As inflation rapidly declined in 2023 and continued to slow this year, Federal Reserve officials were optimistic that the pressure on the U.S. economy was easing without a significant rise in unemployment. Instead, the decline in job openings, which had surged during the pandemic-induced labor shortage, seemed to be a key factor in this positive development.
However, the economy may now be approaching a critical juncture where a continued decrease in job openings could lead to a more rapid increase in unemployment. This concern is highlighted in new research presented at the Kansas City Fed’s annual economic conference in Jackson Hole, Wyoming. The findings suggest that the Federal Reserve may need to consider cutting interest rates to protect the labor market from a potential downturn.
Economists Pierpaolo Benigno of the University of Bern and Gauti B. Eggertsson of Brown University, who authored the research paper, argue that policymakers face two significant risks: delaying rate cuts too long, which could lead to a “hard landing” with high unemployment, or cutting rates prematurely, which could leave the economy vulnerable to rising inflation. Based on their analysis, they believe the risk of delaying rate cuts outweighs the risk of premature action.
The Federal Reserve seems to be aligning with this viewpoint, as expectations grow for reductions in the central bank’s benchmark interest rate at the upcoming September 17-18 meeting, with further cuts likely to follow in subsequent meetings.
Source: US Department of Labor
The research adds valuable insights to ongoing debates within the Fed by integrating two critical economic relationships into a single model: the Phillips Curve, which describes the relationship between unemployment and inflation, and the Beveridge Curve, which links the job vacancy rate to unemployment. The paper suggests that when labor markets are loose, policymakers can view supply shocks as having less impact on underlying inflation and appropriate monetary policy. However, when labor markets are tight, as they were during the recent inflation surge, both supply problems and strong labor demand can combine to fuel persistent inflation.
This research also brings caution to a long-standing debate within the Fed regarding the maximum level of employment consistent with the central bank’s 2% inflation target. The answer, according to Benigno and Eggertsson, depends heavily on the balance between labor demand and supply. They argue that the ratio of job openings to unemployed workers is a more critical metric than the unemployment rate itself in assessing labor market tightness and its impact on inflation.
When job openings and the number of unemployed workers are in balance, reducing inflation may require a significant increase in unemployment, similar to the high inflation and unemployment experienced in the 1970s. Conversely, when the labor market is tight, with a high demand for workers relative to their availability, the cost of reducing inflation in terms of increased unemployment is relatively low.
This ratio of job openings to unemployed workers has been a focal point in recent Fed discussions, particularly when it spiked above 2-to-1 during the economic reopening following the COVID-19 pandemic. At that time, firms were posting two job openings for every available worker, signaling an exceptionally tight labor market.
Fed Governor Christopher Waller and staff economist Andrew Figura suggested in 2022 that bringing this ratio closer to balance could lower inflation without significantly increasing unemployment, challenging predictions from other economists that unemployment rates as high as 10% might be necessary to tame the worst inflation in 40 years. Their findings have largely held true, with the ratio now down to 1.2, the Fed’s preferred inflation measure declining to 2.5% from a peak of over 7% in June 2022, and the unemployment rate remaining below 4% until recently.
Despite these positive developments, the current ratio remains above the one-to-one level that the researchers suggest marks the threshold between labor market conditions that generate inflation and those that do not. Historical data since World War One shows that most inflationary periods have been associated with job openings exceeding the number of unemployed workers.
In the years leading up to the pandemic, Fed officials believed they could run the economy “hot” to benefit workers, with little risk of rising prices. However, the new research suggests that this approach carries significant risks, especially as the job openings-to-unemployed ratio continues to decline. If this ratio falls further, the economy may reach a point where unemployment rises rapidly, a concern recently voiced by Waller.
The researchers project that the Fed could achieve its inflation target with a jobless rate of around 4.4%, a figure still below the long-term U.S. average but notably higher than the rates seen in the past two years. However, if the ratio falls below one-to-one, reducing inflation further could become more costly, potentially pushing unemployment above 5% as the number of job openings lags behind the number of people seeking work.
In summary, while the Fed has managed to navigate the post-pandemic economic landscape without triggering a sharp rise in unemployment, the road ahead may be more challenging. Policymakers will need to carefully weigh the risks of delaying rate cuts against the potential consequences of premature action, all while keeping a close eye on the delicate balance between job openings and unemployment.
