Carney: Jobs Blowout Will Fuel Inflation and Crush Productivity in Biden’s Economy

American employers added jobs at a breakneck pace in July—which could spell trouble ahead.

The Labor Department said the U.S. economy added 528,000 jobs in July, far exceeding the 258,000 expected and demonstrating that the labor market is not cooling off after three interest rounds of Federal Reserve interest rate hikes.

It’s clearly good news that so many Americans have found jobs. The unemployment rate fell to 3.5 percent, matching the prepandemic low of the Trump economy. Unrounded the unemployment rate was 3.458 percent, which makes it the lowest rate since the 1970s.

In a low inflationary environment with a growing economy, like we enjoyed under President Joe Biden’s predecessor, this would be unquestionably good news. In the Biden economy, ravished by four-decade high inflation and an economy that is contracting, there’s plenty to worry about.

The jump in payrolls was accompanied by a big increase in average hourly earnings. More workers plus higher wages creates more demand in the economy. In the near term, this is likely to push core inflation higher, especially in the services sector. When the Department of Labor releases the July Consumer Price Index next week, it is likely to show that headline inflation inched down due to falling gas prices but underlying inflation will likely still be rising. Economists regard this as particularly worrisome because core inflation—inflation minus food and fuel—is a leading indicator of future inflation. So rising core prices means inflation will stay higher for longer.

The massive hiring is also an indicator of inflationary forces. Businesses hire when swamped with demand and 528,000 jobs indicates a tidal wave of demand. The services sector added 402,000 jobs in July, including nearly 100,000 in leisure and hospitality. Education and health services added 122,000, the most ever outside of the May through July hiring reopening hiring spree.  Businesses seeing enough demand to bring on that many workers are going to be raising prices—especially because their own labor and materials costs are rising.

No wonder the market is convinced that the Federal Reserve is going to have to keep its foot on the interest rate accelerator through the September meeting. There are even whispers of the possibility of an emergency meeting if the CPI number comes in too hot next week, although it seems unlikely that we’ll get inflation figures high enough to require that.

It’s also likely that the jump in employment will mean another downward lurch in labor productivity. The government measures productivity by simply dividing economic output by the hours worked. When the economy contracted in the first quarter while payrolls grew rapidly, productivity fell 7.3 percent. That was the biggest decline in labor productivity since 1947. We will get the second quarter productivity figure next week and economists expect it fell 4.5 percent, which is too optimistic. If the forecast is correct, it will be the worst decline—not counting the preceding quarter—since 1981, when productivity fell 5.1 percent. The July jump in employment likely means that the third quarter will see falling productivity also.

Falling productivity combined with rising wages means that labor costs rise. In the first quarter, unit labor costs—the dollars spent on labor to produce a unit of output—jumped 12.6 percent. They’re expected to be up 10 percent in the second quarter. July’s wage gains and the fall in labor productivity we expect will likely push labor costs up more.

When unit labor costs rise in a low-inflationary environment, both economic theory and empirical studies suggest the rise does not necessarily push inflation higher. In a high-inflationary environment, when expectations of inflation are rising and prices have recently been soaring, then unit labor costs most likely will lead to additional inflation. What’s more, when unit labor costs are rising because demand for labor has exploded—rather than the supply contracting—then they are more likely to contribute to inflation.  What’s more, when unit labor costs are rising rapidly in the services sector—as they are—they are likely to contribute to inflation because it is harder to substitute services with imports or to improve productivity through technology.

A while ago, people used to talk about the Goldilocks Economy. The idea was that the economy was just right, not too hot and not too cold, just like when Goldilooks finds the baby bear’s porridge. Today’s jobs numbers indicate that we may be experiencing an economy at the other end of the tale, when Goldilocks wakes up surrounded by the three bears and has to fling herself out the window to escape into the dark forest, never to be heard from again.