Last week’s release of data on gross domestic product (GDP) and employer costs are sending a message to the Fed as it meets to set interest rates: There is substantial disinflation in the pipeline that will allow inflation to normalize in coming months even if the labor market remains strong. But securing this “soft landing” will require patience.
- In the most important markets for normalizing inflation, the housing and labor markets, there are signs of noticeable disinflation happening.
- Further, the Fed has not been the only source of macroeconomic policy tightening this year—the fiscal contraction in 2022 has been highly significant and underappreciated. This contraction has, in turn, contributed to the very slow pace of demand growth over the past year.
- Combined, these facts give the Fed some breathing room to slow the pace of rate hikes, even if these disinflationary trends have yet to show up in the consumer price index (CPI). In short, the “soft landing,” wherein inflation normalizes without sabotaging today’s strong labor market, is still possible and the Fed should try hard to secure it.
Below, we expand on these points.
There is very reliable disinflation coming in housing markets—even if it will take time to show up in official price indices
By now, it is well-known that official price indices—particularly the consumer price index (CPI)—can be extremely backward-looking when picking up inflationary momentum in housing markets. Essentially, the elevated inflation for housing in the CPI in recent months is mostly reflecting developments that occurred up to a year ago in housing markets; developments today in housing markets will hit the CPI in the next 6–12 months. Crucially, the developments over the past year that led to today’s rising housing costs in the CPI look to be one-time shocks associated with a rise in housing demand spurred by remote work. Unless the share of the workforce working remotely continues to grow going forward, upward pressure on housing costs should already be relenting.
This one-time shock appears already-passed in many sources of price data besides the CPI. For example, some industry measures of new rental prices are already showing outright declines. Other industry data suggest that a large surge of rental housing will come online in the next 6–12 months, putting further downward pressure on rental prices. Considering the above, it is likely that rental prices will moderate greatly in 2023. Some informed housing market analysts have even argued that the baseline expectation for rent price growth in the coming year should be “an actual decline in rents.”
Housing is both the most important single component of the CPI and the most backward-looking component. If the Fed waits until CPI measures of housing have cooled off before relenting on interest rate hikes, they will overshoot badly. Some inflation hawks will complain that this same argument works in reverse for the recent past—doves missed a buildup of rental price inflation a year ago that should’ve made them more supportive of some rate hikes to get ahead of the curve on inflation. It’s a fair point, and one that should inform a serious post-mortem of what we’ve learned about this inflationary episode. However, it’s not particularly relevant for answering the question of what the Fed should do from here.
There are clearly encouraging signs that wage growth can normalize without higher unemployment
Average hourly earnings from the Current Employment Statistics (CES) data compiled by the BLS have grown at an average annualized rate of 3.6% over the past two months. This is down significantly relative to mid-2021, and more importantly, is actually a pretty “normal” pace of wage growth. This 3.6% growth is consistent with 2% price inflation over the long-run. Over the short-run, when today’s sky-high profit margins provide some buffer to absorb price increases, wage growth of up to 4.5% could be sustained for a number of years.
Further, this slowing and now-normal rate of wage growth has occurred in the context of a sharp decline in unemployment and a sharp rise in job openings. Many have pointed to the rise in the number of job openings per unemployed worker as a measure of labor market heat that demonstrates the need for the Fed to significantly cool the labor market. But as seen in Figure A (showing a 3-month average of wage growth and monthly openings per unemployed worker), as this measure of heat rose in the second half of 2022, wage growth in average hourly earnings (AHE) quite clearly cooled. The fact that wage growth stabilized and then decelerated even as this oft-cited measure of labor market tightness increased should greatly complicate the narrative that “extremely tight” labor markets will make it impossible to see normalized wage growth (and with it, price inflation) in coming months.
