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The Fed Needs to Cool the Labor Market to Reduce Inflation. It Will Hurt.

Federal Reserve Board Chairman Jerome Powell wants to see inflation come down in a “sustained” fashion.

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Move over, inflation. The labor market is now the most important factor in shaping the Federal Reserve’s deliberations over how high to raise interest rates next year.

The annual pace of consumer price growth has been slowing since June, propelled by deflation in goods prices as supply-chain snarls eased and spending shifted to services. The consumer price index is on track to fall further next year, as shelter costs decline and more U.S. households sign new leases at lower prices. 

But the downward trend in price growth is at risk of leveling off next year well above the Fed’s 2% target unless and until services prices in sectors other than housing start to ease, as well. Achieving that will require some softening in the labor market to bring labor supply and demand back in line. That leaves jobs as the key area to watch in gauging how much further the Fed has to go in its current tightening cycle.

“The appropriate terminal rate [peak level of interest rates] in our view remains linked to labor market developments—particularly employment growth and wages—more so than inflation outcomes,” a team of
Bank of America
economists wrote last week.

The Fed’s progress in taming inflation this year through higher interest rates and quantitative tightening paved the way for the central bank’s decision last week to slow its pace of monetary-policy tightening and raise interest rates by half a percentage point, a downshift after four straight three-quarter-point increases. 

But Fed Chairman Jerome Powell made clear the central bank won’t reverse course and start to cut rates until officials become convinced that inflation is coming down in a “sustained” fashion. That will require services prices to slow—and it makes a softening of the labor market a necessary step before the Fed can begin to wind down its inflation fight.

“The Fed’s largest concern is that inflation could hit a floor in a large swath of the service sector, which they see as linked to the imbalance in the labor market,” says Diane Swonk, chief economist with KPMG.

The imbalance in the labor market is due to surging employer demand paired with a dwindling supply of workers. Employers have been looking for the past two years to hire far more workers than are available, which has put upward pressure on wages and contributed to rampant inflation in services other than housing. 

Now those services—which make up some 55% of the Fed’s preferred inflation measure, the PCE—are the only piece of the inflation puzzle still running hot. And to cool them off, the central bank will have to try to chill the labor market.

The Fed has no good options here.

Rebalancing the labor market requires boosting supply or destroying demand. But supply seems firmly stuck at restricted levels: The share of Americans working or looking for work dropped during the pandemic and has yet to fully recover. Retirements have surged while the U.S. population aged, and fewer young people are joining the workforce. Covid has also killed nearly half a million working-age Americans who would currently be working if not for the pandemic, a point Powell himself made last week.

Plus, a drop-off in immigration over the past several years has vastly reduced the number of foreign-born workers available to fill open jobs. Policies that restrict the number of immigrant workers in each year also make it difficult to compensate for previous years when few immigrants arrived in the U.S.

All of which means that the Fed must hammer employer demand, forcing layoffs that boost labor supply by making newly unemployed Americans available for work.

“Unfortunately, labor-force participation rates have flatlined—and net immigration is also trending poorly—which adds to the burden on the Fed to rebalance the labor market through the demand side of the equation, and raises the risk of triggering a recession,” says Daleep Singh, chief global economist with PGIM Fixed Income and a former Biden White House official. 

The Fed recognizes what needs to happen on the labor front, even as it remains hopeful that it can return the economy to price stability without sparking a recession. But it has made clear that some pain is inevitable.

The central bank’s own forecasts show unemployment rising toward 4.6% next year. While not alarmingly high by historical standards, reaching that level would require more than a million job losses, notes Gregory Daco, chief economist with EY-Parthenon.

“While falling commodity and goods prices have likely put the economy past peak inflation in the eyes of the Fed, the committee sees underlying inflation as remaining sticky due to persistent labor market imbalances,” the Bank of America team wrote. “The Fed remains willing to risk a recession in the labor market to bring inflation down.”

Write to Megan Cassella at Megan.Cassella@dowjones.com.

Credit: marketwatch.com

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