Is high unemployment inevitable?

In a recent piece in the WSJ, Elizabeth Warren criticizes the views of Larry Summers:

Despite these warnings, the Fed chairman still has cheerleaders for his rate-hiking approach. Chief among them is Larry Summers. “We need five years of unemployment above 5% to contain inflation—in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” the former Treasury secretary recently told the London School of Economics. You read that correctly: 10% unemployment. This is the comment of someone who has never worried about where his next paycheck will come from.

My views are closer to those of Summers than to Warren.  Nonetheless, I’m a bit surprised by his unemployment estimates.  If they were based on a “Phillips curve” type model, then I’d view the estimates with a great deal of caution.

It’s true that unemployment often rises during periods when the rate of inflation is brought down.  But the higher unemployment is not directly caused by lower inflation (that would be reasoning from a price change.)  It depends why the inflation rate has declined. 

The real problem is not lower price inflation; high unemployment is more closely linked to a decline in NGDP growth, or a decline in wage inflation, or a decline in inflation expectations.

While the US CPI inflation rate recently reached 9.1%, the (5-year) expected rate of inflation has remained relatively low—mostly in the 2.5% to 3.5 % range.  And the PCE index targeted by the Fed runs about 25 basis points lower, on average. In contrast, even expected inflation rose to near double digit levels at the end of the 1970s.  Thus it should be far less costly to reduce inflation today than it was back in the 1980s.

Wage inflation is also running at excessive levels (roughly 6%), but that’s also nowhere near as bad as CPI price inflation, or as bad as wage inflation in the 1970s.

If you look at the fed funds futures market, investors seem to anticipate short-term rates rising to 3.4% by yearend, and then falling back to slightly below 3% in late 2023.  That sort of yield curve inversion often precedes a recession, but it also indicates that investors expect the recession to be relatively mild.  If unemployment actually were expected to average 7.5% over two years, then interest rates would almost certainly fall to zero in late 2023.

Of course those are just market forecasts; reality almost never turns out exactly as expected.  So a major recession is possible.  But at the moment, investors seem to be pricing in a fairly mild recession, perhaps because inflation expectations never reached the levels of the late 1970s.  Indeed, inflation expectations are even below the levels of the late 1980s, after 8 years of Paul Volcker’s monetary restraint.

All policy failures are relative.

PS.  If I see one more reporter say that two falling quarters of GDP is a “technical recession” I’ll shoot myself.  The US labor market was booming in the first two quarters of this year.  The correct view is that, as a rule of thumb, two quarters of falling GDP is usually accompanied by a recession.