Wage growth cooled as job openings per unemployed worker rose: Monthly wage growth (annualized rate) and job openings per unemployed worker
| Date | AHE | ECI | v/u |
|---|---|---|---|
| Jul-2020 | 1.3% | 2.3% | 0.406 |
| Aug-2020 | 1.9% | 2.3% | 0.467 |
| Sep-2020 | 2.1% | 2.3% | 0.516 |
| Oct-2020 | 1.6% | 3.4% | 0.618 |
| Nov-2020 | 2.3% | 3.4% | 0.635 |
| Dec-2020 | 5.8% | 3.4% | 0.643 |
| Jan-2021 | 5.6% | 4.8% | 0.710 |
| Feb-2021 | 5.5% | 4.8% | 0.787 |
| Mar-2021 | 1.9% | 4.8% | 0.875 |
| Apr-2021 | 3.7% | 3.6% | 0.953 |
| May-2021 | 4.4% | 3.6% | 1.042 |
| Jun-2021 | 6.3% | 3.6% | 1.037 |
| Jul-2021 | 6.4% | 6.5% | 1.244 |
| Aug-2021 | 5.4% | 6.5% | 1.275 |
| Sep-2021 | 5.4% | 6.5% | 1.392 |
| Oct-2021 | 5.9% | 4.7% | 1.504 |
| Nov-2021 | 6.3% | 4.7% | 1.606 |
| Dec-2021 | 6.1% | 4.7% | 1.812 |
| Jan-2022 | 5.9% | 5.2% | 1.732 |
| Feb-2022 | 4.9% | 5.2% | 1.809 |
| Mar-2022 | 4.8% | 5.2% | 1.992 |
| Apr-2022 | 3.9% | 6.5% | 1.966 |
| May-2022 | 4.9% | 6.5% | 1.900 |
| Jun-2022 | 4.6% | 6.5% | 1.867 |
| Jul-2022 | 5.2% | 4.8% | 1.970 |
| Aug-2022 | 4.8% | 4.8% | 1.672 |
| Sep-2022 | 4.4% | 4.8% |
Notes: V/U is job openings (vacancies) per unemployed worker. Because the ECI is released quarterly, the chart shows no variation within-quarters on that measure.
Source: Data on job openings from the Job Openings and Labor Turnover Survey (JOLTS) from the Bureau of Labor Statistics (BLS). Wage growth data from the average hourly earnings (AHE) series from the Current Employment Statistics (CES), and wage and salary data from the Employer Cost Index (ECI).
Additionally, Figure A shows that the measure of openings per unemployed worker stabilized in recent months and fell significantly in the past month, even though unemployment has only slightly ticked up.
Another closely watched measure of wage growth—the employment cost index (ECI)—still shows wage growth running at a pace a bit higher than normal: 4.4% annualized growth in the third quarter of 2022. However, even this measure stabilized as the measure of openings per unemployed worker continued to rise, and it saw a pronounced deceleration in the latest quarter’s data. In short, wage growth and the number of openings are showing signs of normalizing even as unemployment remains very low—an extremely promising set of developments for a “soft landing.”
Monetary policy has not been the economy’s only brake over the past year
Economic commentary—particularly over the past year—focuses enormous attention on the Fed and its control of monetary policy. But fiscal policy changes in taxes and spending are far more important than even quite-large interest rate changes as tools to either boost or depress economywide demand growth.
Since the end of 2021, fiscal policy has been historically contractionary. Net borrowing by the federal government has declined by an average of 10% of GDP over the first three quarters of 2022 (see the large upward spikes at the right edge of Figure B). This is roughly three times more than the previous largest reduction of borrowing (3.4%), which occurred in 2013 when fiscal austerity was widely acknowledged to be dragging heavily on growth from the Great Recession. Before 2007, the largest change in year-over-year borrowing was just 2.0%, a fiscal contraction less than a fifth as intense as the one in 2022.
