The Federal Reserve has now raised its benchmark interest rate from near zero to above 4.5 percent in the space of a year. That represents the most rapid spree of monetary tightening in U.S. history. It is past time for the central bank to take a breather.
In recent weeks, a growing array of evidence has indicated that inflation is firmly on a downward path. At this point, the imperative to avert an unnecessary recession must take precedence over minimizing inflationary risk.
My argument for that assessment has two parts. The first is a matter of data, the second of values.
The consumer price index (CPI) declined by 0.1 percent between November and December. On a year-over-year basis, inflation remained at the elevated perch of 6.5 percent. But as Paul Krugman argues, for discerning the future path of inflation, it may be better to look at the rate of price growth over a six-month period. That interval eliminates the “noise” (i.e., semi-random variations) that can influence month-to-month changes while still cleaving relatively current trends from outdated ones. And if you take the trend of price growth over the past six months, then annualize it, inflation appears to already be on its way back to the Fed’s 2 percent target.
Meanwhile, recent changes in consumers’ savings rates, the money supply, retail sales, and manufacturing orders all suggest that demand is starting to cool.
Over the past year, consumer demand — and thus inflation — has been partly sustained by the cushion of savings that U.S. households built up during the pandemic, when economic shutdowns reduced their spending while COVID-relief payments increased their incomes. As rising rates have forced Americans to make higher interest payments on their auto loans, credit cards, and mortgages, however, they’ve increasingly been forced to spend down those savings and/or cease adding to them.
At the same time, as Bloomberg’s Karl Smith notes, the year-over-year change in M2 — the measure of all the money in U.S. checking accounts, savings accounts, money-market accounts, and other liquid deposits — actually fell by $1.35 trillion between March and December of last year, another sign that high prices and interest payments are sapping households’ spending power.
That’s consistent with the trajectory of retail sales, which fell by 0.6 percent during November, the most recent month for which we have federal data.
Falling demand is also (alarmingly) visible in manufacturing orders. The Institute for Supply Management’s Purchasing Managers Index, which measures new orders, fell for the third straight month in January and is now at its lowest level since May 2020. Historically, every single time PMI has fallen to its present level, a recession has followed in short order.
The labor market remains the one big exception to this picture of a cooling economy. On Friday, the labor department revealed that U.S. employers added 517,000 jobs to the economy in January, obliterating economists’ estimate of 187,000. The unemployment rate is now at 3.4 percent, it’s lowest level in over half a century. Meanwhile, job openings are increasing in defiance of expectations, and there are roughly two unfilled positions for every unemployed American.
These data points are more consistent with an overheating economy than a recessionary one. And the Fed is more concerned with developments in the labor market than with those in any other part of the economy. After all, labor is a key input to virtually every form of economic activity. Therefore, if labor costs rise, then so do the operating costs of virtually all businesses, which then increases their incentive to raise prices. Rising prices can in turn spur higher wage demands, setting off an inflationary wage-price spiral.
The low unemployment rate and high level of job openings suggest that demand for labor currently outstrips its supply. Generally speaking, when that happens, one would expect the price of labor — i.e., wages — to rise.
Fed Chair Jerome Powell has made clear that the central bank does not believe that wages have been the driving force behind the inflation we’ve seen thus far. But it is worried that a wage-price spiral could nevertheless emerge.
And yet, while labor market conditions might lead one to expect accelerating wage growth, that expectation would be mistaken. Rather than soaring, wage growth has actually been slowing in recent months.
In Friday’s jobs report, wages advanced by just 0.3 percent compared to December, after rising at a more rapid pace for most of last year. The Fed’s preferred measure of wages is the employment cost index (ECI), which accounts for all types of compensation including benefits and controls for the effect of employment shifts between jobs and sectors (in other words, if average wages rise merely because a high-wage sector of the economy added a disproportionate number of jobs, rather than as a result of workers securing higher pay for performing the same jobs, the ECI neutralizes the effect of the former). And the ECI shows that wages advanced by just one percent from October to December, its lowest quarterly gain in a year. Wages and salaries rose 0.3 percentage points slower than they had the previous quarter. As the Roosevelt Institute’s Mike Konczal notes, all of the Fed’s favorite measures of wages now show pay rates returning to their long-run trend.
But can the Fed trust that wages will continue on this trajectory? After all, given the high number of job openings and low unemployment rate, won’t the labor market’s tightness eventually generate wage pressure as employers bid against each other for workers?
First, it’s important to put January’s jobs number in context. As Ben Cassleman of the New York Times noted before the report’s release, the Labor Department incorporates new population estimates into its January report – but does not revise its previously published data to reflect its new estimate of the U.S. population. As a result, some portion of the January gain is essentially measurement error. Which is to say, a portion reflects the change in how many people the government thinks are in the country, as opposed to the change in how many people gained jobs between December and January, keeping population estimates constant.
