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March 22, 2023 | 7 Minute Read
Co-Chief Investment Officer, Multi-Asset Solutions
What would it take to tame inflation? More economic slack and higher unemployment perhaps, but that may only solve part of the problem. In our view, monetary tightening is most effective for addressing the cyclical aspects of demand-driven inflation. Under the hood, there are also structural issues that may keep inflation sticky, such as a mismatch between labor supply and demand and the collective bargaining power of workers. Fiscal and government programs may be better positioned to make progress at the sector and regional level as monetary tightening continues to temper the business cycle and the level of aggregate demand.
The Phillips Curve, according to economic theory, suggests an inverse relationship between inflation and unemployment. It implies that to reduce inflation, unemployment must go up. Over time, though, the Phillips Curve appears to have flattened, the result of inflation having become less sensitive to economic slack. If applied in its original form, this framework implies that cooling inflation may require an outsized shock to the labor market.
Some variations of this framework may be useful when considering the labor-inflation tradeoff.1 First, the inflation basket comprises a wide range of spending categories, and the underlying components may respond differently to labor conditions. For instance, demand for services is perhaps more closely correlated with domestic economic slack, whereas the price for goods may be more influenced by changes in global supply chains. In recent quarters, the divergence between goods and services has been particularly wide as global supply chain pressure continues to dissipate. But the tightness in the domestic labor market is still posing upside risks to services inflation. Lower inflation in the services sector will likely have to involve a moderate pickup in the unemployment rate that takes it beyond the NAIRU (Non-Accelerating Inflation Rate of Unemployment). Second, inflation is a self-fulfilling phenomenon, as expectations for higher future prices can lead to higher prices today. Therefore, anchoring inflation expectations may reduce the amount of labor market loosening needed to generate disinflation.
Source: Bloomberg, Bureau of Labor Statistics, Federal Reserve Bank of New York, Goldman Sacsh Asset Management. As of March 14, 2023.
Monetary tightening may cool inflation by lowering aggregate cyclical demand. What it does not do is addressing the uneven distribution of inflationary pressures across sectors and regions. For example, while core CPI inflation began to show some signs of moderation by the end of 2022, transportation services inflation has remained above 10% in the seven months since August, with the most recent reading coming in at 14.6%. Within this bucket, public transportation has seen year-on-year inflation above 15% every month since March 2022. Average weekly wages grew by just 1.5% in California and by 4.8% in New York State between Q3 2021 and Q3 2022, lagging core CPI inflation of 6.6% during this period. But in several inland states, average weekly wages grew by more than 10%. Between public and private sectors, employment cost growth in private industries has been slowing since the third quarter of 2022. But the public sector is still experiencing continued growth in wages, benefits, and aggregate compensation.
Source: Bureau of Labor Statistics, Goldman Sachs Asset Management. As of March 13, 2023.
Certain aspects of wage growth and price inflation may not have much sensitivity to higher interest rates, being more closely tied to structural issues in the economy. The transportation industry is facing a shortage of skilled workers, while collective bargaining by union members may also have added to wage pressure. Some new contracts with material wage and benefit increases have been put forward in recent months include double-digit raises. At the national level, the US has been experiencing unprecedented labor shortages not seen since at least the 2000s. The aggregate US labor demand today is about 171 million across employed workers and job openings, exceeding the total size of the civilian labor force by about 5 million. In particular, the 10.8 million job openings appear to have tilted the supply-demand balance from a net-surplus to a net-shortage of workers.
As might be expected, the labor shortfall is also uneven across sectors and regions. For example, the secular trends of de-globalization and the re-shoring of supply chains have added job openings in manufacturing, whereas the supply of domestic manufacturing workers still has a long way to go to catch up. Since 2009, the job opening rate in the US manufacturing sector grew significantly and peaked at 7.4% in April 2022, compared to a range of roughly 1% to 3% between 2001 and 2008. For the time being, inland states that have higher dependence on industrial sectors, including manufacturing, appear to experience more severe labor shortages. For example, states on the two coasts, including New York and California, are more services-oriented, and labor shortages have not been a pressing problem. In these states, wage growth is already falling behind inflation by a considerable margin. The impact of monetary tightening and aggregate demand cooling will continue to be felt across the country. In relative terms, the coasts may be more vulnerable. However, further loosening of labor markets on the coasts would not lead directly to a replenishment of labor supply in the middle of the country. Fiscal and governmental programs may be better positioned to solve the mismatch between labor supply and demand while making targeted progress toward disinflation. The fundamental cure for these problems may come from immigration, digitalization, and technological advancements.
Source: FRED,2 Goldman Sachs Asset Management. As of March 13, 2023.
As US Treasury Secretary Janet Yellen recently said, the fight against US inflation will not proceed in a straight line. We should start to see a considerable cooling of aggregate demand as a result of the cumulative effects of recent interest rate hikes and the lagged effect of ones yet to come. This suggests that a cautious stance on risk assets is still appropriate.
However, there may be structural limitations in terms of what monetary tightening may accomplish on its own. The impact across sectors and regions may be asymmetric, and certain components of inflation may be more likely to stick around for a while. Those distributional effects may be better addressed by coordinating monetary policy with fiscal and governmental programs to limit the collateral damage from top-down demand destruction. In any case, winners and losers are likely to emerge from the process, and that will present both investment opportunities and risks.
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1 See, for example, Peach, Richard W. and Rich, Robert W. and Linder, M. (2013), “The Parts are More than the Whole: Separating Goods and Services to Predict Core Inflation”, Federal Reserve Bank of New York Current Issues in Economics and Finance, Vol. 19, No. 7; Ball, Laurence and Mazumder, S. (2018), “A Phillips Curve with Anchored Expectations and Short-Term Unemployment”, Journal of Money, Credit and Banking, 51; Stock, James H. and Watson, M. (2020), “Slack and Cyclically Sensitive Inflation”, Journal of Money, Credit and Banking, 52 (S2).
2 Fuller, Jack and Gascon, C. (2023), “Are Labor Supply and Labor Demand Out of Balance?”, Federal Reserve Bank of St. Louis FRED Blog.
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