Powell’s labor market theory turns out to be flawed

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For the past year, Federal Reserve Chair Jerome Powell has floated the idea that the end of the pandemic would push workers off the sidelines, ease upward pressure on wages and ease the forces of inflation. That has proven to be true so far, but Powell needs to let go of the fantasy that the trend has a lot more room to run.

As Friday’s jobs report showed, US adults are simply not returning to the workforce in large numbers. In a sign that things can’t get much better, the US employment rate fell in April for the first time since April 2020, despite a hiring market with nearly two open positions for every unemployed person. The ratio fell to 60% from 60.1% a month earlier, including declines in workers aged 25 to 54, who are believed to be in the “best time” of their working lives.

Even before Friday’s numbers, the notion that a pool of idle labor could somehow solve the massive supply-demand imbalance in the US was beginning to seem like wishful thinking. In March, 80% of the US prime working age population was employed, just below the pre-pandemic peak of 80.5% and above the 10-year pre-pandemic average of 77.5%. It fell to 79.9% last month, but how much better could it get?

The workers-on-the-sidelines thesis increasingly relied on the return of older workers, including members of the baby boom generation, who had good reason to retire while a deadly virus circulated and their investment accounts in the shot up value. Perhaps the endemic Covid-19 and falling stock and bond markets will prompt a rethink on these decisions, but that’s hard to tell in the numbers – and no one should count on such a development to have a significant impact.

However, Powell still cites returning workers as a source of optimism. In his view, there are simply too many vacancies for the available workforce, which drives up wages. The employment cost index — a broad measure of wages and benefits that gives the clearest picture of labor costs — rose at an all-time high in the first quarter. Friday’s report showed that average hourly wages rose 0.3% in April from March, less than economists had expected. (Unlike the ECI, however, this number is vulnerable to changes in the composition of jobs in the labor market. As Renaissance Macro Research pointed out, a decline in retail profits was likely to weigh on the total.)

In Powell’s perfect world, the Fed’s interest rate policy would cause companies to reduce job vacancies (demand); more workers would be created (supply); and he would be able to orchestrate a “soft landing” for the economy, as he put it on Wednesday:

We think through our policies, through further healing in the labor market, higher rates, for example for hiring and things like that, and more people coming back, we’d like to think that supply and demand are getting back into balance. And that therefore wage inflation will moderate wage increases to levels that are still high but more consistent with 2% inflation.

This is a remarkably difficult needle to thread, and Powell will need a lot of luck to carry it.

If there was any silver lining in Friday’s jobs numbers, the black employment rate — one of the sharpest falls since the pandemic — rebounded to 58.6% from 58.3%. This clearly shows room for improvement and gives hope for an offer on the labor market.

But the central bank should not rely on a significant increase in additional labor force participation to slow the pace of wage increases and prevent a wage-price spiral. It is essentially a prayer and should not form the basis of a political framework. The Fed faces an extraordinarily difficult path to raising rates without raising unemployment and throwing the economy into recession, and it might be time to stop doing something else.

More from authors at Bloomberg Opinion:

• Powell hampers the Fed with an unforced error: Levin & Burgess

• Don’t Expect the Federal Reserve to Work Miracles: Editorial

• The Fed must do more than raise interest rates: Mohamed El-Erian

This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the US, covering finance, markets and M&A. Most recently, he was the company’s Miami office manager. He is a CFA charterholder.

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