In case the US economy wasn’t already suffering enough, the Federal Reserve has a message for Americans: it’s about to get a lot more painful.
Fed Chairman Jerome Powell made it clear this week when the central bank predicted its policy rate would hit 4.4% by the end of the year, even if that provoked a recession.
“There will most likely be a softening of labor market conditions,” Powell. “We will continue until we are sure that the work will be done.”
Put simply, it means unemployment. The Fed expects the unemployment rate to rise to 4.4% next year, from 3.7% today, a number that implies the job loss of another 1.2 million people.
“I wish there was a painless way to do it,” Powell said. “There is not.”
Wounded so well?
Here is the idea behind why rising unemployment in the nation could cool inflation. With a million or two more people out of work, the newly unemployed and their families would drastically cut spending, while for most people who are still working, wage growth would be flat. When companies find their labor costs unlikely to rise, the theory says, they will stop raising prices. This, in turn, slows down price growth.
But some economists are wondering whether it is necessary to crush the labor market to bring inflation to the heel.
“The Fed clearly wants the labor market to weaken quite drastically. What we are not clear about is why,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a report. He predicted that inflation is set to “plummet” next year as supply chains normalize.
The Fed fears a so-called wage-price spiral, where workers demand higher wages to keep up with inflation and companies pass those higher wage costs onto consumers. But experts disagree that wages are the main driver of today’s scorching inflation. Although workers’ wages have increased by an average of 5.5% over the past year, it has been eclipsed by even higher price increases. At least half of today’s inflation stems from supply chain problems, former Fed economist Claudia Sahm noted in a tweet.
Sahm noted that lower-wage workers today both benefited most from wage increases and were most affected by inflation, inflation driven by increased spending by affluent households rather than people further down in the ladder.
Rates on the rise, jobs on the decline
While the exact relationship between wages and inflation remains in question, economists are much clearer about how rising interest rates put people out of work.
As rates rise, “Any consumer item that people go into debt to buy, whether it’s cars or washing machines, gets more expensive,” said Josh Bivens, director of research at the Economic Policy Institute.
That means less work for the people who make those machines and washing machines and, eventually, layoffs. Other interest rate sensitive parts of the economy, such as construction, home sales and mortgage refinancing, are also slowing, impacting employment in that sector.
In addition, people travel less, leading hotels to cut staff to account for lower occupancy rates. Businesses looking to expand, such as a coffee shop chain opening a new branch, are more reluctant to do so when loan costs are high. And because people spend less on travel, dining, and entertainment, those hoteliers and restaurateurs will have fewer customers to serve and will eventually cut down on staff.
“In the service economy, labor is the most important component of the cost structure, so if you’re looking to cut costs, that’s where you’ll look first,” said Peter Boockvar, chief investment officer of Bleakley Financial Group.
While from Boockvar’s point of view it is necessary to raise rates, the Fed’s tactics seem aggressive. “I just have a problem with the [Fed’s] speed and scale, “he said.” They’re coming so fast and strong, I’m just worried the economy and markets can’t handle it. “
Redundancies in sight
Meanwhile, according to forecasts by Oxford Economics, the Fed’s current rate hikes have planned for the loss of some 800,000 jobs.
“When we look to 2023, we see almost no net hires in the first quarter and job losses of over 800,000 or 900,000 in the second and third quarters combined,” said Nancy Vanden Houten, a US economist from Oxford.
Others predict an even more difficult landing, with Bank of America forecasting a maximum unemployment rate of 5.6% next year. This would put another 3.2 million jobless people above today’s levels.
Some politicians and economists have denounced the Fed’s aggressive rate hike plans, with Senator Elizabeth Warren said they would “throw millions of Americans out of work” and Sahm calling their “unforgivable, bordering on dangerous”.
Powell promised pain and many wonder how much pain is necessary.
“Inflation will go down a little faster if we actually hit a recession. But the cost of that will be much greater,” Bivens said.
The danger, he added, is that the Fed has set off a runaway train. Once unemployment starts to rise rapidly, it’s hard to stop it. Rather than stopping sharply at the 4.4% rate forecast by Fed officials, the number of unemployed could easily continue to rise.
“This idea that there is an inflation quadrant that the Fed can just drag very hard and leave everything else intact is a mistake,” Bivens said.
Instead of the soft landing for the economy that the Fed says it is aiming for, Bivens added, “we are now aiming the plane on the ground pretty hard and pressing the accelerator.”