Lifting interest rates quickly to relieve wage pressures isn't without risks, but a wage-price spiral would be worse, former Fed economists say.
The Fed is determined to head off a potential wage-price spiral with aggressive monetary tightening, even at the cost of larger-than-desired losses to growth and jobs, former Federal Reserve economists told MNI.
Persistently elevated inflation has renewed fears of a wage-price spiral as employers compete for a limited labor pool and workers look for pay increases to keep up with inflation. Surging prices, initially caused by broken supply chains, could become everlasting if they start feeding into wage demands.
"The goal is to return the labor market to a more sustainable position where wage increases are consistent with the 2% inflation objective. That's the key indicator and it's too high at the moment," former Fed Board research director David Wilcox told MNI.
How that gets accomplished is likely to be bumpy, he said. "It may land with broken crockery, but one important message we’ve heard is Chair Powell is determined to control the inflation rate. They hope to avoid recession, but if it’s necessary to pay that price, that’s what they’ll do."
Some measures of wage growth have stabilized in recent months but remain at historically high levels, where they could stay as long as hiring continues at its current pace of around half a million jobs a month, the ex-Fed economists said.
Unit labor costs surged 7.2% in the first quarter after averaging no more than 2.5% for several decades before the pandemic.
"I don’t think we’ve seen much evidence to date of a wage-price spiral, but going forward I'm much more concerned about that," former Fed Board staffer Stephanie Aaronson told MNI. "A year or so ago people didn’t have very strong expectations that inflation would be so persistent. Now it’s really on everyone’s mind. That matters for businesses."
If demand for services surges this summer, employers could lift wages as they try to hire quickly in a very competitive market, Aaronson said. Hourly earnings rose by 5.5% in the year through April but failed to keep up with CPI inflation, which jumped 8.3% in the same month.
"That's the bad scenario in which it would take much more of an effort on the part of the Fed to get inflation under control," Aaronson added.
The first signs of a labor market slowdown will likely come in the form of a rebound in the weekly initial jobless claims figures, followed by a backing off of the quits rate, the ratio of job vacancies to the unemployed, falling or even negative monthly payrolls, and finally a decline in wage growth.
If all goes well, a soft landing is possible, said former New York Fed economist Aysegul Sahin, who currently consults for several regional Fed banks. She argues wage growth has been high in part because during the pandemic firms have had to poach workers from other firms.
As financial conditions tighten, employers may wait to hire new graduates or people who have voluntarily quit their old jobs, and pay a bit less for them. Job-to-job transitions data will be a key indicator. "Given how strong the job market is, firms can slow poaching, and there's a long way to go before they start letting people go," Sahin said. "The Fed could calibrate this to slow down without getting unemployment above 4%."
The jobless rate isn't likely to rise to 5% without a recession, she said.
But there’s often a "nonlinearity" in dynamics when a contraction takes hold, said Wilcox, currently an economist with the Peterson Institute for International Economics and Bloomberg Economics. Increases in unemployment tend to be much sharper than the recovery. "It’s not well understood, and once in process, it's difficult or impossible to stop."