Lower Inflation Likely Requires Higher Unemployment; How High Is the Question

The Wall Street Journal – How much pain will U.S. workers need to endure if inflation is to return to 2%?

Not much, say most economists. Unemployment is expected to plateau near 4.3% at the end of next year, up from 3.6% in June, according to The Wall Street Journal’s latest survey of economists.

A great deal, according to other economists, who say unemployment might need to rise as high as 10%, implying a deep recession and much higher interest rates from the Federal Reserve.

The answer hinges on how recent economic shocks, from the Covid-19 pandemic to the war in Ukraine, have altered how people think about inflation, and how low unemployment can go without generating persistent inflation overshoots. For the pessimists, a return to the prepandemic U.S. labor market, with 2% inflation and unemployment of about 4% or less, isn’t possible for now.

One point where economists mostly agree: Inflation won’t stay at the 9.1% it reached in June. It will probably fall significantly over the next year or so without the Fed having to do anything, as recent large increases in energy and commodity prices drop out of future readings and supply disruptions that have driven up some prices, such as for cars, resolve.

After that, inflation might be running at about 4.5% or 5%, or as low as 2.5%, according to various measures of underlying inflation. Matt Luzzetti of Deutsche Bank combines a variety of approaches and concludes that trend inflation is 3.3%.

To get it to 2%, the Fed will need to cool the labor market and lower wage growth, currently running around 5% to 7% a year, according to data from the Labor Department and the Federal Reserve Bank of Atlanta.

That effort starts by reducing the number of job vacancies, which are currently historically high relative to unemployed workers. As the economy cools, companies will have less new business and start to withdraw job postings.

As the number of job openings declines, unemployment tends to rise. If fewer firms are looking for workers, that means fewer hires (and less wage growth). The relationship between job openings and unemployment is expressed by the downward-sloping Beveridge curve, named for the British economist William Beveridge.

This time may be different, say some economists and Fed officials, including Chairman Jerome Powell, who told reporters on Wednesday that the number of job openings could fall significantly without a big rise in unemployment.

In a paper published Friday, Fed governor Christopher Waller used the Beveridge curve to argue that unemployment might increase by only 1 percentage point or less, even with a large decline in the vacancy rate.

Vacancies are currently so high relative to available workers, the paper argued, that new job openings generate fewer and fewer hires. That means a given decline in vacancies will have a smaller effect on unemployment than in a normal labor market.

But other economists say that such a free lunch is unlikely.

Since the 1950s, every time the vacancy rate came down from a quarterly peak, it was accompanied by a significant rise in unemployment, according to a recent paper by former Treasury Secretary Lawrence Summers and former International Monetary Fund chief economist Olivier Blanchard.

For example, during the 2008 global financial crisis, the unemployment rate increased by as much as 3.8 percentage points. Since the 1950s, on average, the unemployment rate rose by 2.1 percentage points during the two years following a vacancy rate peak.

Moreover, the post-Covid economy may be less efficient at matching job seekers to job openings. That suggests a higher rate of unemployment might be needed, for a given number of vacancies, to stabilize wages and prices—a measure known as the natural rate of unemployment.

During the pandemic, jobs shifted geographically, especially out of city centers, putting them out of reach of some workers. Certain skills became more important, such as computer programming, while others were less in demand. The Fed can’t do anything to fix such mismatches between workers and jobs.

Fed officials “rely on labor market efficiency somehow going back to where it was before the pandemic,” said Stephen Cecchetti, a finance professor at Brandeis International Business School. “You can’t rule it out, but it seems unlikely and it’s not like something we’ve seen before.”

Mr. Powell said Wednesday that the natural unemployment rate may have risen “materially,” at least temporarily, although he didn’t put a number on it. Since before the pandemic, Fed officials have put the long-run unemployment rate—similar to the natural rate—at around 4%.

Raising unemployment to this new, higher natural rate might not be enough to control inflation, either. If today’s high inflation rates have become deeply ingrained in the thinking of households and businesses, as they did during the 1970s, it will take much higher unemployment, and a punishing recession, to wring it out.

How much higher? One concept used by economists is known as the sacrifice ratio, which measures how much unemployment needs to increase to cause inflation to fall by 1 percentage point.

Mr. Summers estimates that the sacrifice ratio is two, meaning it would take one year of unemployment running 2 percentage points above its natural rate for inflation to decline by 1 percentage point, according to a June speech at the London School of Economics. He estimates that the natural unemployment rate is 5%, and that inflation needs to decline by about 2.5 percentage points to reach 2%.

Taken together, that means “we need two years of 7.5% unemployment, or five years of 6% unemployment, or…one year of 10% unemployment,” Mr. Summers said.

To be sure, American households and investors don’t seem to expect a return to the 1970s, yet. A July survey by the University of Michigan found that consumers expected prices to rise at an annual rate of 2.9% over the next five years, little changed from before the pandemic.

Still, some economists are wary of relying on measures of expected inflation. Businesses set wages and prices based mainly on what they see in the economy, such as rising costs and competition, rather than on general inflation, said Mr. Cecchetti.

He thinks the Fed will probably need to increase its policy rate above 4.5%, and push unemployment to between 5.5% and 6%, to control inflation.