Why the Fed is reading US labour market wrong

The Fed raised interest rates sharply, by 75 basis points, in both June and July, but Powell made it clear that rate hikes are unlikely to stop there or even taper off. Instead, he said, “unusually large” rate increases will continue for the foreseeable future. The next hikes will hurt US households and businesses, but “failing to restore price stability would mean a lot more pain.”

Powell’s aggressive comments caused the S&P 500 to fall 3.4%, with all sectors of the stock index lower. Many fear that if the Fed continues to raise interest rates in large increments, as Powell suggested, investment will plummet and unemployment will rise. Indeed, aggressive monetary tightening would cause undue hardship on the economy, financial markets and people’s well-being. Like a steroid overdose, it can cure disease, but at a disproportionately high cost.

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The Fed’s error reflects a misreading of the US labor market, which Powell said “is particularly strong.” And it’s true that US wages have risen sharply. they are rising faster than the prices of many goods.

But it is a mistake to equate the current strong wage increases in the US with inflation. That’s because the covid pandemic has provided an intriguing twist to a standard economic argument in the form of the ‘Great Renunciation’. This strange phenomenon, whereby many Americans who left the labor market during the pandemic due to school and workplace closures do not return even as the pandemic subsides, has revealed a balance in the labor market that was previously hidden from view. . It is like a seamount that becomes a visible island only when the water level recedes.

Consider a typical American family, with two adults and a few children. When hourly wages are very low, both adults may need to work full time to earn enough to meet basic household needs. But if the hourly wage were substantially higher, adults would choose to work fewer hours so they could take turns at home to better serve their children’s needs. Alternatively, an adult could stay home entirely or do some light work.

Suppose the economy settles in the old low-wage equilibrium, with both parents working full time. Because all households do the same thing, there is a large supply of labor on the market. That keeps the hourly wage low, which in turn means both parents must continue to work full time. The balance persists.

Now let’s say there’s a big pandemic and kids can’t go to school. Even in low-income households, at least one adult must stay home to care for young children.

Later, as the pandemic subsides and children return to school, there will likely be a delay in adults returning to in-person work.

As creatures of habit, many people get used to working from home, or simply not working at all. So as the markets start to return to normal, there is a labor shortage and wages tend to rise.

Eventually, even after these habits resume during the pandemic abatement, the economy may end up in the other higher-wage equilibrium that has always lain dormant. Once this new equilibrium is reached, even if wages are high, the country’s labor market will be tight, without excess jobseekers, and will stay there.

Many have noted that relatively few Americans apply for unemployment benefits these days. This would be a surprise if the labor market were unbalanced, with many people looking for work. Clearly that is not the case. The US economy has simply shifted to a higher wage equilibrium, thanks to the pandemic-induced jolt to the labor market.

Part of the increase in US wages reflects this adjustment. Ignoring this and viewing current wage increases solely as a result of inflation can lead to political overreaction. That is the mistake the Fed will make if it persists in raising interest rates sharply.

My argument is certainly theoretical, but it can be easily evaluated. The US central bank has enough data and experience to calculate how much of the wage movement is simply a shift to the new equilibrium and how much is part of general inflation.

My hunch is that once the US Federal Reserve completes this exercise, it will want to moderate its policy response to current inflation. A less aggressive stance would minimize the adverse side effects of the Fed’s medicine and would greatly benefit America’s small and large businesses, as well as workers and the financial markets, and achieve the same results when it comes to reining in inflation.

Since US monetary policy has a much larger effect on other countries than vice versa, this could also be a huge relief for the global economy. ©2022/projectsyndicate

Kaushik Basu is a professor of economics at Cornell University and a former chief economist at the World Bank.

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