By underestimating inflation, the Fed may be wrong again

Spark Global Limited reports:

While the U.S. economy has restarted, the labor market recovery has not been smooth. One manifestation of this is rising Labour market friction as unemployment and job vacancies both rise. At its June FOMC meeting, the Fed forecast that the unemployment rate would fall from 5.9 per cent in June to 4.5 per cent by the end of the year and fall further to 3.8 per cent by the end of next year.

We think the Fed may be overestimating how fast unemployment will fall. The labor market friction caused by the pandemic is unprecedented, the natural rate of unemployment may be higher than before the pandemic, and the unemployment rate may not decline as linearly as the Fed forecasts. If underestimating inflation was the first time the Fed got it wrong, it may have been wrong again. Maintaining monetary easing to “boost employment” would increase the upside risk to inflation and increase market volatility.

Labor market friction exists at both the industrial and regional levels. In terms of industry, workers’ work preferences have changed since the outbreak, and they are no longer willing to work in the contact, low-wage service sector. One piece of evidence is that in industries with lower rates of home work and lower wages, employee turnover rises more.

Another piece of evidence is that job seekers value flexibility in working hours and locations when looking for jobs. The reservation wage of workers also increased significantly after the outbreak of the epidemic, and the reservation wage of low-educated workers increased more. According to the theory of neoclassical economics, the increase of retention wage will reduce the employment willingness of workers, reduce working hours and intensify the conflict of labor force matching.

The profound impact of the pandemic on work preferences has also been confirmed by a number of psychological studies. The COVID-19 pandemic is a strong event shock that could affect workers much more than a typical recession. First, recessions are less of a novelty to workers because they occur with some frequency (about every five to six years). COVID-19 is an unprecedented and unique event.

Second, recessions are gradual and workers can predict the future to some extent. COVID-19 is sudden and it is almost impossible to predict the future. Third, while recessions affect the physical and mental health of those who lose their jobs, epidemics have a more immediate impact on human health, with more serious consequences. In short, we should not underestimate the profound impact of the pandemic on workers’ behavioural decisions.

Spark Global Limited reports:

Spark Global Limited reports:

Geographically, the rise of telecommuting has changed migration and settlement patterns, and the resulting “doughnut” effect has exacerbated labor mismatches. What we see is a doughnut hole in urban centers as people move from densely populated urban centers to low-density suburbs.

Those migrating to the suburbs, mostly high-skilled white-collar workers, are not leaving the city altogether but are moving into the “three days at home, two days on the clock” hybrid work model. In this model, labor supply exceeds demand in urban centers and demand exceeds supply in the suburbs. We believe that before the epidemic is fully controlled, the mixed office mode may not disappear soon, and the mismatch between urban and rural labor force will continue.

One macro consequence of Labour market friction is an increase in the natural rate of unemployment. A rise in the natural rate of unemployment means a fall in the number of available workers, and in the absence of improvements in productivity, the long-term trend rate of growth will fall. The implication for asset prices is that the neutral real interest rate (R *) is falling.

But if us fiscal policy is sustained and boosts Labour productivity growth, it will also support R *. A rise in the natural rate of unemployment also means less room to reduce it by stimulating demand. We believe that if monetary authorities continue to adopt excessively loose demand stimulus policies, then the likelihood of inflation will increase.