Markets & Economy
4 charts that explain U.S. labor dynamics
Darrell Spence

The latest consumer price index (CPI) report released Wednesday, May 11, has confirmed that the U.S. Federal Reserve has a long way yet to go in its fight against inflation. Core inflation — all items except food and energy — rose 6.2% year over year in April, keeping it at a level not seen in nearly 40 years.

Much of this is, no doubt, created by supply shocks, which fall outside the central bank’s area of control, as Fed Chair Jerome Powell pointed out in his press conference earlier this month. The Fed can, however, affect demand in the historically tight labor market. Its plan to continue implementing 50 basis point (bps) rate hikes should introduce some slack — but the question is, how far will it have to go to achieve its goal on inflation?

We are starting to see a moderate wage-price spiral developing in the United States, and as I've looked at the landscape, I don’t see a clear path to bring inflation back to the Fed’s 2% target without putting the economy into a recession.

Here are four charts about labor dynamics that explain why I believe this is the case.

1. Workers expect bigger salaries to make up for higher prices

Workers are asking for higher compensation because the prices of the products that impact their inflation expectations have surged. As the chart below shows, people’s view of inflation is very closely linked to the prices of gasoline and food. U.S. gasoline prices are already sitting at record highs, even before the peak summer driving season kicks off. And a number of factors, such as the war in Ukraine and a looming fertilizer shortage, are pushing food prices higher.

Inflation expectations largely track food and fuel prices

This chart shows gasoline and food prices and consumer inflation expectations from January 1998 through April 2022. The two data series have largely followed a similar pattern over that time period. Over the past 18 months, the correlation has been very tight, as both rose sharply after the onset of the pandemic. As of March 30, 2022, the average year-over-year change for gasoline and food prices was 29% and the inflation expectation was 4.2%.

Sources: University of Michigan, Bureau of Labor Statistics. Data as of April 30, 2022. Shaded areas represent recessions.

2. Employers are raising wages given tight market

Workers are getting the higher compensation they are asking for because the labor market is extremely tight. Many workers who went missing during the pandemic have not come back. Today’s unemployment rate is similar to before the pandemic, but the labor force participation rate still lags. It was 62.2% in April 2022, compared to 63.4% in February 2020, according to the Bureau of Labor Statistics (BLS). Employers also reported a record 11.5 million open jobs in March 2022, according to BLS data.

The natural unemployment rate, which represents unemployment not linked to cyclical demand, has declined over time, but is still likely a full percent above the current unemployment rate, and perhaps higher.

Compensation soars as unemployment returns to pre-pandemic lows

This chart compares the unemployment rate to year-over-year changes in the employment cost index (ECI) from January 1985 to April 2022, showing a correlation between low unemployment and rising wages. As of March 30, 2022, the ECI grew 4.983% year-over-year and the unemployment rate was 3.6%. For context, the chart also includes the historic “natural” unemployment rate, which represents unemployment not linked to cyclical demand. The current unemployment rate sits about 1 percent below the “natural” rate. As of April 30, 2022, the U.S. unemployment rate was 3.6% and the ECI, wages and salaries year-over-year change was 4.98%.

Sources: Bureau of Labor Statistics, Congressional Budget Office. ECI = employment cost index. Data as of April 30, 2022. Shaded areas represent recessions.

3. Productivity growth is not offsetting compensation costs

Productivity has not been keeping up with wage growth, so unit labor costs have been rising sharply. In fact, over the past four quarters, productivity fell 0.6%, resulting in a 7.2% increase in unit labor costs, the largest since an 8.2% increase in 1982.

Less for more: Productivity declines as wages rise

This chart compares the rate of inflation, represented by the consumer price index, to productivity in the U.S. economy, represented by unit labor costs from January 1950 through March 2022. These lines have historically tracked closely to one another. When inflation goes up, productivity has tended to rise as well, and vice versa. In recent months, inflation has been growing more quickly than unit labor costs. As of March 30, 2022, the year-over-year change for CPI was 8.56%, and 7.17% for unit labor costs.

Source: Bureau of Labor Statistics. CPI = consumer price index. Data as of April 30, 2022. Shaded areas represent recessions.

4. Relieving this pressure could require growth to slow well below potential

The unemployment rate may need to rise as much as 2.0% or more before wage growth starts to moderate. Okun’s law, which describes the relationship between employment and production, suggests if that were to occur in one year, it would require gross domestic product (GDP) growth to be 4% lower than potential, or the level where it would be if all of the economy’s resources were fully employed.

Okun’s law indicates growth must slow to bring inflation down

This chart illustrates Okun’s law, an economic concept that describes the relationship between employment and production from January 1950 through March 2022. Production, represented here by the difference in real GDP and potential GDP (which is the theoretical level of where a country’s GDP should be if all its resources are fully employed), tracks very tightly with unemployment. Historical evidence shows that as the unemployment rate has risen, production has fallen and vice versa. As of March 30, the rate for real GDP less potential GDP was 0.76% and the change in the unemployment rate was -2.4%.

Source: Capital Group calculations, Bureau of Labor Statistics, Congressional Budget Office, Bureau of Economic Analysis. Data as of April 30, 2022. GDP = gross domestic product. Potential GDP is the theoretical level of where a country’s GDP should be if all its resources are fully employed, Y-axis on the right-hand side of the chart is inverted to illustrate the correlation between GDP and unemployment. Shaded areas represent recessions.

The bottom line

Inflation appears to be increasingly entrenched and persistent. Interest rates, both short- and long-term, could go up more than the market expects. The only way to really break the wage-price spiral, in my view, is to create a lot of slack in the labor market, which is done by pushing the unemployment rate up, which in turn could lead us into a recession.

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There are, of course, alternative scenarios that could come to pass, including: 1) inflation falls of its own volition, 2) the Fed capitulates and lets inflation run unchecked, or 3) the Fed achieves a “soft landing” (a moderate economic slowdown). However, none of these appear to me to be high-probability outcomes, and a soft landing may not free up much slack anyway.

Given the Fed’s focus on taming inflation, which is being exacerbated by recent developments that include rolling COVID-19 shutdowns of cities in China and a prolonged Russia-Ukraine conflict, there is now a higher probability that we may be in a recession by the end of 2022 or early 2023.

Darrell R. Spence covers the United States as an economist and has 31 years of investment industry experience (as of 12/31/2023). He holds a bachelor’s degree in economics from Occidental College. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics.


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