The latest monthly US jobs report showed a moderation in employment growth, bolstering hopes that the Federal Reserve can stop raising interest rates. Not so fast, say the monetary policy hawks such as former Treasury Secretary Larry Summers. They point to elevated wage gains as a cause for concern. Specifically, Summers estimates that when combined with trends in productivity, the fatter paychecks indicate an inflation rate of around 3.5%, which is uncomfortably high for the Fed and begs for tighter monetary policy. That estimate sounds overly pessimistic to me.
This may all sound academic, but the debate is central to whether the Fed will be able to achieve a fabled “soft landing” in the economy, getting inflation under control without inflicting broader damage or whether its rate hikes will cause a crushing recession, resulting in millions of workers losing their jobs.
The Summers argument is based on the idea that wage growth is equal to productivity growth plus inflation. So, if wages are expanding at a 5% clip and productivity is increasing at 1.5%, then inflation must end up accelerating at a 3.5% rate. In this world, wage growth would have to slow considerably for inflation to continue to moderate. Otherwise, employers will see their labor costs eat steadily into profits, as they increase pay without enjoying an equivalent increase in productivity. Such an environment can only last for a short while, as businesses will eventually feel the pressure to start raising prices for their goods to make up for increased labor costs.
Such a scenario depends heavily on assumptions about where productivity growth is headed. Using the latest data, wages grew at about 5% on an annualized rate in July, while productivity grew at an estimated rate of 3.7% in the last quarter, which is higher than normal. The difference of 1.3 percentage points is the rate of inflation that should be expected if the trends continue. This aligns with the 1.6% increase in unit labor costs -- the Bureau of Labor Statistic’s estimate for wage-driven inflation -- from the last report on gross domestic product report.
But the Summers camp assumes that the 3.7% productivity growth we saw in the last quarter will soon revert to a rate of below 1.5% that was seen over the past decade. Why? Recall that early in the pandemic productivity soared as hours worked plunged. That only lasted until the first half of 2022, when productivity declined in consecutive quarters. What happened was employers had trouble finding workers as the economy opened, forcing them to pay up for labor that might not have been great matches for the jobs being filled.
So, what to make of the recent gains in productivity? The productivity pessimists erred in predicting that the big mismatch between jobs and the available skilled labor was permanent. Instead, the economy underwent what former Obama administration Chief Economic Advisor Jason Furman called an "immaculate cooling," and employers have refined their understanding of how much they can pay and demand from workers, and what it takes to retain workers.
Which makes the latest productivity gains believable. Indeed, the latest government data show a reduction in job openings along with stable unemployment rates. Even as Summers and his colleagues at the Peterson Institute have pointed out in studies, this could only occur if the ability of employers to recruit suitable workers improved substantially. Indeed, it seems to have done just that, spurring continued productivity gains. And that is why we should all be optimistic that inflationary pressures will continue to recede even without a significant increase in unemployment.
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