MNI: Fed Must Cool Job Market - Ex-Officials

The Federal Reserve needs to take the steam out of a historically tight labor market to increase economic slack, former Fed officials and staff told MNI, with some suggesting that the unemployment rate will have to rise to 4% or higher to be compatible with its inflation objectives.

While the March Statement of Economic Projections implies monetary tightening will cool the labor market simply via a lower rate of job openings than the 400,000 per month average seen over the past 11 months, a jobless rate at March’s post-pandemic low of 3.6% and wages growth at 5.6% are too hot for the Fed’s comfort, the former officials and staff said.

The Fed needs to get rates up closer to neutral to stop the labor market from tightening further, former Fed vice chair Donald Kohn said in a recent interview. The current rate of gains in wages in particular is leaving the central bank in an awkward position, said Jonathan Wright, a former member of the Fed Board's division of monetary affairs.

"They would like real wages to go up, but more than that in the current environment they don't want to see a wage price spiral," Wright said. "With average hourly earnings at 5.6%, it runs the risk of starting a 70s-style wage price spiral."

The Fed may prefer wages growth at closer to 4% over the year, MNI has been told. (See: MNI INTERVIEW: US Can Handle 4% Wage Gains-Minneapolis Fed Econ)

OPENINGS/UNEMPLOYMENT

Chair Jerome Powell and Fed system economists have noted job openings data suggest a super-tight labor market, and Powell has said that "in principle" less accommodative monetary policy could reduce excess demand for labor and stabilize the unemployment rate as supply increases, allowing for more sustainable wage increases over time.

But slowing the pace of job openings while keeping unemployment at such low levels may be too fine a balancing act, former officials said.

"Implicit in the March SEP forecast, they're going to do it by bringing down job openings, rather than dragging the unemployment rate up," said Wright, who has been an outside New York Fed adviser. "To get inflation down from where it is they will have to do more than that and actually drive unemployment probably above what they think is the longer-run level” of about 4%, he said.

The alternative – continuing to tolerate joblessness at levels well below estimates of the non-accelerating inflation rate of unemployment -- might trigger a disproportionate rise in inflation, he said.

"Anyway you cut it, the unemployment rate is way below the natural rate by one or two percentage points,” Wright said, “and there is work on the Phillips curve that argues you don't get much inflation on the Philips curve when the unemployment rate is close to NAIRU but it’s kind of nonlinear when you get into a really hot labor market."

Nathan Sheets, former international finance division director at the Fed Board and now global chief economist at Citi, also doubted that the Fed could cleanly slice off job openings. "This strikes me as an 'immaculate adjustment' narrative that is probably too tidy by half," he said.

"As a general statement, it’s hard to understand why tightening monetary policy would only affect the demand for new labor but have no effect on firms presently holding labor," said Sheets, adding that a services rebound could further support job openings that would be relatively insensitive to rising rates.

LABOR SUPPLY INCREASING

As federal labor data has started showing retirees moving back into the labor market, last week's BLS payrolls report also showed the employment-population ratio and the labor force participation rate moving up, both increasing the most over the last 23 months than any 23-month span in the postwar era.

John Roberts, who retired from the Fed Board staff last year after 35 years and advised Fed Governor Lael Brainard, said the natural rate of unemployment could be temporarily elevated at around 5.25% for another year or two, though he emphasized the good news in the increase in prime-age participation in recent months. Upcoming Employment Cost Index data will be key, he said.

"If wages were to continue to accelerate, that would be an indication they've got a more entrenched inflation problem, and the Committee might need to start leaning towards a higher unemployment rate," he said. "All eyes will be on the ECI at the end of the month."