Brace yourself, America: The Fed plans to drive up unemployment sharply

In case the US economy wasn’t hurt enough already, the Federal Reserve has a message for Americans: It’s going to get a lot more painful.

Fed Chair Jerome Powell made that abundantly clear this week when the central bank forecast its benchmark interest rate to hit 4.4% by the end of the year — even if it sparked a recession.

“There will most likely be some easing in labor market conditions,” Powell said on Wednesday. “We will continue until we are sure the job is done.”

In plain Dutch that means unemployment. The Fed predicts the unemployment rate will rise to 4.4% next year, from 3.7% today — a number that implies an additional 1.2 million people will lose their jobs.

“I wish there was a painless way to do that,” Powell said. “There isn’t.”

Did you hurt so much?

This is the idea why boosting unemployment in the country could cool inflation. With an additional million or two people out of work, the newly unemployed and their families would cut spending sharply, while for most people still in work, wage growth would flatten. When companies assume that their labor costs are unlikely to rise, they will stop raising prices, according to the theory. This, in turn, slows down the price increase.

But some economists question whether the labor market crash is necessary to bring inflation up to par.

“The Fed clearly wants the labor market to weaken quite a lot. What’s not clear to us is why,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a report. He predicted that inflation will “plunge” next year as supply chains normalize.

The Fed fears a so-called wage-price spiral, in which workers demand higher wages to stay ahead of inflation and companies pass higher wage costs on to consumers. But experts disagree that wages are the main driver of today’s red-hot inflation. While workers’ wages have increased by an average of 5.5% over the past year, this has been overshadowed by even higher price increases. At least half of current inflation is due to supply chain problems, former Fed economist Claudia Sahm noted in a tweet.

Much of US inflation (chart) and a very large proportion of German inflation is due to supply-side factors. With enough demand destruction, central banks can now lower inflation, but only temporarily and with great pain. Why do it?

— Claudia Sahm (@Claudia_Sahm) September 22, 2022

Sahm noted that lower-wage workers today have both benefited the most from wage increases and have been most affected by inflation — inflation caused by higher spending by wealthy households rather than those lower down the ladder.

Rising rates, falling jobs

While the exact relationship between wages and inflation is still up for debate, economists are much clearer about how raising interest rates makes people unemployed.

When rates rise, “every consumer item people go into debt to buy — whether that be cars or washing machines — becomes more expensive,” said Josh Bivens, research director at the Economic Policy Institute.

That means less work for the people who make those cars and washing machines, and ultimately layoffs. Other parts of the economy that are sensitive to interest rates, such as construction, home sales and mortgage refinancing, are also slowing, impacting employment in that sector.

In addition, people travel less, which means that hotels need less staff to accommodate a lower occupancy rate. Companies that want to expand, for example a coffee shop chain opening a new branch, are more hesitant to do so if the borrowing costs are high. And as people spend less on travel, dining out and entertainment, those hoteliers and restaurateurs will have to serve fewer customers and ultimately cut back on staff.

“In the service economy, labor is the largest part of your cost structure, so if you’re looking to cut costs, look there first,” said Peter Boockvar, chief investment officer at the Bleakley Financial Group.

While Boockvar says higher rates are needed, the Fed’s tactics come across as aggressive. “I just have a problem with the [Fed’s] speed and scale,” he said. “They’re coming up so fast and strong, I’m just afraid the economy and the markets can’t handle it.”

Potential Fed rate hike fuels fears of economic downturn

In the meantime, the Fed’s existing rate hikes have caused about 800,000 job losses, according to forecasts by Oxford Economics.

“Looking at 2023, we see almost no net hires in the first quarter and job losses of more than 800,000 or 900,000 in the second and third quarters combined,” said Nancy Vanden Houten, Oxford’s chief US economist.

Others predict an even tougher landing, with Bank of America forecasting a peak unemployment rate of 5.6% next year. That would make an additional 3.2 million people unemployed above current levels.

Some policymakers and economists have cited the Fed’s aggressive rate hike plans, with Senator Elizabeth Warren saying they would “throw millions of Americans out of work” and Sahm calling them “unforgivable, verging on dangerous.”

.@federalreserve chairman Powell just announced another extreme rate hike while forecasting higher unemployment.

I warned that Chairman Powell’s Fed would put millions of Americans out of work — and I fear he is already on his way to doing so.

— Elizabeth Warren (@SenWarren) September 21, 2022

Powell promised pain, and many wonder how much pain is needed.

“Inflation will come down a lot faster if we actually get into a recession. But the cost of that will be much higher,” Bivens said.

The danger, he added, is that the Fed has run a runaway train. Once unemployment starts to rise sharply, it is difficult to stop it. Rather than neatly stopping at the 4.4% rate projected by Fed officials, the unemployment rate could easily continue to rise.

“This idea that there is an inflation pointer that the Fed can just hold really hard and leave everything else untouched is a misconception,” Bivens said.

Instead of the soft landing for the economy that the Fed says it is aiming for, Bivens added, “we are now pointing the plane pretty hard on the ground and hitting the accelerator.”

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