Recent data indicate that a “soft landing” is still in reach—the Fed should try to secure it: Ignoring disinflation signs heightens risk of recession

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%
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