How to Deal with a Problem Like Full Employment
The arrival of soft wage data and stronger than expected productivity data this week has reignited hopes that the U.S. economy could achieve a “soft landing” in which inflation comes down steadily without a serious slump in the economy.
This, in turn, has encouraged investors to expect that the Fed could pause earlier than previously expected and at a lower level than the last set of projections that the Federal Reserve indicated. Stocks and bonds have rallied on the renewal of the soft-landing thesis, pushing up equity valuations and pushing down bond yields.
The market seems to have interpreted Jerome Powell’s remarks at the Wednesday press conference as if the Fed chair shares this view. Powell definitely sounded a bit more optimistic than he had back in December and November. This optimism, however, is unlikely to translate directly into a more dovish stance for monetary policy. Even good data on inflation and wages is unlikely to see the Fed pause early or cut rates at any point this year.
When Good News (for Workers) Is Bad News (for Inflation)
As Powell said on Wednesday, the labor market is “extremely tight.” The unemployment rate is at 3.5 percent and has been below four percent since February of last year. To put that in context, a historically normal unemployment rate would be something like 5.5 percent. From 1948 until 2022, unemployment averaged 5.74 percent. By almost any definition, we are at full employment.
Yet the economy has continued to add jobs at an extremely rapid clip. Payrolls have grown by an average of 247,000 jobs per month over the last three months. The numbers continue to surprise to the upside, defying the models of economists. Last month, the U.S. added 223,000 jobs, well above the 200,000 expected. Similarly, job openings surged higher in December, rising to 11 million. The optimism that openings were going to keep falling now seems misplaced. The downward trend in openings ended six months ago, and since then openings have been rising in fits and starts.
The number of workers voluntarily quitting their jobs has been steady for the last six months. This is a powerful measure of worker confidence in the labor market because workers generally only leave when they are confident they can easily find another job—or even have another already lined up. The rate of quits for leisure and hospitality is above five percent, well above the pre-pandemic twenty-first century average of 3.9 percent.
One interesting effect of this is that our politics are weirdly off-base because of full employment. The politics of the last 30 or even 40 years were built around job scarcity. Politicians promoted the policies they offered with promising of job creation because the economy seemed permanently stuck with insufficient demand for labor. Democrats pushed for more spending to pump up demand, and Republicans pushed for tax cuts to encourage investment. Deficits blossomed regardless of which party held control of Congress or the White House.
We have not yet adapted to the politics of labor scarcity, and it will be fascinating to watch it develop. In a scarce labor economy, promising to decarbonize the economy with lots of “green jobs” is a threat to other sectors that would otherwise utilize those workers. Similarly, pushing for an oil pipeline on the grounds that building it will create lots of jobs is much less compelling. New work should not really be seen as creating jobs so much as drawing them away from other work.
Where Are the Workers’ Yachts?
Despite the tightness of the labor market, wage growth is not accelerating. Compensation costs for civilian workers grew just one percent for the three month period that ended in December. Wages and salaries were up one percent, and benefit costs were up 0.8 percent. Compensation costs for civilian workers increased 5.1 percent for the 12-month period ending in December 2022—substantially below the 6.5 percent gain in the Consumer Price Index.
The optimists say this is a sign that disinflationary forces are once again taking hold of the economy. Every time Powell uttered the word “disinflation” at the press conference, a stock market bull got its wings. But Powell was not just acknowledging signs of disinflation, he was also warning about assuming that disinflation is here to stay.
Indeed, that seems unlikely. The legendary Phillips Curve—which posits that there is a trade off between unemployment and inflation—likely did not die during the pandemic. Phil may be lying flat right now, but that likely will not last. If unemployment remains very low—it’s expected to be 3.6 percent for January—workers will push for higher wages to compensate for the higher costs they are paying for food and services. As company after company reports record profits for last year, workers will seek to reclaim some of those gains for themselves. Disinflation may prove to be transitory.
Powell’s “Very Difficult Risk” Assessment: Doing Too Little vs. Doing Too Much
Perhaps the most overlooked part of the Fed chair’s press conference was Powell saying that the risks of doing too little to fight inflation significantly outweigh the risks of doing too much. He argued that if the Fed relents too early and inflation comes back, it is likely to return even stronger because inflation expectations may become unanchored. Solving that problem is a “very difficult risk to manage.” On the other hand, the Fed absolutely knows how to handle an economy that sags because monetary policy is too restrictive. That’s the easy problem.
This analysis implies that monetary policy should stay restrictive even if it no longer seems absolutely necessary. In short, even if inflation softens considerably, do not expect the Fed to ease.