Very rarely should you celebrate rising unemployment. This is one of those times.
Friday’s news that the unemployment rate rose to 3.8% in August, an 18-month high, is one of several recent signs that the labor market has softened significantly. This is a necessary stage in the Federal Reserve’s campaign to bring inflation back down to 2% and keep it there. It isn’t enough to ensure we avoid a recession, but it helps.
Why does the labor market matter so much? After all, inflation has already fallen without it weakening.
The answer comes down to the difference between headline and underlying inflation. Headline inflation—the published increase in prices—shot from under 2% in early 2021 to 9.1% in June 2022 because of snarled supply chains; stimulus- and lockdown-fueled goods purchases; and rising oil prices following Russia’s invasion of Ukraine. It then fell below 4% this year thanks to falling oil prices and airfares, slowing rent increases, and cheaper health insurance.
The question is: Where is underlying inflation (i.e., the rate that prevails once all these idiosyncratic influences wash out)? This depends heavily on the balance between total supply and demand, of which the labor market is the best barometer. Simply put, even if inflation falls to 2%, it won’t stay there if the labor market is so tight that wages rise faster than is compatible with inflation of 2%.
To be sure, August’s rise in unemployment is just one month’s data, and some economists played it down because it reflected a summer surge of people joining the labor force.
Normally I’m all for such nuance, but this time I think the simplest explanation is the right one. Indeed, the beauty of the unemployment rate is its simplicity: a single number that tells us if the economy is running out of slack (that is, inflation pressure is building), or gaining slack (inflation pressure is dissipating).
Averaged over three months, unemployment has been gradually rising since April. This trend corroborates other signs of a loosening labor market, such as the sharp drop in job vacancies in both government and private surveys.
It’s true that job growth doesn’t seem to support the softening story. Payrolls rose 187,000 in August, roughly double what population growth would generate in a steady-state economy. It would have been higher but for a trucking company bankruptcy and Hollywood strikes.
But this data has to be adjusted for the lingering influence of the pandemic. Steven Blitz, chief U.S. economist at TS Lombard, categorizes retail, accommodation and food services, and healthcare and social services as “backfilling” sectors: They were most affected by the original lockdowns and are still hiring to return to normal staffing levels. They account for roughly a third of total employment, but nearly 70% of private hiring in the past three months.
You need to exclude backfilling sectors to get underlying private job gains; just 52,000 in August and averaging 24,000 a month over the past three months, down sharply from 113,000 in May. That “has all the look of a pre-recessionary trend,” Blitz writes.
The public has noticed. Since April, the share of consumers saying jobs are hard to get has ticked up notably while the share saying jobs are plentiful has ticked down, according to the Conference Board.
The labor market’s picture of increased slack, however, is contradicted by economic output. Gross domestic product grew a robust 2.1% annualized in the second quarter, and surging consumer spending has put it on track to top 3% in the third. These rates are well above the economy’s estimated 1.8% long-term potential growth rate and suggest intensifying inflation pressure.
But unlike unemployment, GDP shouldn’t be taken at face value. Indeed, it can be measured in two ways. Adding up spending by government, consumers, businesses and foreigners on goods and services produces the familiar measure of GDP. Adding up the wages, benefits, profits, interest, and rents earned from producing these goods and services yields the lesser-known gross domestic income. Adjusted for inflation, GDP has risen 2.5% in the 12 months through June, while GDI has fallen 0.5%, an unusually wide discrepancy.
Some of that gap might be due to falling Fed profits. Still, Nancy Lazar, chief global economist at Piper Sandler, said GDI lines up with many companies that are reporting stagnant sales volumes.
One way of handling the discrepancy is to split the difference. The average of GDP and GDI is up 1% in the past year, consistent with more slack in the economy but not a recession. Moreover, recent downward revisions to payroll employment and incomes suggest growth might be overstated.
So the labor, output and corporate data as a whole shows that slack in the economy is returning, a necessary condition of getting inflation down. Whether this remains a soft landing—inflation falling to 2% without a recession—depends on two things.
First, will inflation keep sliding toward 2%? If instead, it stalls out between 3% and 4%, the Fed will have to raise interest rates further, eventually inducing a recession.
Though wages aren’t directly driving inflation, they’re a pretty good indicator of underlying inflation because they represent the collective judgment of millions of workers and employers on prices, productivity, and the economy. A composite measure of annual wage growth compiled by
Second, every recession starts out looking like a soft landing. August’s moderate increase in unemployment was welcome. The risk is that plenty more are in store, which won’t be cause for celebration.