As inflation rapidly decreased in 2023 and continued to slow this year, Federal Reserve officials were optimistic that the cooling of the U.S. economy had been achieved without a significant rise in unemployment. This optimism was based on a reduction in the number of job openings rather than widespread layoffs. However, new research presented at the Kansas City Fed’s annual economic conference in Jackson Hole, Wyoming, suggests that the economy may be nearing a tipping point where the continued decline in job openings could lead to a faster increase in unemployment.

Economists Pierpaolo Benigno of the University of Bern and Gauti B. Eggertsson of Brown University argue that the risk of waiting too long to ease monetary policy could result in a “hard landing” for the labor market, characterized by high unemployment. They suggest that the Federal Reserve may need to begin cutting interest rates to protect the labor market. “Policymakers face two risks: being too slow to ease policy, potentially causing a ‘hard landing’ with high unemployment … or cutting rates prematurely, leaving the economy vulnerable” to rising inflation, the researchers wrote. They concluded that the risk of being too slow to ease policy currently outweighs the risk of cutting rates too soon.

This research adds further depth to ongoing debates within the Federal Reserve by integrating two key economic models: the Phillips Curve, which examines the relationship between unemployment and inflation, and the Beveridge Curve, which looks at the relationship between job vacancies and unemployment.

The study suggests that when the labor market is tight, with high demand for workers relative to their availability, the cost of reducing inflation in terms of increased unemployment is relatively low. However, if the ratio of job openings to unemployed individuals continues to decline, the risk of a sharp rise in unemployment becomes more pronounced.

This concern is echoed by Fed Governor Christopher Waller, who, along with other officials, has focused on the job-openings-to-unemployed ratio as a crucial indicator of labor market health. The ratio, which spiked above 2-to-1 during the post-pandemic economic recovery, has since dropped to 1.2. Although inflation has fallen to 2.5% from a peak of over 7% in June 2022, the researchers warn that the current ratio remains above the one-to-one level that historically marks a balance between inflationary and non-inflationary labor market conditions.

The findings suggest that the Federal Reserve may need to tread carefully as it seeks to maintain its dual mandate of low inflation and maximum employment. If the job-openings-to-unemployed ratio continues to slide, the researchers predict that unemployment could rise rapidly, potentially exceeding 5% if the ratio drops to 0.8.

The study also challenges the notion, held by some Fed officials before the pandemic, that the economy could run “hot” with low unemployment and minimal inflation risks. The researchers caution that the current economic environment may require a more cautious approach to avoid triggering a sharp increase in unemployment.

(Adapted from BeamStart.com)

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