The conventional wisdom among central bankers and pundits is that the labor market is “too hot” and the Federal Reserve has to engineer an increase in the unemployment rate rise in order to get torrid inflation under control.
Some economists think this is the wrong prescription for inflation.
One such economist is Peter Diamond, winner of the Nobel Prize in economics in 2010, Considered by his peers as among the smartest of economists, Diamond is concerned that the labor market is going through an historic transformation in the post-Covid pandemic economy – one that the Fed should not meddle with. And if the central bank does try to meddle, the damage could be enormous.
Diamond’s view, which he detailed in an interview with MarketWatch last month, was that the labor market is being hit by supply shocks, as American workers have gotten tired of harsh working conditions and are demanding changed.
In a surprise to mainstream economists, Diamond’s views were confirmed in some of the important details of the September jobs report released on Friday.
Read: U.S. adds 263,000 jobs in September
Julia Coronado, president of Macropolicy Perspectives, noted that the labor market was not behaving as the Fed’s standard “Phillips Curve” model suggests.
The Phillips curve claims to model an inverse relationship between inflation and unemployment.
In September, worker wages cooled even though the unemployment rate declined. The unemployment rate remains well below the Phillips -Curve notion of a “neutral” rate that boosts wages and inflation.
Brian Bethune, an economics professor at Boston College puts it more succinctly: “Any narrative that the employment market is “hot,” or that the tight employment market is the main culprit behind the ‘inflation surge’ is nonsensical,”
Here are five insights from the hour-long conversation with Professor Diamond:
‘I think we’re seeing a significant shift in power from employers to workers’
Diamond agreed that the U.S. labor market is tight. This is relevant to inflation because it results in higher wages, rising at a 5.2% pace in the latest quarterly reading. Workers’ higher wages are fueling a spending boom. Many economists think the only way that the Fed can get inflation down is to weaken the bargaining power of workers by pushing up the unemployment rate.
But this shift in power, a prime driver of inflation, won’t be cured by interest-rate hikes. That’s because it’s about supply, not demand.
Due to the pandemic, workers are starting to take back some of the power they ceded beginning in the 1980s, Diamond said.
People in occupations like nursing and education are quitting because of working conditions. Many workers are seeking jobs that allow them to work from home.
It is a slow process because businesses have to reorganize to make decisions about what to do and how to invest to carry out the new plans.
“I think it will give us a more productive labor force,” Diamond said. “But I worry that if we get a bad recession… that will disrupt the whole process. And I don’t know how that disruption will play out.”
“The labor market is different, and it is going to take a while to sort out, and that’s something to keep in mind,” he said.
So inflation is only going to come down slowly because one of its prime drivers isn’t so sensitive to a slower aggregate demand, he concluded.
‘The message is you go slow’
In the interview, Diamond said the models of the U.S. economy that the Fed uses to see trends “aren’t as relevant as people are thinking.” But the same is true for critics of the Fed such as Larry Summers, former U.S. Treasury Secretary and director of the National Economic Council, he added.
“The pandemic recession was different. The recovery is different. We’re not flying blind, but [there] is uncertainty,” he said.
As a result, “it seems to me the message is you go slow,” Diamond said.
Diamond said he agreed with the central bank’s desire to raise interest rates, but “75 basis point moves at a blow are too big.”
Peter Diamond in 2010, when he was awarded the Nobel Memorial Prize in Economic Sciences.
Flickr/U.S. Embassy in Sweden
Most Fed watchers think the central bank will raise its policy rate by three-quarters of a percentage point next week to a range of 3% to 3.25%. That will be the third straight move of that magnitude, which would represent the most aggressive rate-hiking pace since 1980 – 1981.
Many Fed officials have talked about getting that rate up to, or even above, 4% by year-end.
“I have no argument with 4% — it seems a reasonable number,” Diamond commented.
“If inflation comes down very slowly, maybe they have to go further. [But] if inflation is coming down slowly, and you’re not triggering a bad recession, then you carry on.”
