The lesson the Federal Reserve drew from the pre-pandemic economy was that unemployment could run at historic lows without fueling inflation. It’s why the central bank last year promised to never again raise interest rates just because the job market was strong.
That assumption is turning out to be wrong and the Fed thus finds itself in a situation it hoped to never face: preparing to raise interest rates to slow the economy though the labor market remains far from where it was two years ago.
Unemployment has fallen rapidly this year, hitting 4.2% in November. That is still above the pre-pandemic trough of 3.5%, and it doesn’t count millions of people who left the labor force and have yet to return. Five million fewer people are employed now than if the pre-pandemic trend had continued.
And yet, as Fed Chairman Jerome Powell said at his press conference following the Fed’s policy meeting Wednesday, “The labor market is by so many measures hotter than it ever ran in the last expansion.” The ratio of job vacancies to unemployed people is at a record and wages are rising briskly, particularly for the lowest paid workers.
This hot labor market is a key reason Mr. Powell has pivoted from a sanguine to more worried outlook on inflation, culminating in Wednesday’s decision to “taper” bond buying much more quickly. Fed officials signaled 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 aren’t why inflation hit 6.8%, a 39-year high in November. That mainly reflects demand far outstripping supply for houses, cars and other durable goods.
But wages will determine whether today’s inflation is transitory or persistent. Labor is the primary input to most of what consumers buy, in particular services. A key factor in Mr. Powell’s pivot was a report that hourly wage costs surged at about a 6% annual rate in the third quarter. That sort of labor cost growth would only be compatible with the Fed’s 2% inflation target if worker productivity grew 4% a year, roughly twice its historical rate. As it is, productivity actually declined in the year through September.
The Fed revamped its monetary framework last year because the inverse relationship between unemployment and inflation, dubbed the Phillips curve, had all but disappeared. As such, the Fed assumed unemployment could run below 4% for years before inflation crept above 2%. So is the Phillips curve back? That may be premature. Today’s upward pressure on wages and prices isn’t coming just from excess demand, but even more so 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 reduced the supply of labor: generous unemployment insurance, now expired, ample wealth, accelerated retirements, and fear of Covid-19—which may have been revived by the new Omicron variant.
“The question is, are we in a permanent situation of scarcity of labor or does it have to do with Covid,” said Roberto Perli, economist at Cornerstone Macro. Evidence for the latter came last month, he noted, when the labor-force participation rate rose, breaking out of the flat trend that had prevailed since July of last year. For 25-54 year-olds, it’s “finally on an upward trend.”
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But the labor market has also become less efficient at matching jobs to workers. The job vacancy rate has risen more relative to unemployment (a relationship dubbed the Beveridge curve) in the U.S. than in Japan or Western Europe, according to Hyun Song Shin, economic adviser to the Bank for International Settlements. Wages have also accelerated more in the U.S., he said.
Yet employment in the U.S. was 4% lower in the second quarter compared with the end of 2019, one of the weakest among industrialized countries, according to the Organization for Economic Cooperation and Development. That is despite a much stronger recovery in output.
“When Covid-19 hit, the U.S. chose to support workers largely by letting companies fire them and then pay generous unemployment insurance to keep incomes stable,” noted Kristin Forbes, an economist at the Massachusetts Institute of Technology. As a result, “people lost connection with their jobs and dropped out. In Europe they chose to take the route of furloughing people, and they were still connected and had a job to come back to. Even if they were just getting emails, they felt like they were employed.”
Ms. Forbes said the U.S. approach may, over time, facilitate shifting workers to more innovative industries from those set back by the pandemic. But meanwhile, she said, the difficulty of reconnecting workers to jobs may have raised the “natural” unemployment rate, that is the rate consistent with low, stable inflation.
This presents the Fed with a dilemma. It has good reason to believe the factors holding down labor supply will go away as shortages and mismatches sort themselves out and Covid recedes. But that could take years, long enough for higher prices and wages to take on a life of their own, becoming a lasting inflation problem. To forestall that, the Fed has to tighten monetary policy now, in effect slowing the economic and jobs recovery and, however incrementally, raising the risk of a recession later on.
“What does the labor force look like in a world without Covid? It doesn’t look like that’s coming any time soon.” Mr. Powell said Wednesday, adding, “We have to make policy now.”
Write to Greg Ip at [email protected]
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