Solving the puzzle of high inflation, weak growth and low unemployment

One of the biggest challenges officials and investors face is assessing how the COVID-19 pandemic is affecting the U.S. economy. Three years after it struck, the impact is most visible in high U.S. inflation and near-record low unemployment. This is a paradox considering the economy could be near recession, and it has left many wondering how the Federal Reserve will respond.

To understand what is happening, one needs to consider how the pandemic unfolded, the policy response to it and the ways businesses and workers altered their behavior.

When the pandemic struck in early 2020, the economy nose-dived as businesses and schools were shuttered. Job losses totaled nearly 23 million from February through May, while the unemployment rate spiked to nearly 15 percent. This figure understated the number of people out of work, because millions of workers dropped out of the labor force to take early retirement, avoid being exposed or care for family members. 

There was considerable uncertainty then about whether a recovery would be “V-shaped” or gradual. This debate was resolved when businesses reopened and legislation was enacted that granted massive transfer payments to individuals and businesses. By the end of 2020, more than half of the job losses had been recouped, and most of the unemployed had jobs by the end of 2021.

This past year, there were two major surprises that complicated the economic outlook.  One was the spike in inflation that Fed officials initially attributed to supply disruptions linked to the pandemic. But as inflation rose well above the Fed’s 2 percent target, it was compelled to raise interest rates aggressively, which caused investors to worry about a recession or stagflation.

The second surprise was that the job market remained tight even as the pace of economic growth slowed to 1 percent from 5.7 percent in 2021. This pattern continued into January amid a blockbuster job report that showed nonfarm payrolls increased by 517,000, while the household survey posted nearly a 900,000 increase. They resulted in the unemployment rate falling to 3.4 percent, the lowest level since 1969.

Some commentators have dismissed the January data as a statistical fluke owing to seasonal adjustments and benchmark revisions. Nonetheless, there is no mistaking the trend over the past year: Nonfarm private payrolls expanded by 4.5 million — a monthly average of 375,000. The pace of hiring moderated during the year, but it remained well above levels that previously were strong.

What stands out in the data is that job growth has been broad-based despite Fed tightening. There also has been a rotation in the sectors that have led in job gains since the recovery began in mid-2020. Initially, the strongest job gains were in areas that benefited from disruptions caused by COVID-19. They included technology and professional services, construction, manufacturing and transport and warehousing.  Over the past year, by comparison, sectors that are recovering from the pandemic, including leisure and hospitality, health care and professional and business services, were the leaders.

The biggest swing in jobs over the past three years has been in leisure and hospitality, where most of the losses of 8 million workers has been reversed. This has caused some observers to believe the scope for further large gains is limited. Yet, there are still numerous “help wanted” signs posted for workers in restaurants, hotels and cruises.

This is also true of the labor market as a whole: The latest Job Opening and Labor Turnover Survey (JOLTS) showed job openings rose to 11 million in December from 10.4 million in November. With 6 million people unemployed, there are now more than 1.8 openings for each job seeker.

On the supply side of the equation, there has been a steady increase in labor force participation over the past 18 months. In January, the rate rose to 62.4 percent, while the ratio of employment-to-population rose above 60 — the highest since COVID struck. The quit rate has also declined since mid-2022.

So, what is inducing people who dropped out of the labor force to re-enter the market?

One explanation is that this group is now feeling the pinch of higher inflation squeezing their real income and increased uncertainty about the economic outlook. During 2020-2021, many people received generous transfer payments from the federal government and were able to save a significant portion of the proceeds. According to Moody’s Analytics, U.S. households amassed $2.7 trillion in extra savings by the end of 2021.

Over the past year, however, the household saving rate has plummeted as transfer payments were phased out and people resumed normal activities as fears of the pandemic lessened. Goldman Sachs estimates that Americans have now depleted about 35 percent of the extra savings they accumulated, and that they will have exhausted roughly two thirds of the windfall by the end of this year.

With jobs still plentiful, one might expect wage pressures to build. Yet, there are indications that they are moderating. The year-over-year increase in average hourly earnings, for example, has slowed to about 4.5 percent recently, from 6 percent in mid-2022, and it has been accompanied by a slowing in unit labor costs. This partly reflects a shift in hiring to low-skilled workers, which should help keep wage increases in check.

So, how will the Fed respond to high inflation, a tight labor market and weak growth?

In the wake of the January job report, investors reassessed the prospect for Fed tightening. They now concur that the Fed will raise the funds rate to 5.0-5.25 percent by May, and will likely pause in the second half of this year. This is reasonable considering the Fed’s mandate is to seek both price stability and full employment. Indeed, with unemployment now at a five-decade low and inflation at a four-decade high, investors should not expect the Fed to lower rates until there is a significant rise in unemployment and decline in inflation.

Nicholas Sargen, Ph.D., is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”