It would normally be cause for unalloyed celebration. According to figures released on August 5th, America’s unemployment rate in July fell to 3.5%, matching a half-century low hit just before covid-19. Moreover, with nearly 530,000 jobs created last month—more than twice as many as expected—the economy has now recovered all of the jobs lost during the pandemic. That caps America’s strongest bounce-back in employment from a downturn in decades.
But in many parts of the economy, there is more consternation than celebration. An ultra-tight labour market is a challenge for companies struggling to return to pre-pandemic staffing levels. For investors and policymakers it poses a conundrum, suggesting the central bank may need to forge ahead with yet more jumbo interest-rate rises, despite other signs of slowing economic growth.
Ever since the Federal Reserve began tightening monetary policy earlier this year, economists have debated how big a trade-off there will be between inflation and jobs. Actions by the Fed to tame prices inevitably lead to weaker growth, weighing by extension on the labour market. Jerome Powell, chairman of the Fed, has long insisted that labour-market tightness may mean there is a path whereby companies can reduce their demand for new workers without large numbers ending up on the dole. In other words, the trade-off may between inflation and jobs could be less severe than in previous periods of monetary tightening.
One key piece of evidence in this debate is the level of job openings. Vacancies in June fell sharply to 10.7m, the lowest in nine months, though still high by historical standards. All else being equal, a decline in vacancies without a concomitant rise in unemployment would lend credence to the Fed’s view that the trade-off may be relatively mild. The counterpoint is that the trade-off has only just begun, since the Fed still has its work cut out to tame inflation. Consumer prices are forecast to have risen by nearly 9% last month, just shy of a four-decade high.
To understand the debate, consider the non-accelerating inflation rate of unemployment, known more commonly by its acronym, nairu, or simply as the natural rate of unemployment. It refers to the lowest level of unemployment that an economy can sustain before wage inflation starts to accelerate. The concept of nairu was once central to economic analysis and to the Fed’s thinking about rates. But it fell out of favour before the pandemic when unemployment dipped well below the assumed nairu threshold without any discernible pick-up in inflation. In a strategic review published in 2020, the Fed indicated that the concept would no longer figure prominently in its policy decisions.
However, the surge in inflation over the past year alongside the sharp drop in joblessness has put nairu back in the spotlight. The basic problem with the natural rate of unemployment, and why some object to its use, is that it is not observable. Instead, economists must derive estimates of where it lies based on the relationship between unemployment and inflation over time. That is necessarily imprecise. But there is a good case to be made that nairu shifted markedly higher early in the pandemic.
In mid-2020 unemployment soared to almost 15%. As Brandyn Bok and Nicolas Petrosky-Nadeau of the San Francisco Fed have noted, in conventional frameworks such a jump would have warranted a bigger slowdown in inflation than actually occurred. In other words, the natural rate of unemployment seemed to have shifted higher, limiting the disinflationary impact of a big rise in unemployment. They estimated that nairu may have reached 8% in 2020, before edging down to 6% at the end of 2021. The economy is now experiencing the flipside of an elevated nairu: high inflation as unemployment falls.
Structural changes in the shape of the economy during covid help explain why the natural rate of unemployment likely increased during the pandemic. From the boom in delivery and warehouse work to the later recovery in restaurant and travel work, employers have struggled to keep up with fast-evolving staffing needs. Compounding that has been a change in what people expect from their jobs, epitomised by the shift to more remote working. One response from companies, naturally, has been to offer higher wages. Hourly earnings are up by about 5% in nominal terms compared with a year earlier.
A gap between the measured unemployment rate of 3.5% and the estimated natural rate of 6% implies that wage pressure is likely to remain high in the coming months, making for yet more stubborn inflation. Immediately after the latest jobs report, traders ratcheted up their expectations for monetary tightening. They now assign roughly two-in-three odds to the Fed delivering its third consecutive three-quarter-point rate increase at its next meeting in September.
A pessimistic interpretation is that the Fed may have to keep raising rates until measured unemployment approaches the nairu level. Millions of people would lose their jobs if so. A hopeful interpretation is that the gap may be closed not by unemployment rising but by nairu falling. At a news conference after the Fed’s most recent rate rise in July, Mr Powell laid out this more hopeful perspective: “Logically, if the pandemic and the disorder in the labour market caused the natural rate to move up, then as the labour market settles down, in principle you should see it move back down.”
The result is that wages are at least as important as unemployment in gauging the health of America’s labour market now. It is impressive to see such strong job growth at this point in the economic cycle. But only if that comes alongside a moderation in salary pressures will the consternation give way to celebration. ■