A Resolute Fed Looks To Labor Market For Inflation Relief

The June FOMC minutes suggested Fed officials aren’t satisfied that US inflation is on a sustainable path back to target.

Because what else were the minutes going to suggest, right? We’re talking about a policy meeting after which the Fed released a set of projections that conveyed an ostensible preference for two additional rate hikes in 2023.

Notwithstanding weak personal spending figures for May and another contraction-territory ISM manufacturing print (which, it should be noted, included an improvement in new orders), the evidence points to a US economy that’s resilient. Indeed, the Bloomberg US Economic Surprise Index is perched near a two-year high.

I continue to believe the neutral rate is higher. Several Fed officials appear to agree based on the dots. The minutes didn’t include anything revelatory vis-à-vis that discussion, but at some point, if the economy doesn’t cool substantially, policymakers will have to confront the issue head-on.

There’s little utility in parsing the minutes for clues about the July policy gathering. You don’t need the tasseography this time. Barring a big downside miss on the NFP headline and/or an extremely benign CPI report (you’d probably need both), the Fed intends to hike later this month.

The key from there will be the labor market and, more to the point, the extent to which wage growth moderates. That’s all that matters given the link to services sector inflation and the extent to which the services sector is what matters for the overall effort to restore price growth to tolerable levels.

On that score, Goldman continues to see progress. The bank this week lowered its December 2023 core PCE and core CPI forecasts (by two tenths and three tenths, respectively, to 3.5% and 3.9%)  in no small part due to what the bank’s Spencer Hill called “the fruits of labor market rebalancing.” (There’s a joke in there if you look hard enough.)

Goldman uses a jobs-workers gap measure derived from online job postings to complement the JOLTS-derived measure. It (the alternative gauge) shows the gap is now around 2.5 million, considerably lower than the JOLTS-implied gap.

“Either way,” Hill wrote, there’s been “significant progress” toward two million excess jobs. Why is two million important? Well, because that’s the level Goldman believes is “required for wage growth to stabilize at 3.5%-4%, which would in turn allow core inflation to stabilize at 2-2.5% over the medium-term.”

Markets will get an update on job openings Thursday, less than 24 hours ahead of June payrolls.

The ongoing rebalancing shown above has “already helped catalyze a significant decline in wage growth,” Hill went on to say. The bank has its own wage growth tracker (Goldman has a tracker for everything), and it’s down a full percentage point, albeit still far too high for comfort it you’re the Fed.

Average hourly earnings are on the brink of falling into the acceptable range, while a hodgepodge of leading indicators, including advertised wages, “also suggest continued progress,” Hill said.

As ever, the hope is that Fed tightening will manifest in fewer job openings, not layoffs. The fewer openings, the less churn and the less upward pressure on wages. That, in turn, should eventually help bring down inflation.

Unfortunately, it’s not that simple. The job openings side of the equation is complicated by matching efficiency concerns, and the recession crowd continues to doubt the idea that “this time is different,” to use the four most dangerous words in finance and economics. Instead, pessimists worry, the “immaculate disinflation” currently observable in the juxtaposition between a big decline in job openings and still low unemployment, will eventually give way to a sharp rise in the jobless rate. In a worst-case scenario, the unemployment rate rises as firms cut costs and prepare for slower demand, while openings remain elevated due to a structural mismatch between labor supply and demand in some key sectors.

It’s also possible, of course, that the problem “resolves” on its own through a hard landing. If this time really isn’t different, then at some point in the not-so-distant future, the most aggressive rate-hiking campaign in a generation will hit the economy all at once, lending will dry up, spending will crater, the unemployment rate will jump sharply and inflation will fall commensurate with demand destruction. If that happens, expect a lot of “I told you sos.”