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Fed's New Forecasts May Hinge on Higher Productivity – But Is Higher Unemployment More Likely?
Last week, the Federal Reserve left their policy rate range unchanged at 5.25%–5.5%, while signaling another hike is possible later this year. This was widely expected and unremarkable. What caught our attention were the changes in the Fed's economic projections. The Fed now expects core U.S. inflation to cool from an estimated 3.7% at year-end 2023 to 2.6% at year-end 2024 while the unemployment rate rises to 4.1%. This is only 0.1 percentage points (ppts) over the 4% long-run unemployment projection of 4%, the Fed's traditional estimate for the neutral rate of unemployment. Similarly, real U.S. GDP growth is projected at 1.5% in 2024, only slightly below the Fed's estimated long-run trend of 1.8%. We are concerned these forecasts may rely too heavily on supply-side dynamics in taming inflation.
Unconventional forecasts
The Fed's new forecasts fly in the face of conventional wisdom about economic relationships. Conventional macroeconomic modeling suggests that in order to moderate inflation, a central bank must tighten financial conditions enough to bring real GDP growth below its potential level and raise the unemployment rate above its neutral level. The central bank's efforts to moderate demand, in turn, reduce inflation back to target over time.
The Fed's large-scale macroeconomic model (FRB/US) suggests that a fed funds rate of around 5%–5.5% is restrictive enough to reduce real GDP growth to 1% on average in the 2 years after rates increase (versus the 2% trend) and to lift the unemployment rate by roughly 1 ppt – both of which would serve to moderate inflation back toward the Fed's 2% target. This is more or less what Fed officials expected in their previous projections from June 2023.
By contrast, the median path in the new Fed forecasts suggest that inflation will moderate by more than 1.5 ppts with only very slightly below-trend growth and a limited rise in the unemployment rate. To us, these forecasts only make sense under the assumption that positive supply-side gains will moderate inflation. Such gains could take the form of higher productivity, for example, which would increase the amount of output firms achieve from their labor, or perhaps an increase in labor supply would cool wage inflation. Indeed, Fed Chair Jerome Powell noted in the press conference the possibility that supply-side labor market improvements could help bring the labor market into better balance – implying that an increase in labor supply while labor demand remains strong (as indicated by a 4.1% median unemployment rate forecast) is enough to help inflation moderate.
The assumption that supply-side improvements are key to a soft landing fits with the lessons from historical hiking cycles that we laid out a few weeks ago (see our 6 September 2023 edition of Macro Signposts). Analyzing more than 140 rate-hiking cycles, we found that economic soft landings occurred only 25% of the time but when they did occur, they almost always coincided with some sort of supply expansion: productivity boom, international trade expansion, OPEC oil production acceleration, etc. (In this analysis, a soft landing is defined as an economic expansion that continues for more than 4 years after the start of a hiking cycle.)
Impact of the pandemic
The COVID-19 pandemic was an unprecedented economic disrupter in the way it affected both supply and demand. It's possible that underlying the Fed's forecasts is an increase in its confidence that the normalization in supply will be enough to bring inflation back to target. While it is possible – and we hope it is right – we see good reasons not to be so sure.
Both product and labor market supply were disrupted during the pandemic. And, to be sure, market snags – such as port congestion and severe pandemic-related restrictions in China, both of which impacted trade, backlogs, and availability of product inputs – appear to have normalized. However, two pandemic-related labor market developments may take longer to dissipate.
First, the demographic makeup of the U.S. labor force has changed. While the labor force participation rate is back to 2018 levels, the pandemic created a large retirement wave for those 55 and older, one that doesn't appear to be subsiding. Indeed, labor force participation for this older demographic dropped almost 2 ppts during the pandemic and has hardly recovered – all the improvement has come from the age 24–55 category. This demographic change is important because older Americans tend to switch jobs less frequently, so their natural rate of unemployment is less than their more youthful colleagues'. They also may have different skills than younger cohorts, creating a skills mismatch. Consistent with this, indexes measuring the labor supply and demand mismatch by industry and skill remain elevated.
The second post-pandemic development is the shifting geographical dispersion of labor demand versus labor supply. In particular, the ability of many high-skilled service sector employees to work remotely likely changed the geographical makeup of demand from city centers to suburban or even rural areas. Micro credit data from Equifax suggest a significant portion of people moved from high population density ZIP codes to less-congested ones – and those flows haven't reversed. This likely shifts the geography of demand for restaurants, bars, retail, etc., to areas where labor supply has been slower to normalize. Indexes quantifying the mismatch between labor supply and demand suggest that regional mismatch is also still elevated.
Related to this is the elevated percentage of U.S. households that locked in low coupon fixed-rate mortgages after the pandemic. Today's much higher mortgage rates makes it more costly for them to move for work – another factor underpinning the regional labor market mismatch.
Implications for inflation and wage growth
Why does all of this matter? Since the onset of the pandemic, price levels have risen dramatically due to fiscal stimulus and capacity constraints. Aggregate wage levels have also increased, but there is still a sizable gap among the cumulative changes in each income level, which has produced an equally sizable cumulative decline in real wages. As a result, workers will likely continue to bargain hard for real wage "catch-up" while labor markets are tight, and this can produce an extended period in which wage inflation exceeds levels consistent with the Fed's 2% target for overall inflation.
Much uncertainty remains around the precise level of unemployment needed to moderate wage inflation. However, it's possible that persistent post-pandemic labor market changes may have increased the natural rate of unemployment. If this is the case, one of two things is needed to fully restore 2% inflation: higher unemployment or a productivity acceleration that lifts real wages. We believe the Fed's new forecasts hinge on the latter, but we are worried it might actually take the former.
This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out, please email [email protected].
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