The Fed wants to control inflation. And to do so, it’s coming for your paycheck.
The Fed’s one job (er, dual mandate) is to keep inflation and the job market in a healthy balance. Right now, that balance is out of whack. To get inflation down, the Fed is taking aim at a remarkably strong job market.
How strong? We’re talking an unemployment rate at a 50-year low, two job openings for every unemployed person, and “the great resignation” of everybody you know casually looking for new opportunities. Very strong.
It’s a historic moment for the American worker, but it may be a big reason why we’re dealing with painful price increases.
And as the Fed told us this week, eventually, something has to give.
Your paycheck and inflation
For many of us, our jobs are a source of income, a passion project, or a community of like-minded people to bond with — maybe all of the above. To the Fed, our jobs are the main mechanism for managing consumer spending and confidence. It makes sense. Usually, when we make more money, we’re more inclined to spend it, especially since many Americans’ primary income is from their employment.
But sometimes, the job market can be a little too hot. Wage growth and abundant job opportunities can be good for your wallet, but they can ultimately lead to higher costs for businesses. After all, wages and salaries have accounted for about 70% of business costs in past years, according to the Bureau of Labor Statistics. If companies incur higher costs, they’re more likely to raise their prices.
In a way, that’s what’s happening right now. America’s workers are getting more leverage, but that leverage has transformed into a runaway economy. Inflation has now outpaced wage growth for 17 straight months. A higher paycheck with even higher prices isn’t the kind of raise you want. Eventually, rapidly rising inflation could create a nasty self-fulfilling prophecy that sows distrust in the financial system.
Unfortunately, the main driver of all of this is your paycheck. Powell even said it himself — inflation coming down depends on wage growth coming down as well.
To fix this, the Fed is starting to prepare Americans for some job market pain. On Wednesday, the Fed projected that the unemployment rate could increase to at least 4.4% next year — a 0.7% jump from today’s rate. Seems like a small change, but we’ve never seen the unemployment rate increase that quickly over the course of a year without a recession occurring.
An alternate reality
For what it’s worth, the hot job market has barely skipped a beat recently, even though the Fed has hiked rates at the fastest pace in four decades. Companies are still hiring at a rapid pace, and many businesses still can’t find enough qualified workers. When they do find workers, they have to pay up:wage growth! Layoffs are happening — you seem to read about one every day now — yet claims for unemployment benefits haven’t risen significantly. It’d be an encouraging situation, if inflation weren’t so high.
It feels like corporate America is living in an alternate reality while the rest of the economy is suffering. What’s going on here?
First, companies may not be feeling the heat of cost pressures yet. Even though business costs are rising fast, S&P 500 company profit margins are near their highest in a decade. They’ve come down a bit this year, but not significantly. In other words, there hasn’t been a need to cut costs, because demand has been strong and earnings haven’t taken much of a hit.
Also, skilled employees are valuable commodities for many companies right now. Many businesses dealt with severe labor shortages last year, and they’re still having trouble measuring exactly where demand will be a few months down the road. It’s like the bullwhip effect, but for employees. Add in the fact that corporate America was running especially lean when COVID hit, and you can understand why companies are so hesitant to let people go.
Still, if companies aren’t willing to concede, the Fed could keep swinging its rate hike hammer in hopes of getting inflation down. And with each swing of the hammer, the chance of a policy mistake could grow.
Shutting off the engine
If you’re like me, you’re probably stewing over how unfair this is. Why do people have to lose their jobs and income in order to get the economy back in balance? It’s a fair question.
Thankfully, there’s a situation in which the labor market doesn’t have to suffer as much as we think. Instead of achieving balance through lower demand and layoffs, we could theoretically see labor supply pick up enough to absorb job openings and cool wages down. Also, while unemployment could increase, it still seems like a manageable downturn. The unemployment rate has spiked above 6% in every other recession in the past five decades.
Still, the Fed has to be careful. The job market is the engine of the economy. Shut it off too quickly, and you could risk inflicting serious pain on swaths of consumers, many of whom are trying to catch up after a decade of stagnant wage growth. But if you don’t address the problem, you risk damaging the economic psyche with persistently high inflation and permanently stifled growth.
For now, watch wages for signs of where inflation is heading next, and keep in mind just how painful recessions can be for the economy, markets, and humanity.
The Fed doesn’t take that kind of pain lightly.
*Data sourced through Bloomberg. Can be made available upon request.