The Fed’s Labor Market Problem

The Fed’s Problem With The Job Market


Are wages rising inflation, or is it the other way around?

Federal Reserve officials worry that rising wages will lock the economy into a high inflation regime. The question facing policy makers is how great the risk is of that happening.

Fed policymakers seem almost certain they will increase their target overnight rate range by three-quarters of a percentage point when they meet this week, but the focus has already shifted to what they will do next. On the one hand, inflation is still running high, with the Fed’s preferred measure of inflation showing that consumer prices were 6.2% higher as of September than a year earlier. It’s not as bad as the 7% recorded in July, but it hasn’t declined as quickly as the Fed or private economists had expected. So maybe the Fed should keep on putting on the brakes.

On the other hand, the central bank has already raised interest rates sharply in a short space of time – on Wednesday the midpoint of its target range is likely to be 3.875%, compared to 0.125% in March. Given that the full force of rate hikes is working on the economy with some lag, as well as a slew of anecdotal reports that some prices are cooling, the Fed may want to slow the pace of its rate hikes. Fed Chair Jerome Powell could indicate that whether the central bank should raise another three-quarters point, or a smaller one-half point, at its December meeting is up for debate.

Much of that debate, and that about how far the Fed should eventually raise interest rates, depends on how much the tight labor market is driving inflation. There’s no question that the job market is tight: Economists polled by The Wall Street Journal believe Friday’s jobs report will show the unemployment rate in October was 3.6%, slightly above September’s 3.5%, but still extremely low. In addition, they think average hourly wages will rise 0.3% in October from September, representing a 4.7% increase from a year earlier.

On the other hand, the unemployment rate was 3.5% in January 2020, before the economy experienced pandemic effects. At the time, however, average hourly wages were up 3% year-on-year and inflation lagged behind the Fed’s target of 2%. So something has changed.

One difference could be that despite similar unemployment rates, the labor market is actually much tighter now. The number of unfilled vacancies has recently started to decline, but is still much higher than before the pandemic. The proportion of workers leaving their jobs, seen by some as a better measure of labor shortages, is also higher than before the pandemic, but has been declining since late last year — an indication, economist Justin Bloesch argues in a recent Roosevelt. Institute posts that the current low unemployment rate is not inherently more inflationary than it was before the pandemic.

Separately, a recent Evercore ISI analysis suggests that wage growth is more of a delayed response to the rise in inflation than inflationary per se. Wages are not going up because people are trying to get ahead of future inflation as much as they are trying to catch up on costs that have already gone up. Some corroborating evidence for that: On Friday, the Department of Labor reported that the Employment Cost Index, a measure of workers’ wages and benefits, rose 5% in the third quarter from a year earlier. That’s a big jump, but still less than inflation.

The problem with all of this for the Fed is that it’s easier to sit back and argue that the labor market might not be generating as much inflation if there isn’t much inflation. The price hike may well have more to do with factors such as pandemic-related disruptions and the Russian invasion of Ukraine than anything else, but evidence of that won’t come until inflation cools. The best outcome would be for it to show up before the Fed breaks the labor market.

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