Fiscal policy has become sharply contractionary in the past year: Net borrowing by the federal government as a % of GDP
| Quarter | Change in lending |
|---|---|
| 1961Q1 | -2.1% |
| 1961Q2 | -1.9% |
| 1961Q3 | -1.6% |
| 1961Q4 | -0.9% |
| 1962Q1 | -0.3% |
| 1962Q2 | 0.0% |
| 1962Q3 | 0.0% |
| 1962Q4 | -0.1% |
| 1963Q1 | 0.1% |
| 1963Q2 | 0.4% |
| 1963Q3 | 0.8% |
| 1963Q4 | 0.8% |
| 1964Q1 | 0.4% |
| 1964Q2 | -0.3% |
| 1964Q3 | -0.7% |
| 1964Q4 | -0.6% |
| 1965Q1 | 0.1% |
| 1965Q2 | 0.8% |
| 1965Q3 | 0.9% |
| 1965Q4 | 0.5% |
| 1966Q1 | -0.2% |
| 1966Q2 | -0.5% |
| 1966Q3 | -0.4% |
| 1966Q4 | -0.3% |
| 1967Q1 | -0.7% |
| 1967Q2 | -1.2% |
| 1967Q3 | -1.5% |
| 1967Q4 | -1.1% |
| 1968Q1 | -0.3% |
| 1968Q2 | 0.2% |
| 1968Q3 | 1.0% |
| 1968Q4 | 1.2% |
| 1969Q1 | 1.7% |
| 1969Q2 | 1.9% |
| 1969Q3 | 1.5% |
| 1969Q4 | 0.9% |
| 1970Q1 | -0.4% |
| 1970Q2 | -1.4% |
| 1970Q3 | -2.3% |
| 1970Q4 | -2.6% |
| 1971Q1 | -2.1% |
| 1971Q2 | -1.7% |
| 1971Q3 | -1.0% |
| 1971Q4 | -0.5% |
| 1972Q1 | -0.1% |
| 1972Q2 | 0.3% |
| 1972Q3 | 0.7% |
| 1972Q4 | 0.7% |
| 1973Q1 | 0.8% |
| 1973Q2 | 0.8% |
| 1973Q3 | 1.0% |
| 1973Q4 | 1.4% |
| 1974Q1 | 1.1% |
| 1974Q2 | 1.2% |
| 1974Q3 | 0.4% |
| 1974Q4 | -0.2% |
| 1975Q1 | -1.4% |
| 1975Q2 | -3.4% |
| 1975Q3 | -4.0% |
| 1975Q4 | -4.0% |
| 1976Q1 | -1.9% |
| 1976Q2 | 0.5% |
| 1976Q3 | 1.7% |
| 1976Q4 | 2.0% |
| 1977Q1 | 1.1% |
| 1977Q2 | 0.9% |
| 1977Q3 | 0.8% |
| 1977Q4 | 0.7% |
| 1978Q1 | 0.4% |
| 1978Q2 | 0.4% |
| 1978Q3 | 0.5% |
| 1978Q4 | 1.0% |
| 1979Q1 | 1.4% |
| 1979Q2 | 1.4% |
| 1979Q3 | 1.1% |
| 1979Q4 | 0.5% |
| 1980Q1 | 0.0% |
| 1980Q2 | -0.8% |
| 1980Q3 | -1.5% |
| 1980Q4 | -1.6% |
| 1981Q1 | -0.9% |
| 1981Q2 | 0.0% |
| 1981Q3 | 0.8% |
| 1981Q4 | 0.6% |
| 1982Q1 | -0.3% |
| 1982Q2 | -1.4% |
| 1982Q3 | -2.2% |
| 1982Q4 | -2.5% |
| 1983Q1 | -2.6% |
| 1983Q2 | -2.0% |
| 1983Q3 | -1.4% |
| 1983Q4 | -0.4% |
| 1984Q1 | 0.4% |
| 1984Q2 | 0.8% |
| 1984Q3 | 1.0% |
| 1984Q4 | 0.5% |
| 1985Q1 | 0.5% |
| 1985Q2 | -0.1% |
| 1985Q3 | -0.1% |
| 1985Q4 | -0.2% |
| 1986Q1 | -0.1% |
| 1986Q2 | 0.0% |
| 1986Q3 | -0.3% |
| 1986Q4 | 0.1% |
| 1987Q1 | 0.1% |
| 1987Q2 | 0.9% |
| 1987Q3 | 1.4% |
| 1987Q4 | 1.5% |
| 1988Q1 | 1.3% |
| 1988Q2 | 0.7% |
| 1988Q3 | 0.7% |
| 1988Q4 | 0.5% |
| 1989Q1 | 0.8% |
| 1989Q2 | 0.7% |
| 1989Q3 | 0.5% |
| 1989Q4 | 0.2% |
| 1990Q1 | -0.2% |
| 1990Q2 | -0.4% |
| 1990Q3 | -0.5% |
| 1990Q4 | -0.6% |
| 1991Q1 | -0.3% |
| 1991Q2 | -0.4% |
| 1991Q3 | -0.4% |
| 1991Q4 | -0.7% |
| 1992Q1 | -1.2% |
| 1992Q2 | -1.1% |
| 1992Q3 | -1.1% |
| 1992Q4 | -0.7% |
| 1993Q1 | -0.3% |
| 1993Q2 | 0.1% |
| 1993Q3 | 0.6% |
| 1993Q4 | 0.9% |
| 1994Q1 | 1.1% |
| 1994Q2 | 1.3% |
| 1994Q3 | 1.4% |
| 1994Q4 | 1.1% |
| 1995Q1 | 0.7% |
| 1995Q2 | 0.4% |
| 1995Q3 | 0.4% |
| 1995Q4 | 0.5% |
| 1996Q1 | 0.6% |
| 1996Q2 | 0.7% |
