September 29, 2022 | 13:41
How Much Pain, Mr. Powell?
How Much Pain, Mr. Powell?
“Reducing inflation is likely to… bring some pain to households and businesses.” — Fed Chair Powell, August 26, 2022
“There ain’t no easy way out.” — Tom Petty, 1989
If there was any doubt about the Fed Chair’s resolve to restore price stability even at the cost of an agonizing recession, it was laid to rest at his Jackson Hole speech in August and more recently affirmed at the press conference following an unprecedented third straight 75 bp rate increase. Even after the most aggressive course of tightening in decades (300 bps in six months), Powell isn’t backing down, claiming “We will keep at it until we are confident the job is done”. Simply put, it’s not a question of whether inflation will return to target; only the amount of pain that will be needed for it to do so. In this article, we address one major source of suffering: how high the jobless rate will need to go to restore price stability.
The Fed’s mission is clear-cut: reduce core inflation from a four-decade high of 4.7% (based on an average of three measures) to 2% (Chart 1). To do this, it will need help from two key drivers of inflation that it has no direct control over, commodity prices and supply chains; and two that it can influence, wages and rents. Led by a downturn in oil, resource prices (CRB spot index) have retraced their post-war spike and are now little changed from a year ago. Supply chain pressures have also eased according to the New York Fed’s measure, though they remain problematic due to the war in Ukraine and pandemic restrictions in China. The Dallas Fed found that roughly half of the rise in inflation during the pandemic was caused by global supply disruptions; so any further improvement here would help.
By clobbering a pricey housing market with rate hikes, the Fed has already taken a major step toward getting rent growth under control. However, low vacancy rates and the high cost of owning a home suggest it will take time before rent increases normalize from multi-decade highs of around 6% y/y (Chart 2). With rents accounting for 15% of personal expenditures, a moderation here would go partway to restoring price stability.
But the road to full price stability ultimately travels through the labour market. Powell left little doubt that an “out of balance” job market was in his crosshairs. Personal income continues to run hot, fanning demand and prices, with the salary component leaping 10% y/y in July due to solid gains in payrolls and pay. For inflation to return to the target, annual wage growth will likely need to fall to 3½% from 6%, across the average of four measures (Chart 3). If productivity also picks up to a more normal 1½% rate, trend growth in unit labour costs should then moderate to 2% from around 5% (Chart 4). Ever since the Fed informally adopted a 2% target in the mid-1990s (formalized in 2012), it’s been rare for core inflation to stay above the target unless unit labour costs were also rising faster than 2%. That’s largely because they account for the bulk of a business’s expenses.
Historically, to reduce growth in wages or prices by 1 ppt often required lowering economic activity by about 2% relative to potential. Assuming this “sacrifice ratio” still holds, a 2½ ppts decline in wage growth and core inflation today would require that economic growth cumulatively run 5 ppts below potential growth for a period of time. With long-run potential running near 2%, this could involve a 3% decline in real GDP in one year (i.e., a standard recession), no growth for 2½ years, or some other combination of weakness and time. The required decline could be smaller if productivity improves, thus raising potential growth; or, if supply chains progress more quickly, thus lowering inflation.
Based on a so-called Okun’s Law relationship, a 5 ppts decline in economic growth (relative to potential) could lead to a 2½ ppt increase in the unemployment rate. This means the U.S. jobless rate might need to rise from a recent half-century low of 3.5% to around 6% to restore price stability. That would put it above the median of the past three decades (5.4%) and close to the peak of the mild 2001 recession.
However, due to the current substantial excess demand for labour, the economy might need to weaken even more than suggested above. Prior to the pandemic there were 7 million job openings; today, there are a near-record 11.2 million, or two for every unemployed person (Chart 5). The job vacancy rate, which measures how much labour demand is going unfilled, is 2.5 ppts higher than in early 2020. Meantime, payrolls and job vacancies rose a combined 4.2 million from February 2020 to July 2022, even as the labour force shrank by 0.6 million, suggesting that the excess demand for workers is about 4.8 million, or 2.9% of the workforce. This excess demand for workers could make the unemployment rate sticky, requiring an even larger economic hit. Moreover, subduing wage growth might require the economy to weaken enough not only to lift the jobless rate but to also reduce job vacancies, as workers may still feel emboldened to seek large wage gains if openings stay high.
On a more positive note, the required increase in the jobless rate could be smaller than suggested above if workforce participation remains sluggish (though this could also lead to stickier wages). Moreover, companies could be tempted to hoard workers even in a slumping economy amid ongoing challenges of finding and retaining staff, so long as the downturn is short-lived. Excess labour demand could fall sharply if many of the current vacancies simply reflect the need to lure workers and overstaff in the event that current staff quit. As well, some wage pressure likely reflects the need to fill current vacancies, which will be less pressing in a weaker economy. Most importantly, well-behaved inflation expectations could help temper wage demands, notwithstanding some recent large settlements.
For these reasons, we subscribe to the view that a major economic slump might not be required to control inflation. We expect a moderate downturn in real GDP in the first half of next year and no growth in 2023, which should lift the jobless rate to 5.0%. The forecast reflects a material decline in financial conditions, which will subtract about 2 ppts from GDP growth next year (Chart 6). This stems from an expected further 150 bps of Fed rate hikes, an anticipated 15% correction in house prices, a continued strong U.S. dollar, and the angry bear market in equities. High household savings and some pent-up demand for services will temper the slump. It’s worth noting that the Fed has a more sanguine view than ours, expecting real GDP to slow to 1.2% next year (Q4/Q4) and the jobless rate to rise only to 4.4%. We suspect a harsher reckoning is in the cards.
Bottom Line: A moderate downturn in the economy and material rise in the jobless rate will likely be required to control U.S. inflation. The good news, in a way, is that a deep recession might not be necessary for the Fed to get the job done. The bad news is that a weakened economy will remain highly vulnerable to shocks, risking a more painful outcome.