What is unsustainable is unlikely to be sustained?

The new Fed chair received deserved praise for his “plain English” press briefing in June.  However, we thought he struggled a bit in answering a question on the widening gap between the median Fed forecast for the unemployment rate and the estimated “longer-run normal” level—essentially the NAIRU.

He effectively downplayed the significance of the longer-run normal estimate, saying, “We’re learning about the real location of the natural rate of unemployment as we go.” He also pointed out that Fed officials are not forecasting a significant overshoot on inflation.  He added, “We can’t be too attached to these unobservable variables… I think we have to be practical about the way we think about these things and we do that by being grounded in the data and what we see happening in the real economy.”

Mr. Powell is right, of course, to take his cue from the data and not just “unobservable variables” such as the NAIRU.  However, based on the data, we suspect he is not fully appreciating how tight the labor market is already, as well as the extent to which the unemployment rate is still trending down.  The downward momentum in the already low unemployment rate reinforces our view that markets are still pricing in too little Fed tightening over the next year and a half.  We see upside risks to the Fed’s projections as well.

A key issue for the Fed will be whether an unsustainably low unemployment rate puts sustained upward pressure on wage gains and inflation, such that they keep rising even after the unemployment rate stops falling.  We believe it will, consistent with the NAIRU framework.  That is the takeaway from our chart, which lines up acceleration/deceleration in wages in the ECI with the differential between the unemployment rate and the estimated NAIRU.

Along with the unemployment rate, several indicators are signaling an increasingly tight labor market, including the vacancy and compensation series in the NFIB survey, the Conference Board survey data on perceptions of the labor market, and the job openings rate.

The link between a tight labor market and inflation is inevitably more indirect than the link between a tight labor market and wage gains, so we have less conviction that the recent pick-up in core inflation will continue over time.  That said, other indicators are suggesting that the pick-up is more than just noise.  Acceleration is also being signaled by the core PPI, the New York Fed’s Underlying Inflation Gauge—UIG—series and the NFIB measures tracking the share of firms raising selling prices.

In conclusion, maybe the economy can indeed sustain an unemployment rate as low as 3.5% without a persistent upward bias to inflation, but we are highly skeptical.  Nor do we believe Fed officials will be able to nudge the unemployment rate back up without the economy falling into recession.  In any event, we believe an end to the downtrend in the unemployment rate will likely require significant Fed tightening first.

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