Impossible to say whether the U.S. is headed for a severe recession or something milder
Economists are debating how much unemployment has to go up to get inflation all the way down to the Fed’s annual 2% target.
The rule of thumb, known as the Sahm Rule, is that the start of a recession is signaled when the three-month moving average of the national unemployment rate rises by a half a percentage point relative to its low during the past 12 months.
When the pandemic struck in March 2020, the unemployment rate jumped to 4.4% from 3.5% in February. It then soared to 14.5% in April before steadily easing back to 3.7% this August.
Optimists, including Fed Chairman Jerome Powell and central-bank governor Christopher Waller, think the Fed may be able to cool the labor market simply by reducing excess demand for workers that’s seen in the large number of vacant jobs being advertised.
At the moment, there are nearly two jobs vacancies for every worker seeking a job, according to U.S. Labor Department data.
The relationship between unemployment and job openings is through something called the Beveridge curve.
Pessimists including Larry Summers point to the possibility that a 6% unemployment rate could be needed to sufficiently cool inflation. Such a large increase in joblessness implies a deep recession.
Asked to play referee and decide the contest, Diamond demurred.
“Each of them say: If the Beveridge curve does this, we can have a soft landing. If the Beveridge curve does that, we can have a hard recession,” Diamond said. “I don’t have anything different to say about that, except to repeat my message: This is uncertainty. You don’t know what kind of recession you’re going to get.”
Little attention in the debate has focused on how a sharp rise in interest rates might affect the hiring of workers who are not unemployed. The so-called quits rate has been unusually high.
Summers has predicted a big jump in unemployment but didn’t specify who is going to lose their jobs, Diamond said.
Fed should abandon the 2% inflation target in favor of a band as wide as 2%–3%.
Right now, the Fed has as one of its operating mandates a targeted inflation rate of 2%, and Fed officials show no sign of wanting to shift their compass.
Diamond thinks this is a mistake. He suggests a range “at least as large at 2% to 3% and possibly wider on both ends.”
A range, he said, makes more sense than a 2% target. “What’s a disaster for the U.S. economy is exploding inflation,” Diamond said. “I see no reason to think a roughly steady 4% [inflation rate] is noticeably different from a roughly steady 3% or 2%,” he said.
What the Fed wants to avoid is a widely held sense among households that the inflation rate will move higher and not be reined back in — an expectation that then could feed back through wages into an upward inflation spiral.
Can the Fed avoid that without pushing for a return to 2% inflation?
“So,” replied Diamond, “I think the Fed should be recognizing that there’s nothing magical about 2%.”
“My take on what they might say is, ‘We’re moving in the right way. It doesn’t make sense to hurry because we have these uncertainties and because of the risk of unemployment,’ ” he said.
A recession might not cure inflation, and it could make matters worse.
Diamond said a concern for him is that a recession may not be a cure for inflation, as many — including the central bank — appear to assume. And this could backfire.
“If the Fed does something to hammer inflation, and I mean people are noticing unemployment coming from Fed actions, and then inflation doesn’t come down or as much as the public was led to expect, then the expectations piece gets more explosive,” he said.
The failure to bring inflation down sharply would erode the public’s confidence that the Fed can do the job. When you set a high bar, you are inviting people to be disappointed.
“To trigger a recession and not get inflation down to the satisfaction of expectations is an invitation to higher expectations. This is going to spin out of control,” Diamond said.
Bottom line: Diamond’s dovish views run counter to Wall Street ‘s hawkish shift.
Diamond’s remarks run counter to the trend. The Fed and the bond market
have grown more hawkish about the outlook for inflation in the wake of the hot August consumer price data, which has caused tremors in stocks
with the benchmark S&P 500 having shed 5% this week and many notable stocks slumping by double-digit percentages.
Most of the voices loudly critiquing Fed policy at the moment tend to be from the hawkish camp and argue that the Fed’s policy rate might have to climb above 5% to truly cool inflation.