Over the last few months, the Federal Reserve (Fed) has changed its angle of attack quite dramatically, in an attempt to battle surprisingly and stubbornly high inflation. There is nothing wrong with this – pilots often do it due to unforeseen circumstances, be it inclement weather or crowded skies. However, forcing a plane into a nosedive to create a more immediate path to the runway could risk life and limb, while trying to move the runway itself would, of course, be futile. Instead, simply allowing the pilot’s skill with the instruments in the cockpit to guide a plane back to the right trajectory is much more likely to engineer a desired soft landing, even if it results in a 20- or 30-minute delay.
So, what are the economic indicators telling the Fed today, and can it engineer a soft landing? Inflation data has suggested that the Fed’s policy trajectory was far too shallow earlier this year. While data in August might seem to reinforce this by its ubiquitous strength, the Fed has already made substantial corrections to the trajectory of interest rates, with the policy rate now above most estimates of “neutral,” with more tightening to come. While August’s 8.3% inflation is much too high, suggesting that there is work still to be done, the Fed can exhale slightly knowing that July’s print was the first miss in 18 months, and that June’s peak is unlikely to be exceeded in the foreseeable future. The challenge will be to continue making progress on the inflation front without sending the labor market into a nosedive.
There is much to appreciate in recent employment reports: while the strongest labor market in decades has, rightly, been identified as one of the causes of inflation, it also means that it can withstand an unusually stern degree of policy tightening without crashing. And one of the reasons not to deliberately crash the labor market is the equitable distribution of income that has accompanied this rude health. The bottom half of earners have seen real incomes grow faster than the top 10%, an unusual pattern that should be nurtured, not nixed (see Figure 1).
Figure 1: Real incomes at the bottom are growing faster than at the top
Source: Realtimeinequity.org, data as of March 31, 2022
Preserving the current state of the labor market may not be as difficult as it appears. The U.S. economy is an adaptive and flexible one, and over time, has shown an ability to dynamically reallocate resources (labor and capital) to where they are needed. This happened in the early stages of the pandemic, as the services component of GDP detracted from growth, while goods gained ground (see Figure 2). Today that trend is being reversed, both in terms of output and its impact on the labor market. We often view net job gains of 300K a month as a strong number, but the reality under the surface is staggering – a full 30% of all unemployed people find a job each month, and over 6 million people churn through from one job to the next…every month.