For quite some time, prominent economists have cautioned that the most effective way to control inflation would be to increase unemployment, essentially triggering a recession. Last summer, former Treasury Secretary Lawrence Summers even predicted that we would need five years of unemployment above 5 percent. Paradoxically, every strong jobs report seemed like a negative sign, signaling potential financial hardships to come.
However, the latest official data reveals a significant cooling of inflation since last summer, even with a low unemployment rate. It seems that we may be able to conquer inflation without causing millions of Americans to lose their jobs. The likelihood of a recession is diminishing. So, where did the pessimistic forecasters go wrong?
The notion that a recession was necessary to combat inflation was based on a specific assumption—the labor market was overly tight. During the initial years of the pandemic, employers faced difficulties in hiring as many workers as they desired, causing wages to surge at an unsustainable pace. The qualifier here is “unsustainable.” Although wage growth is generally celebrated, it can lead to detrimental inflation if it occurs too rapidly and for too long. There are two ways this can happen: Firstly, when employers have to pay higher wages, they pass on the cost to customers through increased prices. Secondly, if companies cannot recruit enough workers, they may fail to meet the demand for their goods, resulting in further price increases due to excessive money in circulation and limited supply.
Summers and other economists believed that a recession was the only solution because they reckoned that the economy had effectively run out of available workers. Although unemployment wasn’t literally zero, economists generally consider it to have a lower bound, below which a lack of workers leads to significant wage growth and inflation. Historically, an unemployment rate of 3.5 percent is exceptionally low, so many experts assumed that we were nearing that level. In this case, the only way to cool down the labor market would be to reduce the demand for workers. The government primarily achieves this by increasing interest rates. As borrowing money becomes more expensive, the demand for goods and services diminishes, resulting in reduced labor requirements. Given the labor market imbalances of 2022, this likely meant raising interest rates until a recession was triggered.
However, this argument only holds if we consider the official unemployment rate as an accurate measure of available workers. The recession predictors, including Summers, believed that there were no additional potential workers who could be enticed by better employment opportunities. While it is understandable to exclude retired individuals and full-time students from the labor force, as they genuinely do not want work, they are not the only adults who are not employed. There are also individuals who might be interested in finding a job if the conditions were favorable. These potential workers could relieve the pressure in the labor market by entering the workforce, resulting in more workers available to fill job openings.
Recent economic data clearly indicate that the unemployment rate significantly underestimated the pool of available workers. Despite the official rate remaining at historical lows, four million workers have found jobs in the past year. The labor market was in better shape than many experts believed. Inflation and wage growth have both slowed down. This did not necessitate a prolonged period of high unemployment, as Summers had proposed. On the contrary, the economy continues to add jobs.
In the context of an unprecedented global pandemic, economists, including myself, are bound to make mistakes. However, it is important to note that we have witnessed similar errors before. After the Great Recession, many economists believed that the share of people who were unwilling to work had permanently increased. Reasons cited varied from health issues to the allure of high-quality video games. Yet, as the recovery progressed, more and more people returned to work, repeatedly disproving pessimistic forecasts regarding the labor market. Wages increased at a pace that improved living standards without causing inflationary pressures.
The fact that many leading economists lean towards excessively negative views of the labor market is troublesome. If the perspective put forward by Summers had prevailed, the Federal Reserve may have felt compelled to induce a recession, leading to unnecessary suffering on a massive scale. The positive news is that ongoing improvements in labor supply increase the likelihood of a soft landing. The share of prime working-age adults employed remains below the peak seen in the late 1990s, indicating that there is still room for the workforce to grow. This does not imply that labor supply alone is responsible for the slowdown in inflation, or that we could have reached this point without interest rate hikes to curb demand. Inflation is still higher than desired, and in a period of constant economic surprises, any forecast should be made with humility. However, the more supply contributes, the less demand needs to do, and the lower the risk of the Fed resorting to recessionary measures to combat inflation.
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