| 1996Q3 | 0.7% |
| 1996Q4 | 1.0% |
| 1997Q1 | 1.3% |
| 1997Q2 | 1.5% |
| 1997Q3 | 1.5% |
| 1997Q4 | 1.2% |
| 1998Q1 | 1.1% |
| 1998Q2 | 1.0% |
| 1998Q3 | 1.1% |
| 1998Q4 | 1.0% |
| 1999Q1 | 1.0% |
| 1999Q2 | 0.8% |
| 1999Q3 | 0.6% |
| 1999Q4 | 0.5% |
| 2000Q1 | 0.6% |
| 2000Q2 | 0.7% |
| 2000Q3 | 0.9% |
| 2000Q4 | 0.7% |
| 2001Q1 | 0.3% |
| 2001Q2 | -0.1% |
| 2001Q3 | -1.3% |
| 2001Q4 | -1.8% |
| 2002Q1 | -2.8% |
| 2002Q2 | -3.0% |
| 2002Q3 | -2.9% |
| 2002Q4 | -2.6% |
| 2003Q1 | -1.8% |
| 2003Q2 | -1.7% |
| 2003Q3 | -1.4% |
| 2003Q4 | -1.3% |
| 2004Q1 | -1.1% |
| 2004Q2 | -0.4% |
| 2004Q3 | 0.2% |
| 2004Q4 | 0.6% |
| 2005Q1 | 0.8% |
| 2005Q2 | 0.8% |
| 2005Q3 | 0.7% |
| 2005Q4 | 0.7% |
| 2006Q1 | 0.7% |
| 2006Q2 | 0.8% |
| 2006Q3 | 0.9% |
| 2006Q4 | 1.0% |
| 2007Q1 | 0.8% |
| 2007Q2 | 0.4% |
| 2007Q3 | -0.1% |
| 2007Q4 | -0.5% |
| 2008Q1 | -0.9% |
| 2008Q2 | -1.9% |
| 2008Q3 | -2.3% |
| 2008Q4 | -3.3% |
| 2009Q1 | -4.3% |
| 2009Q2 | -5.2% |
| 2009Q3 | -5.6% |
| 2009Q4 | -4.5% |
| 2010Q1 | -3.1% |
| 2010Q2 | -1.1% |
| 2010Q3 | 0.0% |
| 2010Q4 | 0.5% |
| 2011Q1 | 0.9% |
| 2011Q2 | 1.0% |
| 2011Q3 | 1.1% |
| 2011Q4 | 0.9% |
| 2012Q1 | 1.0% |
| 2012Q2 | 1.3% |
| 2012Q3 | 1.6% |
| 2012Q4 | 1.7% |
| 2013Q1 | 2.0% |
| 2013Q2 | 2.8% |
| 2013Q3 | 3.1% |
| 2013Q4 | 3.4% |
| 2014Q1 | 2.6% |
| 2014Q2 | 1.6% |
| 2014Q3 | 0.7% |
| 2014Q4 | 0.1% |
| 2015Q1 | 0.1% |
| 2015Q2 | 0.2% |
| 2015Q3 | 0.5% |
| 2015Q4 | 0.7% |
| 2016Q1 | 0.2% |
| 2016Q2 | -0.3% |
| 2016Q3 | -0.6% |
| 2016Q4 | -0.7% |
| 2017Q1 | -0.5% |
| 2017Q2 | -0.5% |
| 2017Q3 | -0.3% |
| 2017Q4 | 1.2% |
| 2018Q1 | 1.2% |
| 2018Q2 | 1.0% |
| 2018Q3 | -0.6% |
| 2018Q4 | -2.2% |
| 2019Q1 | -2.2% |
| 2019Q2 | -2.2% |
| 2019Q3 | -0.7% |
| 2019Q4 | -0.6% |
| 2020Q1 | -0.5% |
| 2020Q2 | -7.8% |
| 2020Q3 | -11.3% |
| 2020Q4 | -12.6% |
| 2021Q1 | -9.8% |
| 2021Q2 | -1.8% |
| 2021Q3 | 1.6% |
| 2021Q4 | 7.4% |
| 2022Q1 | 8.7% |
| 2022Q2 | 10.0% |
Notes: The data are rolling 3-quarter average of changes in net lending/borrowing as a share of GDP compared to the same quarter a year ago. A positive number means the federal government is borrowing less than in previous years.
Source: Data from Table 4.1 from the National Income and Product Accounts (NIPA) of the Bureau of Economic Analysis (BEA).
For further perspective, note that the swing in net borrowing by the household sector that caused the Great Recession and financial crisis of 2008 was roughly 9% of GDP, but spread over more than two years. In that episode, the deflating housing bubble led families to stop borrowing and to reduce spending to make up for lost wealth driven by falling home prices. This bursting of the housing market bubble is why the Great Recession began and why it was so damaging. Further, this private-sector contraction in borrowing in 2006–2009 was even larger than the one that led to the Great Depression in the 1930s.
