US economists said unemployment would spike. Why they were wrong.
Last year’s inflation spike, to the highest level in four decades, was painful enough for American households. Still, the cure — a much higher interest rate, to cool spending and hiring — was expected to cause even more pain.
Grim forecasts from economists had predicted that as the Federal Reserve would push interest rates higher and higher, consumers and businesses would rein in spending, companies would shed jobs and unemployment would rise as high as 7% or more – twice what it was when the Fed started . tighten credit.
But so far, to widespread relief, the reality is anything but: as interest rates have risen sharply, inflation has fallen from a peak of 9.1% in June 2022 to 3.7%. Yet the unemployment rate, at a still low 3.8%, has barely risen since March 2022, when the Fed began imposing a series of 11 rate hikes at the fastest pace in decades.
If such trends continue, the central bank could achieve a rare and difficult “soft landing”: curbing inflation without triggering a deep recession. Such an outcome would be very different from the last time inflation peaked, in the 1970s and early 1980s. Then-Fed Chairman Paul Volcker attacked inflation by raising the central bank’s key short-term interest rate above 19%. The result? Unemployment shot to 10.8%, at the time the highest level since World War II.
A year ago, Chairman Jerome Powell warned in a high-profile speech that the Fed was prepared to be just as aggressive, saying its rate hikes would cause “some pain” in the form of higher unemployment. The Fed, Mr. Powell said emphatically, would “keep at it,” a play on the title of Volcker’s autobiography, “Keeping At It.”
Over time, as the labor market has shown surprising resilience, Mr. Powell has adopted a friendlier tone. At a news conference last week, he suggested a soft landing remains a “possible,” if not guaranteed, outcome.
“That’s really what we saw,” he said. “Progress without higher unemployment, for now.”
How have the Fed’s rate hikes managed to substantially slow inflation without also having serious consequences? And can the labor market and economy maintain their sustainability even as the Fed plans to keep interest rates at a peak well into 2024?
Here are some reasons for the economy’s unexpected resilience and a look at whether it can hold up:
The replenished inventories have helped cool inflation
The idea that beating high inflation would require sharply higher unemployment is based on an old economic model that may prove ill-suited to the post-pandemic period.
Claudia Sahm, a former Fed economist, suggested that those who assumed that rising unemployment was a necessary price to overcome inflation believed that the price spikes of the past two and a half years were caused mainly by overheated demand. Locked-down consumers have increased their spending on patio furniture, exercise bikes and home office equipment as stimulus checks hit their bank accounts.
But to curb demand-fueled inflation, the Fed’s policies would have had to cut spending, which would have reduced sales and forced companies to cut jobs. Still, inflation has cooled, even as Americans as a whole have continued to spend freely on shopping, travel and entertainment.
“The fact that the economy is recovering without unemployment rising, without consumption slowing much — that suggests the driving force behind all this was something else,” said Alan Detmeister, a former Fed economist now at UBS .
Mr. Detmeister and other economists increasingly believe that supply disruptions caused by the pandemic and Russia’s invasion of Ukraine have played the biggest role in accelerating inflation. While spending on goods soared, spending on services fell, leaving overall demand roughly in line with pre-pandemic trends.
This inflation episode, Mr. Detmeister said, could ultimately become more like the post-World War II episode than the late 1970s and early 1980s. After World War II, manufacturing output slowed as factories had to restructure from wartime production. At the same time, many returning service members moved to the suburbs, and demand for homes, appliances and furniture increased. However, inflation declined as soon as production resumed.
In a recent study, Mike Konczal, director of the Roosevelt Institute think tank, found that the prices of nearly three-quarters of goods and services have fallen as quantities have increased. This suggested to him that rising supply has been the main reason why inflation has fallen. (The figures exclude volatile food and gas prices to reflect underlying trends.)
It is unclear how long this trend can continue to contribute to slowing inflation. Susan Collins, president of the Federal Reserve Bank of Boston, said Friday that the recovery in supply has indeed eased inflation in goods. But the costs of most services, she said, “have yet to show the sustained improvement” needed to bring inflation back to the Fed’s 2% target.
Mr Konczal remains optimistic. Inflation is slowing in many service categories, including restaurants, laundry services and veterinary care, even without a major drop in demand.
“The disinflation we see,” he wrote in his research, “is therefore broad-based and could continue.”
The labor market has changed
There has been another improvement in supply on the labor market: the labor supply. Since the Fed started raising rates last year, about 3.4 million people have started looking for work. One of the key factors was the uptick in immigration, which followed the easing of pandemic-era restrictions.
And more and more job seekers are still coming from the sidelines. The share of adults in their prime working years (25 to 54 years) who have a job or are looking for one has reached a twenty-year high.
At the same time, companies seem to need fewer employees. But instead of cutting jobs, they are looking to hire fewer new workers. The number of open jobs fell from more than 12 million last year to 8.8 million in July, although it is still well above pre-pandemic levels. And fewer people are quitting their jobs in search of higher wages elsewhere.
Mr Powell noted last week that fewer vacancies and more workers mean the labor market is better balanced. This has taken the pressure off companies to raise wages to find and retain workers. But now that inflation has subsided, hourly wages are growing faster than prices.
Even among companies concerned about the economic outlook, many are more reluctant to cut jobs than in the past. Jay Starkman, CEO of Engage PEO, which provides HR services to small businesses, said many employers are “hanging” on rapid layoffs and then rapid rehiring during and after the 2020 pandemic recession.
“Employers these days say, ‘Well, my company is in a bit of a bad position. I can bear to keep these employees for now. I really don’t want to have to find and train good employees again.’”
Consumers and businesses have moved on
Another reason why high interest rates have not caused unemployment to rise is that many households and businesses were better protected against interest rate increases than in the past.
Americans as a whole have saved a significant portion of the thousands of dollars in stimulus checks and enhanced unemployment benefits they received during the pandemic. These savings have helped boost consumer spending well into this year.
Fed officials are watching to see how long these cuts will continue to boost spending. Americans are running up more and more credit card debt, a sign that their savings are running low. Bank of America has said that credit card balances for its upper- and middle-income customers are still below pre-pandemic levels, but have grown sharply for lower income groups.
Businesses, especially large corporations, also took advantage of lower interest rates in 2020 and 2021 to refinance debt, locking in lower payments. As a result, interest rate increases have not necessarily increased borrowing costs. According to a report from the Boston branch of the Federal Reserve, many of those loans will eventually have to be refinanced at higher interest rates. Profit growth could then suffer and companies could lay off employees.
For now, some companies are also benefiting from government subsidies in legislation pushed by the Biden administration, including measures to boost investment in infrastructure, renewable energy and semiconductor manufacturing. In response, spending on new factories has increased.
“We have had a supply-side rebound, partly driven by public investment,” said Daleep Singh, chief economist at PGIM Fixed Income and a former top economic official in the government.
Last week, Fed policymakers revised their economic projections to show that core inflation — excluding volatile food and energy — will reach 2.6% at the end of next year, up from 4.2% now, according to the Fed’s preferred benchmark. At the same time, they expect unemployment to rise to just 4.1% – lower than their June forecast of 4.5% for 2024.
“If we actually get an outcome like that… without a recession, that’s a very good outcome given the size of the shock,” said William English, a former senior Fed official who is now a professor at the Yale School of Management .
This story was reported by the Associated Press.