MNI INTERVIEW: Employment Could Be Less Sensitive To Fed Hikes

U.S. labor demand could be less sensitive to higher interest rates than in previous decades, possibly requiring the Fed to tighten policy even more to slow the economy and tame inflation, Federal Reserve Bank of Atlanta economist Jonathan Willis told MNI.

Despite lifting the fed funds rate 450bps in less than a year, the Fed's hiking campaign isn't getting much traction in the labor market. Employers added an average of 356,000 jobs a month over the past three months, triple what's needed to keep up with workforce growth, and job openings remain much high than pre-pandemic levels.

Economists say it could take up to 24 months for monetary policy to take full effect, and Willis argues declining interest-rate sensitivity could be to blame. Structural changes in industries and financial markets since the 1970s and early '80s have led to a diminished response by employment to monetary policy shocks outside of the most interest-rate-sensitive sectors.

"When the Fed did make changes in policy that we can designate as monetary policy shocks, you really didn't see industries respond in a significant way, which draws the question: what will it take to slow down employment growth and the economy?," Willis said in an interview. "If it is the case that interest rates are less potent for slowing the broader economy, one conclusion might be the Fed might have to do more work to lift rates higher." (See MNI: Fed's Peak Rate Looking Perkier As Jobs Boom-Ex-Officials)

RATE SENSITIVITY

A research paper by Willis and Guangye Cao, published by the Kansas City Fed in 2015, attributes the apparent decline in interest-rate sensitivity after the mid-1980s to both industry changes like the shift away from auto and other durable goods manufacturing and toward services, and to weaker transmission mechanisms from shorter-term to longer-term rates and from longer-term rates to employment.

The most interest-sensitive sectors experienced the largest decreases in responsiveness, but the trend was widespread. As a simple example, whereas before the mid-'80s, auto factories would shed workers and close temporarily in an economic slowdown, modern just-in-time-inventory practices mean worker ranks are also kept lean, Willis said.

On the financial market side, the 10-year yield appears to respond to a rate cut with a longer lag in more recent decades, while models suggest aggregate employment also responded more slowly to unexpected movements in longer-term interest rates unrelated to monetary policy after 1984, according to their research.

"Even now, residential investment has slowed but overall construction is still growing. We haven't seen falling construction worker growth," Willis said. "Why aren't we seeing more signs of a slowdown in labor demand? Given those big shifts in interest rates, you might have expected everything should start to slow down."

SOME MORE SOFTENING

Inflation is retreating from its peak last summer, but key for the Fed is whether it will settle close to 2% over the next two to three years or whether even tighter monetary policy is needed to slow consumer demand, Willis said.

"Is inflation going to moderate to 3.5%? Is it going to moderate to 3%? Or is it going to moderate to 2.5% without needing to see more significant slowing in the labor market? I think that will be what provides information for Federal Reserve officials to determine what to do next," Willis said.

"We certainly want the labor market to not be weak. But it's possible that it might take some softening to get things in balance before we can get back on our growth path."

On the other hand, if interest rates need to go a lot higher than everyone expects, it is not clear that financial institutions, market participants, and borrowers with adjustable-rate loans would be sufficiently prepared, Willis noted.

"This type of disruption in financial markets could lead to a more negative outcome for the economy. It doesn't point to an easy answer."