About the author: Sonia Meskin is the head of U.S. Macro at BNY Mellon Investment Management in the New York office. Previously, she held roles with the International Monetary Fund, Standard Chartered Bank and the Federal Reserve Bank of New York.
The Federal Reserve may soon find itself at a crossroad. The two parts of its mandate, full employment and price stability, are likely to come into conflict. The Fed would then have two options: eliminate a sizable number of jobs to sustainably bring down inflation, or accept a higher inflation objective than it formally committed to in January 2012. Both options would present significant political and institutional challenges for the Fed and could also call its credibility into question.
Was this fork in the road inevitable? No, but the uncertainty of the pandemic likely made it hard to anticipate. While economists can agree that the pandemic upset many economic relationships from the past decade, it’s much harder to find consensus on whether these changes are temporary or permanent.
Those who believe that the aggregate supply-demand imbalances wrought by Covid are largely transitory assert that 2% core inflation is on the horizon. This group notes that the slow trend gross domestic product growth (near 1.5%), a relatively stable share of federal deficit in GDP, and the proportional shares of capital and labor in the national income look similar to pre-Covid levels. In econometric models, these variables largely underpin estimates of the so-called neutral real policy rate, or the rate which keeps potential output and prices stable. For the good part of the previous decade, the neutral U.S. real policy rate was estimated to be between 0-1%, consistent with the 2-3% long-term nominal policy rate estimate in the Federal Reserve Open Market Committee’s Summary of Economic Projections. As long as the structural configuration of the economy has not changed, this argument works; inflation should eventually subside from currently elevated levels and return closer to its long-run neutral stance of the nominal fed funds rate of roughly 2%. The question is when, not if.
Others believe structural changes have been afoot for some time, whether brought on by Covid or accelerated by it. This camp points to signs of an altered aggregate supply-demand balance that may keep inflation elevated compared to pre-Covid levels. On the supply side, such changes include resource constraints such as a shortfall in the labor force of developed economies, both caused by and coincidental to Covid, and upcoming net-zero transition processes. However, I believe labor market changes alone would suffice for persistent upward inflation pressures.
The U.S. labor market is currently exhibiting a shortfall of nearly 5 million people compared to pre-Covid, which is unlikely to reverse. Recall that a major U.S. economic theme in 2021 was the hope of a significant bump in labor participation once Covid-related benefits expired. That hope never materialized. Instead, U.S. labor-supply growth remains constricted by Covid-related deaths and retirements, baby-boomers exiting the labor force, and low immigration. With a persistent shortfall in labor supply relative to the previous decade, existing workers can command greater wage increases. Indeed, average hourly earnings in the U.S. have been growing at roughly 5% year over year, over 3% higher than levels compatible with the stable 2% core inflation rate. Wage gains are particularly pronounced in the services industry, especially in leisure and hospitality, but also in health, education, and broader professional and business services. Monthly gains in average hourly earnings (a more volatile series) have moderated recently but remain above the pre-pandemic trend.
If labor markets stay tight and wage gains remain elevated for a prolonged period, inflation expectations may ultimately unanchor. This would unnerve econometricians whose models’ predictive power depends crucially on stable inflation expectations. More importantly, it would mean a major headache for the Fed, for the success of the central bank’s policy initiatives crucially relies on stable long-term inflation expectations. An unanchoring of that stability could lead to a loss of Fed credibility and significantly complicate the conduct of monetary policy.
For a relatively closed and services-dominated economy, services inflation tends to be closely linked to wage pressures, especially when labor supply is constricted. The longer the dynamic persists, the greater the risk of a “wage-price spiral” developing; a situation in which higher prices induce workers to bargain for higher wages, which in turn enables companies to command higher prices in lieu of increasing production. Typically, once a wage-price spiral sets in, the only way to reverse it is through demand destruction or a weaker labor market.
The Fed may opt to wait in the first half of 2023 rather than keep raising rates. Weakness in the goods sector and favorable base effects from substantive price increases in the first half of 2022 produce better overall inflation optics. This would entail raising the target fed funds rate by another 50-100 basis points in early 2023 then staying put to observe the so-called lagged effects of monetary policy. The U.S. may also enter a recession in 2023, which would entail a loss of jobs and therefore some demand destruction. However, a mild recession may do little to alleviate structural tightness of the labor market, nor would it definitively sap core services inflation.
If so, the central bank could face a very difficult choice. One option would be to acknowledge that the core inflation trend consistent with full employment is structurally higher than in the previous decade. This would allow the central bank to drop its commitment to the 2% inflation objective. The Fed could then preserve jobs, thus, staying faithful to the second half of its mandate. However, the wavering on its inflation objective could erode the central bank’s credibility and further unanchor inflation expectations. The other option would be to engineer a deep recession that would eliminate enough jobs to create a job hysteresis (a persistent job shortfall) and bring inflation to its heel. This would allow the Fed to preserve its commitment to the 2% inflation objective, but could displease Congress, the White House, and the broader public. Neither choice is appealing, and both could ultimately involve some credibility loss for the institution that has worked hard to rebuild itself from the days of former Chair Paul Volcker and his famous campaign against inflation.
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