The Big Idea

Seeking a soft landing

| May 6, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Fed Chair Powell offered an optimistic vision of a soft landing at the last post-FOMC press conference.  He used the labor market to illustrate how the Fed might engineer a slowdown in the economy sufficient to tamp down inflation while avoiding a recession.  In the process, he introduced a new measure to the array of labor market barometers that economists and financial market participants can track: the ratio of job openings to unemployed. But the new look does not make a soft landing more certain.

Getting to a soft landing

As Powell underscored on May 4, the labor market is currently grossly out of balance.  Demand far exceeds supply.  The FOMC’s job is to get inflation down to its 2% target, and, to do so, it will need to bring the economy broadly and the labor market, in particular, off the boil.  Powell offered a benign vision for how that might look.

In the near term, the labor market is overheated.  The FOMC believes the lowest sustainable unemployment rate is 4.0%. In my view, the equilibrium level of the rate is more likely higher than 4% than lower.  Policymakers and private economists optimistically assume that having reached the pre-pandemic level of 3.5%, at least a 50-year low, the jobless rate is likely to stabilize.

Powell outlined how joblessness might stabilize at his press conference.  He predicted that job creation will slow and labor force participation will increase. Powell conceded that the unemployment rate could fall further, but he said that he expects any further decline would be “relatively limited, because of the additional supply and also just the slowing in job creation.”

In my view, this rather benign scenario seems overly optimistic.  As I have discussed elsewhere, labor force participation has already jumped over the past several months, and those new entrants to the job hunt have been snatched up quickly without cutting into the level of job openings at all. The JOLTS job openings measure hit a new high in March.  And if job creation slows in the near future, it will most likely signal that firms have run out of qualified candidates to add, not a perfect cooling in labor demand.

As a result, the unemployment rate should continue to decline noticeably, at least through the balance of 2022.  I am projecting a jobless rate of just above 3% by the end of this year, and I think we may see a sub-3% rate next year, a first since the Korean War in the early 1950s.  Normally, a falling unemployment rate is a good thing, but when the economy is overheating, the lower the jobless rate goes, the further it will have to rise to bring the labor market specifically and the economy more generally back into balance.

Keeping the landing soft

In any case, once the unemployment rate bottoms out, whether that is now at 3.5% or in early 2023 at 3% or lower, the next step in the process of a soft landing is slowing demand down by enough to put the economy on a more sustainable path without causing a recession.

Powell also described how the economy might avoid recession.  This is where he introduced a new labor market metric, the ratio of JOLTS job openings to unemployed people.  He noted that there are currently 1.9 vacancies for every unemployed person (Exhibit 1).

Exhibit 1: Ratio of job openings to unemployed

Source: BLS.

The JOLTS data only goes back to 2001, so we are unable to compare the current situation to the late 1990s or the late 1960s, but the measure dramatically shows how far the labor market is currently out of balance compared to, for example, the extremely tight labor market in the years just before the pandemic.  When pressed, Powell noted that that the Fed was not targeting a level for this ratio, but he did offer that “when we got to one to one, in the, you know, in the late teens, we thought that was a pretty good number.”

Powell suggested that the FOMC could, like a barista shaving the froth off the top of an espresso, slow the economy so that job openings would decline without any rise in the unemployment rate. In arithmetic terms, the Fed could lower the ratio by trimming the numerator rather than increasing the denominator.

There is a certain plausibility to this scenario, in that cooling the demand for workers (job openings) at a time when demand clearly exceeds supply could achieve better balance without curtailing economic activity.  I have suggested that we could see a dynamic along these lines for the housing market, where a deterioration in affordability crimps demand, ending the days of bidding frenzies without necessarily lowering home sales by very much.

However, every job opening that disappears reflects a tiny hit to economic growth, as employers lower their outlook for output going forward and need fewer hours of work.  Threading the needle of cooling growth by just enough to bring the labor market and the economy more broadly into balance without creating a self-reinforcing negative feedback cycle is not impossible but it is exceedingly tricky.  Of course, it is a worthy goal for the FOMC, but achieving it has been rare historically.

Moreover, the success stories have generally come when the Fed got started early, such as in 1994.  I cannot think of a single example of a soft landing occurring when the Fed was so obviously late in starting to normalize policy.  This points to the folly of the Fed’s new policy framework, rolled out in 2020, which ruled out pre-emptive rate hikes, like we saw in 1994.  The unemployment rate is already running at a level that is below the Fed’s own estimate of what is sustainable.  So, by definition, the Fed is likely to need to push joblessness higher to create an economic environment consistent with a stable inflation rate.

One can also see why Powell and the FOMC would like to believe that the unemployment rate will soon stabilize.  The further it falls, the harder the Fed will need to tap on the brakes to get the economy back into balance. Every additional drop in the unemployment rate that we see going forward will make the Fed’s job ahead more difficult and should further lower the odds of ultimately achieving the elusive soft landing.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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