Whether policymakers were overly aggressive in response to the Covid-19 pandemic is an ongoing debate, contributing to the untenable inflation environment that is now the No. 1 domestic scourge in the minds of households. This is the flip side of the debate over the response to the 2008 Great Recession, which is now considered to have been overly restrained. While the tamer response then kept inflation in check it took 6 1/2 years to restore the job losses incurred during that downturn and the unemployment rate remained over 5% for six years. In contrast, unemployment has currently remained under 4% for 16 consecutive months and still counting, something not seen since the 1960s, and all the jobs lost during the pandemic were recovered in just over two years.
Achieving the right balance between unemployment and inflation is a long-standing challenge of policymakers. Not only is that inflection point very difficult to identify, but It is also a moving target. In the past, a 5% unemployment rate was viewed as consistent with stable inflation, a rate that would be totally unacceptable now. That said, it is generally accepted that lower unemployment is associated with higher inflation and vice versa. That’s why the Federal Reserve still clings to the notion that wrestling inflation down to its 2% target can only be accomplished by a weaker job market.
In recent comments, Fed Chair Powell and other Fed officials have questioned whether monetary policy is sufficiently tight, despite the aggressive rate hikes over the past 19 months if the job market continues to be as strong as it is. After all, if jobs are plentiful and generating hefty paychecks, workers would be more willing to accept higher prices, and companies would feel empowered to raise them. The Fed needs to short-circuit that link and believes that a softer job market is the only way to accomplish that.
Weakening Signs
To its dismay, however, job growth has picked up in recent months, with employers adding an average of 266 thousand workers a month during the third quarter, including 326 thousand in September, up from 201 thousand in the second quarter. In the eyes of the Fed, this growth in paychecks provides households with more spending power and, perhaps, the ability to withstand further price increases. While policymakers may refrain from hiking rates again, preferring to wait to see how past increases play out, the sustained strength in job growth at least bolsters their announced intention to keep rates “higher for longer.”
Clearly, the resilient job market alongside of robust consumer spending underpins the heightened optimism of economists that a recession can be avoided. We caution, however, that
the surprising strength we have been seeing is based on backward looking data through September, and market interest rates have since risen by another half-percent. Cracks in the economy are beginning to open up. The housing market is being clobbered by mortgage rates approaching 8%, auto loan delinquencies are at record levels, and banks are stiffening lending standards, particularly for consumer loans.
Importantly, some of the data are not as strong as they seem on the surface. While job growth has accelerated, workers are putting in fewer hours, so the growth in weekly earnings fell in September. The surge in net worth may have strengthened balance sheets, but consumers cannot easily spend their housing wealth or liquidate stock holdings without incurring a sizeable tax bill. Hence, they drew heavily on savings to finance spending, and the savings rate is now well below prepandemic levels. Simply put, the financial muscle driving the economy’s growth engine is weakening, and households may soon behave more as they feel. When that happens, the economic community will be far less optimistic that a recession can be avoided.