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Analysis | Unemployment Heads in the Wrong Direction for the Fed

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The tight labor market probably didn’t get the US into this inflationary mess, but it is part of the reason that it’s going to be so hard to get out of it.

A report Friday showed nonfarm payrolls jumped 528,000 in July, bringing the unemployment rate to just 3.5%, matching the lowest level since 1969. Where the household and establishment surveys had sent mixed signals in previous months, the latest data showed unambiguously that the labor market remained red hot in July. Average hourly earnings rose 0.5% last month from a month earlier, pushing the year-over-year rate to 5.2%.

Of course, good news is bad news in these financial markets, and everything turned back to what it meant for a Federal Reserve intent on breaking the back of the worst inflation in 40 years.

Those remarkable numbers struck fear into the hearts of traders, who instinctively know that they will embolden the Fed to raise interest rates even higher, with two-year Treasury yields surging 20 basis points on the day, seemingly en route back to their June highs. Traders are right, of course, because the brisk pace of wage increases that’s come from the tight labor market is simply inconsistent with the Fed’s goal of stable prices. Companies can’t stop raising the prices of goods and services while they’re handing out raises at this pace. Fed Chair Jerome Powell is likely to see the latest report as a green light to stay aggressive with his interest-rate increases, including a 75-basis-point one at the next meeting in September.

Of course, average hourly earnings are subject to compositional effects — a shift to certain types of employment can distort the average — but this month’s uptick was fairly broad-based across industries and sectors. It also confirmed further signs of wage pressure in the better (but more lagging) employment cost index published last month.

So how much pain in the job market will be necessary to get inflation under control? 

Nobody wants to see people lose their jobs, but the Fed governors and presidents who vote on monetary policy all seem to acknowledge that curbing inflation will entail some level of trade-off with unemployment. Everyone who submitted estimates for the Fed’s summary of economic projections forecast unemployment reaching at least 3.9% by the end of 2024 — the median was 4.1% — and it’s likely that those estimates will be revised up in September.

Before the current bout of inflation, many in the economics community were ready to abandon their historic emphasis on the relationship between unemployment and inflation, known as the Phillips curve. In the decades leading up to the pandemic, the “curve” had become more of a “cloud,” and many economists thought that the relationship had ceased to be very helpful either as a predictive or prescriptive tool. In 2019, San Francisco Fed President Mary Daly said the real argument was on “whether it’s dead or just gravely ill.”

That was easy to say when inflation itself seemed as if it was gone forever. Now, the Phillips curve is back with a vengeance and features prominently in many of the most public debates about inflation. Among several others, economists Olivier Blanchard, Alex Domash and Lawrence Summers now suggest that the unemployment rate may have to rise to around 4.9% to get inflation under control. They say that the job market is overheating at current levels, as exemplified not only by low unemployment but also by an unprecedented level of job vacancies.

Ultimately, you don’t have to agree with the theory. Unemployment is probably going to rise in the in the months ahead no matter what, whether you see it as a requirement for taming prices or just collateral damage.

The Fed’s interest-rate policy is a blunt and brutal tool for fighting inflation. Higher interest rates make money harder to come by, while slumping asset prices make people feel a little poorer. Chair Powell understands that, even if he won’t admit it, which is why the central bank won’t back off of its interest-rate campaign anytime soon. For better or worse, this report is only going to embolden the Fed to go harder.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.

More stories like this are available on bloomberg.com/opinion

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