Is America's Job Market "Too Good"?
Federal Reserve officials want to reduce businesses' demand for workers to put downward pressure on wage growth and contain inflation. Yet the pace of hiring remained strong as of mid-July.
American businesses keep adding workers to payrolls at a brisk rate. By most measures, employment has returned to pre-pandemic levels. That’s good news for everyone who has yet to participate in the recovery.
But for some observers, the ongoing strength of the U.S. jobs market is a problem. To them, the better things are for workers, the less likely that price pressures will fade away by themselves. From this perspective, unwanted inflation is ultimately caused by pay packets rising “too fast”—and the only solution is a prolonged period of elevated joblessness that weakens workers’ bargaining power and forces wage growth to slow down. Waiting for normalcy to return would simply postpone the adjustment and ultimately make things worse.
Fortunately, there are reasons to be skeptical of this dire analysis. While pay increases in excess of productivity could reinforce and sustain excessive increases in prices, the latest labor market data suggests that underlying inflationary pressures are dissipating even as employment holds up. The information we have right now is more consistent with a large one-off shift in the levels of wages and prices, rather than a persistent acceleration in the rate at which incomes and prices rise.
What Links the Job Market to Inflation?
Both the U.S. unemployment rate and the total number of Americans with jobs are essentially the same now as in February 2020, yet the inflation rate is far worse. That is broadly similar to the situation in Australia, Canada, Europe, the U.K., and Korea, although there are important distinctions across those economies. Even Japan, which has enviably slow inflation compared to the rest of the rich world, is nevertheless in a situation where prices are rising far faster than before the pandemic while the job market looks about the same. The years before the pandemic were characterized by steadily improving job markets across the rich countries—and quiescent inflation.
At first glance, blaming overheated job markets for our current troubles therefore makes little sense. As I have outlined at length in previous notes, the excess inflation we have experienced over the past 2.5 years is ultimately attributable to disruptions in production and consumption caused by the pandemic and the Russian invasion of Ukraine. Inflation was a global problem well before job markets had recovered.
Nevertheless, the job market can matter for inflation insofar as wages are the most important source of nominal spending power for consumers. To be clear, there is no dependable relationship between changes in wages and changes in consumer prices, especially over shorter time horizons.1 But there is something significant about the fact that the average growth rate of nonmanagerial worker pay went from 8% a year in 1976-1981 to just 3% a year in 1985-2019, while the average growth rate of the PCE price index went from 8% a year in 1976-1981 to 2% a year in 1985-2019.
The growth rates of wages (or prices) can accelerate or decelerate by a percentage point or two without a commensurate change in the growth rate of prices (or wages), but it’s difficult to imagine a massive sustained gap between the growth rates of the two measures.
The danger is that workers and businesses respond to the recent increases in prices by agreeing to longer-term changes to the growth rate of worker pay. If that were to happen, nominal spending power would keep rising too quickly relative to the supply of goods and services, which would keep the inflation rate elevated and sustain the social consensus in favor of excessive wage growth. Policymakers would need to break that consensus if they wanted to squeeze inflation out of the economy—and that process would almost certainly involve a prolonged and painful downturn.
Bridgewater’s Bob Prince laid out the argument in a recent note (emphasis mine, do read the whole thing):
Income growth establishes the base level of nominal spending. This is because spending produces income, and then that income gets spent, producing an income-spending flywheel that has inertia and thus tends to be self-sustaining…Policy tightening is likely to slow inflation from where it has been, but whether it brings inflation down to what is discounted (2.5%) and to what the Fed expects and is targeting (2%) depends on how deep the contraction is and how long it lasts. It needs to be deep and long-lasting because there is inertia in the system in the form of wage growth that is much higher than what would be required for 2.5% inflation.
A big near-term decline in wages is unlikely because labor markets are now tight. The unemployment rate is near its lows, job offers are plentiful, and the cost of living is giving people reason to ask for more. Thus, the degree and duration of the tightening must be strong enough and long-lasting enough to bring credit growth down by enough (roughly by half) for long enough—to bring spending down by enough for long enough—to weaken labor markets by enough—to bring wages down by enough—that NGDP growth falls by enough and stays there—to bring inflation down to 2.5%.
The key question is the extent of “inertia in the system”. Has there been a persistent change in the growth rate of nominal spending power? If so, by how much? Or was there a substantial but time-limited shift in the level of income, which temporarily made it seem as if the underlying growth rate had meaningfully accelerated?