TAMING INFLATION WILL COST JOBS. HERE´S HOW MANY. / BARRON´S MAGAZINE

Taming Inflation Will Cost Jobs. Here’s How Many.

By Lisa Beilfuss

Federal Reserve Chairman Jerome Powell says he’s determined to bring inflation back to 2%. That’s probably unrealistic. / Win McNamee/Getty Images

When Federal Reserve Chairman Jerome Powell said that tightening monetary policy will bring “some pain” to households and businesses, he pushed back on the idea that the central bank would flinch in its inflation fight. 

But how much pain is the Fed willing to inflict before it has no choice but to raise its inflation target?

To quantify the amount of economic damage from the current tightening cycle—where rate hikes work on a lag of about a year, inflation is both supply and demand driven, and balance-sheet tightening is about to ramp up—Barron’s spoke with Joe Brusuelas, RSM’s chief economist. 

To estimate how high unemployment must rise to bring inflation back to the Fed’s 2% target, Brusuelas puts a new twist on an old, and increasingly controversial, idea and concludes that the number of job losses might be higher than policy makers and investors appreciate.

At the heart of the current policy debate is the so-called sacrifice ratio, which Brusuelas says matters for the first time in 40 years. 

The ratio represents the trade-off between price stability and the economic growth that policy makers must give up to achieve it. 

More technically, it’s an estimate of the slope of the Phillips curve.

Named for New Zealand economist A.W. Phillips, the curve reflects the inverse relationship between unemployment and wage growth and connects the Fed’s dual mandates: price stability and maximum employment. 

The logic is that employers have to raise wages to attract workers when unemployment is low, boosting overall inflation, and vice versa. 

Many economists and policy makers declared the Phillips curve dead after the prepandemic stretch of ultralow unemployment failed to drive wages or inflation higher. 

But the postpandemic’s rapid rise in wages as labor remained tight has resurrected the curve.

Jefferies chief economist Aneta Markowska says that the Phillips curve is back with a vengeance and suggests that the labor market will set a floor for inflation around 4%, although others argue that the curve should remain buried insofar as it affects policy decisions.

To advance the debate, Brusuelas created a supply-augmented Phillips curve to make it more relevant for today’s economy and policy decisions, including using RSM supply-chain data with variables such as inflation expectations and the unemployment rate. 

He says that without controlling for supply-chain deficits during the pandemic, the Phillips curve shows significant downside biases and helps explain why so many failed to predict how elevated inflation would become. 

By contrast, he says his supply-augmented curve tracks actual inflation levels significantly better before and through the pandemic.

Using his curve, Brusuelas arrives at two sets of sacrifice ratios. 

Getting the Fed’s preferred inflation metric, the personal consumption expenditure, or PCE, to 2%, he says will cost 5.3 million jobs and result in an unemployment rate of 6.7%. 

The PCE rose 6.3% in July from a year earlier. 

In its latest summary of economic projections, the Fed estimated the jobless rate would rise to just 3.9% this year and 4.1% in 2023 from a current 3.7%.

In his July press conference, Powell acknowledged that while the Fed targets the PCE, the public focuses more on the consumer price index, or CPI. 

“The difference really is because the CPI has higher weights on things like food, gasoline, motor vehicles, and housing than the PCE index does,” he said. 

“Given the importance in the public eye of CPI, we are calling it out and noticing it.”

The point: To the extent that inflation expectations drive inflation, which central bankers tend to believe, policy making can’t altogether dismiss the CPI. 

The CPI rose 8.5% in July from a year earlier. 

To get it down to 2%, Brusuelas estimates that some six million job will have to be lost and the unemployment rate will rise to 7.1%.

This column has long argued that the Fed may have no choice but to lift its inflation target. Brusuelas agrees. 

“We don’t think 2% in the near term is a reality-based option,” he says, given the amount of economic carnage it would require. 

He believes the Fed will engage in what he calls “opportunistic reflation” and raise the inflation target to 3%. 

Hitting that target in the PCE would require a loss of 1.7 million jobs and a rise in unemployment to 4.6%, he says, while to get the CPI there would take 3.5 million jobs and a 5.6% jobless rate. 

Fed officials have said they remain committed to 2% inflation.

Some central bankers and economists have said that the historically high number of job vacancies will serve as a cushion and limit job losses because firms would pull job listings before they start laying off workers. 

But Alex Domash, an economist and research fellow at Harvard University, says the argument that the Fed can bring down inflation through clearing job vacancies alone is “unreasonably optimistic and is not based on the historical evidence.”

All of this will take time, but not necessarily that much time. 

Jeffries’ Markowska estimates there are some 1.5 million workers who can still be brought back into the workforce, and she predicts it will take the next four to five months to burn through that slack. 

“This means that by the end of the year, there will be no one left to hire,” and employment growth will become constrained by the growth rate in the working-age population, which translates to about 50,000 net new workers a month, she says.

She adds that we have more job openings at a given level of unemployment because the jobless either aren’t qualified for available jobs, or live too far from employment and are unable or unwilling to move, amounting to a structural shortage of labor that reinforces a steeper Phillips curve. 

The upshot: higher wages and inflation pressure.

The question for policy makers is no longer whether there will be pain in bringing inflation down to an acceptable level, but what that level is—and how many millions of jobs will be sacrificed to reach it.