- The Federal Reserve thinks US unemployment has to top 4% before inflation will cool, given rising wages.
- But Pantheon Macro says if people's expectations for inflation are lower, that will drag on wage growth.
The Federal Reserve is overlooking the chances of an ideal end to worries about how it can aggressively tighten its monetary policy without pitching the US into recession, according to Pantheon Macro's top economist.
There are concerns the US central bank could go too fast in hiking interest rates as it tries to cool inflation near 40-year highs. It's seen as a balancing act, where too much dampening of demand will lead to a "hard landing."
But both the Fed and investors have been discounting the likelihood of a more painless outcome — where people have lower expectations about inflation and that means they push less for wage rises, according to Pantheon Macro's Ian Shepherdson.
"For the Fed, and markets, this scenario — strong payrolls, soaring participation, steady unemployment, falling inflation and slowing wage gains — would be nirvana," the research consultancy's chief economist said in a note to clients Tuesday.
"We think markets and the commentariat underestimate the chance that it happens."
The central bank's most recent forecast is for a rise in unemployment to 4.4% by 2024. Some of its policymakers believe that level is needed to slow down wage growth enough to bring inflation in line with the central bank's 2% target.
"The Fed doesn't publish forecasts of wage growth, but we are pretty sure that all forecasters' models show wage growth slowing markedly after the unemployment rate rises by a full percentage point," Shepherdson said.
"It is not clear to us, however, that unemployment needs to rise that much in order to slow the pace of wage growth to 4% or less.
"It's important to appreciate just how fast inflation could fall across the next year or so, thanks to margin re-compression — from wildly elevated levels — and plunging food and energy inflation."
So far, inflation has turned out to more difficult to squash than the Fed might have expected. The Consumer Price Index climbed 8.3% in the year through August — a sizeable drop from July's 8.5% pace but above the 8.1% expected.
"The key to the idea that wage growth will slow without a clear increase in unemployment is the extent to which inflation expectations fall, on the back of lower inflation over the next few months," Shepherdson said.
"Inflation expectations influence wage bargainers' behavior, alongside the unemployment rate, so if expectations fall sharply, as we expect, wage growth will slow, other things equal."
The Fed, which aims to keep both inflation and unemployment low, hasn't fully taken into account the impact that falling food and gas prices will have on wage expectations, the economist said.
The US average price of gas at the pump is now just above $3.80 a gallon, after topping $5 in June, according to AAA data — though it has started rising again as demand intensifies and supply tightens.
Meanwhile, US food prices remain high. But Shepherdson noted that pandemic-related supply-chain disruption, which boosted inflation, has now subsided — and that should mean prices fall steadily over the next year.
That could drag inflation down to around 3% by the middle of 2023, he said.
If gas and food prices fall naturally, that could prevent the development of a wage-price spiral – where soaring costs encourage employees to ask for wage rises, which in turn pushes prices even higher.
That would represent an ideal scenario for the Fed, according to Shepherdson. Markets would also be buoyed by a significant fall in inflation, which would offer policymakers scope to protect the economy by hiking interest rates less aggressively.
The Fed has rattled markets with 75 basis point rate hikes at three consecutive meetings, and investors are are bracing for another 50 basis point hike in November. The central bank is also plowing ahead with its program of quantitative tightening, where it seeks to slash its balance sheet in a bid to cut the money supply and tame soaring prices.