Yet over the past year the public-sector contraction in borrowing has been larger and faster than either of these. To be clear, this does not mean that a recession is inevitable. The economy in 2021 had been given a large fiscal stimulus (see the large downward spikes in Figure B around 2021) that provided strength to private-sector demand that has so far allowed it to weather the fiscal policy contraction without great damage. Still, this reduction in federal borrowing over the past year is a huge macroeconomic policy shift that is often overlooked as people focus on the Fed’s movement of interest rates.
This contractionary shift, combined with the Fed’s interest rate increases, has led to a sharp slowdown in demand growth. One useful measure of domestic demand growth is real final sales (stripping out volatile inventory changes) to domestic purchasers. Over the past year, this measure has grown less than 1%. This is surely substantially slower than the growth rate of the economy’s potential: This means that even if one thought the economy had too strong demand in mid-2021 and that this was a key source of inflationary pressure, this excess demand is being worked off quickly.
What is the prudent path forward?
There is substantial disinflation in the pipeline for the U.S. economy. In addition to the developments in housing and labor markets highlighted here, large reductions in goods prices will also likely come soon as we move on from COVID-19 driven distortions to demand and supply chains continue to heal.
Given this, the prospects for a “soft landing”—whereby inflation normalizes even as labor markets remain strong—are alive and well. But this soft landing will be threatened by continued aggressive interest rate hikes in coming months. Data from the past few weeks should convince the Fed to forego another 75-basis point hike in the Federal Open Market Committee (FOMC) meeting this week. The evidence that demand is slowing and inflationary pressures are set to normalize is strong. Given this, preserving today’s strong labor markets should be a key priority.
Recent data have been encouraging that a soft landing is possible if policymakers are patient. If the Fed instead ignores the signs of disinflation coming down the pipeline and continues rapid interest rate hiking until the CPI slows substantially, it will almost certainly be too late to preserve today’s strong labor market and a recession will be likely. If this happens, it will not have been an inevitable casualty in a necessary fight against inflation—it will have been an overreaction and a mistake.
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