Second, it’s worth reiterating that we already have reason to believe that demand is cooling, which could loosen the labor market. Monetary policy generally works on a lag, so it’s possible that the rate hikes that the Fed has already executed will eat away at job openings, if not jobs themselves, in the coming months.
Third, as Konczal notes, by some measures, the labor market isn’t all that tight: The quit rate, which offers a pretty good indication of how secure workers are feeling in their capacity to find better jobs, is actually lower than one would expect given current wage growth. Which is to say: By that measure, wages have risen by more than the degree of labor-market tightness would predict and are therefore likely to come down.
Fourth, relatedly, it’s plausible that the wage growth we’ve seen thus far has been fueled primarily by the one-off aberration of post-COVID reopenings and economic adjustments. The pandemic induced a historic shift of consumer demand away from services and into goods. Reopenings then swiftly shifted demand back in the other direction. With many firms suddenly desperate to rapidly restaff — in a context where many workers had built up savings — employers were forced to offer higher wages in order to attract labor in a timely manner.
Once that reshuffling was complete, however, there aren’t necessarily any mechanisms that ensure that rising prices will translate into higher wage demands. During the inflation of the 1970s, many millions of U.S. workers had cost-of-living adjustments guaranteed in their union contracts, such that wages increased mechanically with prices. Today, however, a mere 6 percent of America’s private-sector workers belong to unions. And cost-of-living adjustments are a less common feature of labor contracts today than they were then. In the absence of high levels of labor organization and militancy, it’s not clear that workers’ wage demands are all that sensitive to the price level. America’s highest-earning workers have seen their real wages fall significantly over the past year. If any segment of the U.S. labor force has the bargaining power to dictate terms to employers, it would presumably be this elite segment of high-skilled workers. Yet in recent months, wage growth for high earners in the U.S. has slowed, according to Indeed’s wage tracker.
Ultimately though, the question of whether the Federal Reserve should prioritize avoiding a recession over preempting resurgent inflation cannot be settled by data alone. It all depends on the relative weight one places on low price growth versus high employment.
In my view, avoiding a sharp increase in joblessness is far more important than bringing inflation back down to the Fed’s desired 2 percent level. This is true for reasons both moral and economic.
Recessions concentrate economic pain on those segments of the labor force least equipped to comfortably weather it: lower-income, low-skill workers are disproportionately likely to lose their market incomes in a downturn, even as they are disproportionately unlikely to have a cushion of savings to fall back on. Elevated prices, by contrast, diffuse the costs of economic adjustment across the broad population.
This does not mean that high and accelerating inflation is preferable to a mild recession, since the former is economically and socially destabilizing. But the same cannot be said of, say, a stable rate of 4 percent of inflation. Thus, if one is committed to mitigating economic inequality, then an above-target inflation rate is preferable to a recession.
But even if one is an “anti-woke” inegalitarian, there remains a general economic case for prioritizing continuous expansion over returning to 2 percent inflation. Negative growth makes our society as a whole poorer. And recessions can weigh on the economy’s productive capacity for a long time after they’re through. The U.S. economy never returned to its pre-crash trajectory after the 2008 crisis. And the COVID recessions seem to have accelerated the boomer generation’s exit from the labor force, with many older workers opting for early retirement instead of seeking new jobs, thereby reducing America’s labor supply and growth potential.
On the other side of the ledger, the Federal Reserve’s 2 percent inflation target is entirely arbitrary. There is little empirical evidence to suggest that 4 percent inflation yields worse long-term economic outcomes than 2 percent. For much of the past decade, many eminent mainstream economists have implored the Fed to raise its inflation target. Their argument centered on the notion that somewhat higher inflation would yield higher nominal interest rates and thus more room for the central bank to reduce rates in the event of a downturn before hitting the zero percent lower bound.
For their part, consumers do not seem to experience anything below 4 percent inflation as a particularly great economic burden. One recent paper found that Google searches for “inflation” (a proxy for attention to the subject) do not increase until inflation exceeds the 3 to 4 percent range.
If one stipulates that a stable rate of inflation between 3 and 4 percent is entirely acceptable — and, in some respects, preferable to a 2 percent one –— then there is little reason to believe that the Fed should continue tightening credit rather than waiting for its past rate hikes to ripple through the economy. The Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), has been on a downward trajectory for months and was already down to a 4.4 percent annualized rate in December.
In sum, the Fed should ease up on the gas before its paranoia about wage-price spirals and fixation on an arbitrary inflation target drive the U.S. economy into a ditch.
