Lower unemployment poses a threat of inflation, defeating Fed’s hopes

This assumption is proven wrong and the Fed thus finds itself in a situation it will never face: preparing to raise interest rates to slow the economy although the labor market is far from two years ago.

Unemployment has fallen sharply this year, from 4.2% in November. This is still above the pre-pandemic trough of 3.5%, and that does not count the millions who left the labor force and have yet to return. There are now five million fewer people employed than the trend continued before the pandemic.

And yet, as Fed Chairman Jerome Powell said in his press conference after the Fed’s policy meeting on Wednesday, “the labor market is hotter than so many measures as went into previous expansions.” The ratio of job vacancies to unemployed is a record and wages are rising rapidly, especially for the lowest-paid workers.

This hot labor market is a major reason Mr. Powell has turned from an optimistic to a more anxious outlook on inflation, culminating in Wednesday’s decision to make bond purchases more rapid. Fed officials indicated they expect to raise rates three times next year. Nine months ago they saw no increase until 2024 at the earliest.

To be sure, wages are not why inflation hit a 39-year high of 6.8 percent in November. This primarily reflects demand far exceeding the supply of homes, cars and other durable goods.

But wages will determine whether today’s inflation is transitory or persistent. Labor is the primary input in everything consumers buy, especially services. A key factor in Mr. Powell’s pivot was a report that hourly wage costs grew at a nearly 6% annual rate in the third quarter. That type of labor cost growth would only be compatible with the Fed’s 2% inflation target if worker productivity was at 4% per year, nearly double its historical rate. Anyway, productivity actually declined the year through September.

The Fed revamped its monetary structure last year because the inverse relationship between unemployment and inflation, called the Phillips curve, disappeared. As such, the Fed assumed that unemployment could run below 4% for years before inflation topped 2%. So is the Phillips curve back? This may be premature. Today’s upward pressure on wages and prices is coming not only from excess demand, but also from too little supply. “The inflation we got was not at all the inflation we were talking about last year,” Mr. Powell said.

A combination of factors has decimated the labor supply: liberal unemployment insurance, now defunct, adequate funding, accelerated retirement, and fear of Covid-19 – which may have been revived by the new Omicron version.

“The question is whether we are in a permanent state of labor shortage or it has anything to do with COVID,” said Roberto Perli, economist at Cornerstone Macro. Evidence for the latter came last month, he said, when the labor force participation rate rose, which is out of the flat trend prevailing since July last year. For 25-54 year olds, it’s “finally on an upward trend.”

But the labor market has also become less efficient at matching jobs with workers. According to Hyun Song-Shin, economic advisor at the Bank for International Settlements, the job vacancy rate relative to unemployment (a relation called the Beveridge curve) has risen higher in the US than in Japan or Western Europe. He said that wages have also increased in America.

Employment in the US was down 4% in the second quarter compared to the end of 2019, according to the Organization for Economic Co-operation and Development, which is the weakest of the industrialized nations. This is despite a very strong recovery in output.

Kristin Forbes, an economist at the Massachusetts Institute of Technology, said, “When Covid-19 hit, America largely resorted to fire companies and then pay generous unemployment insurance to support workers to keep income steady. Chosen.” As a result, “people lost ties to their jobs and dropped out. In Europe they chose to take people off leave, and they were still connected and had a job to come back to.” That if they were just getting emails, they thought they were employed.”

Ms Forbes said the US approach could, over time, facilitate workers to move to more innovative industries from those set back by the pandemic. But in the meantime, she said, the difficulty of reconnecting workers to jobs has pushed up the “natural” unemployment rate, a rate in line with low, stable inflation.

This presents the Fed with a dilemma. There is good reason to believe that the factors constraining labor supply will go away as shortages and mismatches resolve themselves and Covid subsides. But it can take years, high prices and wages can take a long time to live out their lives, which can become a permanent inflation problem. To prevent this, the Fed would now have to tighten monetary policy, in effect slowing economic and jobs recovery and, although incrementally, increasing the risk of a subsequent recession.

“What would the labor force look like in a world without Covid? It doesn’t look like it’s coming anytime soon.” Mr. Powell said on Wednesday, “We have yet to make policy.”