The Fed’s job-friendly “soft landing” depends on history not repeating itself

By Howard Snyder

(Reuters) – Federal Reserve officials have acknowledged that the fight against inflation will be paid for in lost jobs and the U.S. central bank will need an unlikely combination of events to keep those losses to a minimum as interest rates continue to rise.

Economists assessing the trade-off facing the Fed estimate that US employment could fall anywhere from a few hundred thousand jobs to several million.

The final tally will depend on how closely the economy follows the patterns seen in recent decades, the extent to which things like improved global supply chains help reduce inflation, and how strict the Fed is in enforcing its 2% inflation target .

With the central bank’s preferred measure of inflation currently rising at an annual rate of more than 6%, Joe Brusuelas, chief US economist at RSM, a US-based consultancy, estimates that 5.3 million jobs would be needed of work and an unemployment rate of 6.7%. almost double from 3.5% in July, to reduce inflation to 2%.

“Can the Fed achieve a clean soft landing? … Probably not,” Bruzuelas said, referring to a scenario in which monetary tightening slows the economy and inflation, without triggering a recession. “It’s hard to envision a benign outcome.”

Friday’s release of the Labor Department’s August jobs report will provide the final pulse of an economy that continues to falter. Economists polled by Reuters expect 300,000 jobs were added last month as U.S. companies scramble to hire hard-to-find workers, even as the economy slows and Fed rate hikes promise to slow it further.

The report will include data on wage growth that is important to the Fed’s deliberations on whether to raise interest rates by half a percentage point or by three-quarters of a percentage point at its Sept. 20-21 policy meeting.

After July’s gain of more than half a million jobs blew away expectations, another strong job growth reading could push policymakers to raise rates more as strong wage gains continue. A dip toward the average monthly gain of 183,000 jobs seen in the decade before the coronavirus pandemic could pull in the other direction.

Fed officials hope that the burden of fighting inflation falls less on employment than on other parts of the economy, even as they have for months bemoaned the current state of the labor market as unsustainable.

Cleveland Fed President Loretta Mester this week said recent wage increases were “inconsistent with inflation returning to the 2% target.” An Atlanta Fed wage tracker shows workers’ average pay was rising at an annual rate of 6.7% as of July, and Mester said it “should moderate to about 3.25% to 3.5% to be in line with price stability”.

Graphic: Job vacancies fall, unemployment rises – https://graphics.reuters.com/USA-FED/JOBS/zjpqkrkdapx/chart.png

‘UNPRECEDENTED’

Fed officials were less specific about what would bring things into balance, with some of the jobs ideas requiring US labor markets to act differently than in the past.

Fed Governor Christopher Waller has pointed to the Beveridge curve, which plots the relationship between job openings and the unemployment rate, to argue that the labor market could behave differently this time around.

The current ratio of two jobs for every unemployed person is a record high. Typically, when the job vacancy rate falls, the unemployment rate rises as it becomes more difficult for job seekers to find a match. But Waller argues that the Beveridge curve shifted during the pandemic and is at a point now that would allow jobs to fall sharply as the economy slows, easing pressure on wages and prices, without a big rise in unemployment.

“We recognize that it would be unprecedented for job vacancies to decline significantly without the economy falling into recession… In fact, we are saying that something unprecedented could happen because the labor market is in an unprecedented state,” wrote Waller in a research note published by the Fed in late July.

Other soft-landing narratives also depend on history not repeating itself.

Graphic: A shift in the Beveridge curve? – https://graphics.reuters.com/USA-FED/JOBS/zgpomomzqpd/chart.png

HELPING HAND

In June, for example, the median estimate among Fed officials was that unemployment would rise somewhat — but only to about 4.1 percent by the end of 2024, a slow and contained rise.

Updated forecasts are due to be released at the end of the policy meeting in September. If, as expected, they experience higher unemployment, the chances of a soft landing will face an unfortunate historical fact: Once the U.S. unemployment rate rises beyond a certain amount, it tends to keep rising.

Since at least the late 1940s, even modest half-percentage-point increases in the unemployment rate from a year earlier—the size of the increase that Fed officials have begun to hint at—tended to jump into 2-percentage-point jumps or more.

At the current labor force level of 163.9 million, that would translate to about 3.3 million fewer people employed—down by some estimates, but still high.

“Typically, when the labor market goes down, it picks up and goes,” says Claudia Sahm, a former Fed economist and founder of Sahm Consulting.

As a Fed economist, he developed the eponymous “Sam’s Rule,” which says that once the three-month average unemployment rate rises half a percentage point from its recent low, the economy is already in recession. Given the quirks of the pandemic-era labor market, however, this time she’s open to an exception.

Graphic: US unemployment rate: higher means higher – https://graphics.reuters.com/USA-FED/JOBS/lgvdwdwoopo/chart.png

Sahm’s bottom line is to raise the unemployment rate to around 4%, which would translate into less than a million job losses, but for the economy to avoid recession.

A lot has to be done right to get this result.

“It depends on supply chains healing, getting more people back into the workforce, consumer price sensitivity,” Sahm said. “It’s a normalization of the economy.”

If that doesn’t happen and labor market pain increases, the Fed would have options, Brusuelas and others noted: Raise the inflation target from the current 2 percent. It estimates that achieving 3% inflation would cost 3.6 million fewer jobs than sticking to the current target, with the unemployment rate rising just over one percentage point from its current level.

So far, this is not a conversation the Fed wants to have.

“We have communicated over and over and over again our commitment to achieving that 2 percent target,” New York Fed President John Williams told the Wall Street Journal this week. “I think it’s going to take a couple of years, but there’s no confusion… We’re absolutely committed to doing it.”

(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)

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