While the US Federal Reserve (Fed) has argued that it can engineer a soft landing to cool the red hot labor market without plunging the economy into recession, the cold, hard truth is that this isn’t very likely.
Don't overlook the overheating labor market
It’s been a while since there’s been good news when it comes to inflation, but we may be starting to turn a corner. The July Consumer Price Index (CPI) report provided some relief, showing falling energy prices and weaker-than-expected core inflation.The year-over-year headline inflation rate is now down from its 9.1% peak in June, albeit to a still very high 8.5%. We expect this trend to continue in August, with, for example, gas prices falling more over the month. Demand has weakened a bit in certain goods sectors and the supply backdrop is slowly improving, which suggests that we might also see easing pressures in some goods prices.
But don’t get so caught up looking at this inflation peak in the rearview mirror that you miss other red flags ahead. The trends in core services prices remains a cause for concern. While air fares may have fallen in July, shelter costs are soaring and inflation continues to wreak havoc on the price of many other services. All of this speaks to an overheated domestic economy.
All of this speaks to an overheated domestic economy.
These pressures will be harder to shift, especially with such a tight labor market (Chart 1). While job openings have declined lately, they still outnumber unemployed workers and strong labor demand continues to drive higher payroll numbers.
Chart 1: Labor market metrics look as tight as ever
Source: Haver, abrdn, August 2022. (Z score – lower reading corresponds to a tighter labor market)
Looking forward, there are a couple of scenarios that could play out in the labor market. It’s possible that a large decline in vacancies could be achieved via a small rise in unemployment, but we don’t find this scenario probable.
To achieve this we would need to see a significant decline in the reallocation of jobs within the economy and/or a dramatic improvement in efficiency of matching the appropriate workers to jobs. What seems more likely is that rising unemployment will unfortunately be required to stem labor market pressures. This rougher adjustment is more consistent with what we have seen from past labor market cycles.
Indeed, on average in the post-war period, we can see that in the 24 months after vacancy rates peak, these typically fall by 1.5%, while unemployment rates rise by 2.1% on average. So the soft landing the Fed is hoping for doesn’t have any historical precedent.
We have yet to see exactly what the central bank adjustment process to bring inflation down to more normal levels will entail. But whether or not we agree with the Fed’s present forecast, we don’t see it as a lack of the central bank’s resolve. We believe that the Fed will ultimately do whatever is required to restore price stability — even if their soft landing forecast does not play out and a tougher adjustment is required. Which is why we continue to think a recession is on the way.
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Can the Fed cool the labor market without pushing unemployment up?
Some folks at the Fed, including Chair Jerome Powell, have argued that it’s possible for labor demand to ease and unemployment to stay low. This would require firms to hire less, rather than lay off workers. It may be difficult to deliver on this goal. Why? There’s been a significant reallocation of labor demand into new sectors and roles during the Covid-19 pandemic. And some evidence suggests that the labor market has struggled to match relevant workers to jobs in the wake of this shift. This implies a labor market not functioning as well as we might have hoped.Looking forward, there are a couple of scenarios that could play out in the labor market. It’s possible that a large decline in vacancies could be achieved via a small rise in unemployment, but we don’t find this scenario probable.
To achieve this we would need to see a significant decline in the reallocation of jobs within the economy and/or a dramatic improvement in efficiency of matching the appropriate workers to jobs. What seems more likely is that rising unemployment will unfortunately be required to stem labor market pressures. This rougher adjustment is more consistent with what we have seen from past labor market cycles.
Indeed, on average in the post-war period, we can see that in the 24 months after vacancy rates peak, these typically fall by 1.5%, while unemployment rates rise by 2.1% on average. So the soft landing the Fed is hoping for doesn’t have any historical precedent.
Is the Fed in denial?
In our view, the Fed may have an excessively sanguine view about its ability to engineer a soft landing. They may have argued that job openings can take on the burden of loosening the tight labor market, but we don’t think that the reality of the post-pandemic labor market, or historical labor market shakeouts support this view.We have yet to see exactly what the central bank adjustment process to bring inflation down to more normal levels will entail. But whether or not we agree with the Fed’s present forecast, we don’t see it as a lack of the central bank’s resolve. We believe that the Fed will ultimately do whatever is required to restore price stability — even if their soft landing forecast does not play out and a tougher adjustment is required. Which is why we continue to think a recession is on the way.
IMPORTANT INFORMATION
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.US-170822-179304-1