There are any number of ways to dissect the spread between the 7% job openings rate and 3.5% unemployment, but the needed drop in demand’s contribution to current inflation occurs when this spread turns negative. Inflation will lessen should supply chains ever “normalize”, but normalization alone will not return inflation to 2% -- despite the FOMC’s hope that it will. Remember that goods and energy prices ratcheting downwards revives consumer purchasing power still buoyed by low unemployment, high nominal wage growth, and high savings. On the other hand, and there is always at least two, normalized supply chains could, by itself, reduce demand for labour skills that are in short supply in the US if it means reduced frictions to source global labour and capital – including the return of immigrant labour. Nevertheless, no matter how many hands one throws up, there is no shortcut to reducing inflation in the short-term other than an extended period of labour market slack.
Quantifying the needed slack is another matter. The case can be made that the noninflationary rate of unemployment has shifted higher due to the greater mismatch between job skills needed and those that are available for hire. Based on past dynamics between the job openings rate and the unemployment rate, a 5.5%-6.0% unemployment rate over an extended period is needed to reduce inflation to target. Interestingly, my favourite forward indicator of unemployment, the HMI (housing market index, survey of new homebuilders) forecasts 5.5% in around 18 months.
For whatever reason, the HMI has an excellent track record of forecasting the unemployment rate 18 months. It has guided me to the right unemployment mark through several cycles (Chart 1), including the most recent. There is no reason to believe its prescient powers have evaporated. A simple regression forecasts a 5.5% unemployment rate by the end of next year. Odds are this level is broached sooner than that.
This, in sum, leads to the bigger question – will the Fed drive the real funds rate high enough and keep it there long enough to sustain sufficient labour slack to in turn, reduce wage growth. My answer is no, given how quickly the Fed pulled the market back from expecting a 100bp rate increase after the June CPI was reported. The tenor of their comments suggests that the “soft landing” outcome still predominates Fed thinking, they are drunk on their own Kool-Aid. The notion that inflation magically falls back to 2% without disrupting labour markets is a fairy tale whose belief, when exercised in policy, translates into inflation during the recovery that follows the coming recession that will be higher than what the economy experienced in the 2010-19 expansion. This is not a policy bias that ends well.