterpret it as a deterioration in labor market strength, reacting negatively and elevating recession concerns; or,
  2. The drop in the labor participation rate—if significant enough—may result in lower breakeven employment without widespread layoffs. Under the severe risk scenario, the unemployment rate could potentially fall over the coming year from today’s levels and mask a gradual cooling in labor demand. Markets and policymakers may interpret this as a sign of a strengthening labor market and could hinder the Fed from delivering necessary rate cuts.

A mixed narrative between tighter labor supply and slowing labor demand presents additional challenges for the Fed in interpreting underlying labor market conditions ahead.

For risk assets, as stocks have shown resilience against policy uncertainty this year, positive gains for the broad S&P 500 Index are still expected. However, if higher wage costs materialize, investors should focus on companies with strong margins and high pricing power to meet earnings expectations. There should also be additional emphasis on industries less sensitive to labor market dynamics and more capital-intensive, such as technology, which stands to make significant efficiency gains from future productivity growth and innovation.
Macro views

Footnotes

According to a 2024 study by Warwick McKibbin, Megan Hogan, and Marcus Noland (Peterson Institute for International Economics) and a 2025 study by Pia Orrenius, Grace Ozor, Madeline Zavodny and Xiaoqing Zhou (Federal Reserve Bank of Dallas) on immigration policies’ effect on inflation.
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