In case the US economy isn’t hurting enough already, the Federal Reserve has a message for Americans: It’s going to get a lot more painful.
Fed Chairman Jerome Powell made that clear this week when the central bank forecast its benchmark rate to hit 4.4% by the end of the year, even if that causes a recession.
“There will most likely be an easing of labor market conditions,” Powell said.. “We will continue until we are satisfied that the job is done.”
In short, this means unemployment. The Fed expects the jobless rate to hit 4.4% next year, from 3.7% today, a figure that implies 1.2 million more people will lose their jobs.
“I wish there was a painless way to do this,” Powell said. “There are not any.”
Hurt so good?
Here’s the idea behind why increasing the nation’s unemployment could cool inflation. With one or two million more people out of work, the newly unemployed and their families would significantly reduce their spending, while for most people still working, wage growth would stagnate. When companies assume that their labor costs are unlikely to increase, the theory goes, they will stop raising prices. This, in turn, slows down price growth.
But some economists wonder whether it is necessary to crush the labor market to control inflation.
“The Fed clearly wants the labor market to weaken quite sharply. What’s not clear to us is why,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics, in a report. He predicted that inflation will “plunge” next year as supply chains normalize.
The Fed fears a so-called wage-price spiral, in which workers demand higher wages to stay ahead of inflation and businesses pass these higher wage costs onto consumers. But experts disagree that wages are the main driver of today’s runaway inflation. While workers’ compensation has increased by an average of 5.5% over the past year, it has been eclipsed by even larger price increases. At least half of current inflation stems from supply chain issues, former Fed economist Claudia Sahm noted in a tweet.
Sahm noted that today, the lowest paid workers have both benefited the most from wage increases and been hit the hardest by inflation – inflation driven by higher spending by wealthy households rather than by people lower on the scale.
Rates up, jobs down
While the exact relationship between wages and inflation remains under debate, economists are much clearer about how rising interest rates put people out of work.
When rates rise, “any consumer good that people go into debt to buy — whether it’s automobiles or washing machines — becomes more expensive,” said Josh Bivens, research director at the Economic Policy Institute.
That means less work for the people making those cars and washing machines, and possibly layoffs. Other interest rate-sensitive sectors of the economy, such as construction, home sales and mortgage refinancing, are also slowing, affecting employment in this sector.
Additionally, people are traveling less, leading hotels to downsize to accommodate falling occupancy rates. Businesses looking to expand – for example, a coffee shop chain opening a new branch – are more reluctant to do so when borrowing costs are high. And as people spend less on travel, dining, and entertainment, these hoteliers and restaurateurs will have fewer customers to serve and eventually downsize their staff.
“In the service economy, labor is the most important component of your cost structure, so if you’re looking to cut costs, that’s where you’ll look first,” said Peter Boockvar. , chief investment officer at Bleakley Financial Group.
While, according to Boockvar, a rate hike is necessary, the Fed’s tactics seem aggressive to him. “I just have a problem with the [Fed’s] speed and scale,” he said. “They’re coming so fast and so hard, I’m just afraid the economy and the markets can’t handle it.”
In the meantime, the Fed’s existing rate hikes have put about 800,000 job losses in the pipeline, according to forecasts from Oxford Economics.
“When we look at 2023, we see almost no net hiring in the first quarter and job losses of over 800,000 or 900,000 in the second and third quarters combined,” said Nancy Vanden Houten, chief US economist at Oxford.
Others predict an even harder landing, Bank of America expects a record unemployment rate of 5.6% next year. This would put an additional 3.2 million people out of work above current levels.
Some policymakers and economists have denounced the Fed’s aggressive rate hike plans, with Senator Elizabeth Warren saying they would “put millions of Americans out of work” and Sahm call the “inexcusable, verging on dangerous”.
Powell promised pain, and many wonder how much pain is necessary.
“Inflation will come down a bit faster if we actually hit a recession. But the cost of that is going to be much bigger,” Bivens said.
The danger, he added, is that the Fed has started a runaway train. Once unemployment begins to rise sharply, it is difficult to stop it. Rather than stopping dead at the 4.4% rate projected by Fed officials, the number of unemployed could easily continue to rise.
“This idea that there’s an inflation dial that the Fed can just pull really hard and leave everything else untouched is a mistake,” Bivens said.
Instead of the soft landing for the economy that the Fed says it’s aiming for, Bivens added, “we’re now pointing the plane at the ground pretty hard and stepping on the accelerator.”
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