Wall Street seems convinced the Federal Reserve will begin raising interest rates before the year is out. The growing concern is that in the face of soaring energy and food prices, people are starting to believe higher inflation is here to stay. The fear is that these expectations could alter wage- and price-setting behavior in a way that would cause inflation to become unglued, speading beyond energy and food, the way it did in the 1970s. Many investors believe the Fed has no choice but to nip this in the bud by raising its target rate, now exceptionally low in relation to inflation, back toward more normal levels.
What's missing from this argument are the strong labor markets necessary to generate a widespread inflationary spiral. Rising inflationary expectations cannot push prices up broadly unless the job markets are strong enough to lift wages enough to maintain consumers' purchasing power. That was the case in the 1970s: Prior to that decade's two broad accelerations in inflation (outside of energy and food), unemployment was declining while wages and salaries, adjusted for overall inflation, were growing about 6% yearly.
Flash forward to 2008: The mix of rising unemployment and soaring gas prices is sharply eroding buying power. Payrolls are shrinking, and the growth in inflation-adjusted wages and salaries has fallen to just shy of zero (chart). The squeeze will get worse in the second half. Overall inflation in May was running at 4.1% yearly, and by late summer, economists expect rising gasoline prices to push it above 5%. All the while, core inflation, which excludes energy and food, has been edging lower all year, because higher prices at gas stations and grocery stores are cutting demand elsewhere.
It's true that much of the pressure on U.S. inflation is coming from overseas, but it's the labor-market differences between the the U.S. and economies abroad that will determine the U.S. inflation outlook and the Fed's policy actions. In Europe the link between prices and wages is much tighter, given the stronger influence of powerful unions to negotiate cost-of-living increases, and rigid rules on hiring and firing. The greater likelihood that costlier energy and food will work their way into other prices there is one reason the European Central Bank had a more hawkish response recently, compared with the Fed's latest rhetoric.
By contrast, U.S. jobs and wages respond more quickly to weak demand, which means right now the labor market outlook is not good. The economy would have to expand about 2% to 2.5% to generate the job growth necessary to hold unemployment steady. That pace of economic growth would allow payrolls to increase about 100,000 per month, the gains needed to match the growth in job seekers.
However, the economy grew just 0.6% in the fourth quarter, and it's crawling along at 1% to 1.5% in the first half, with most economists expecting a similar pace in the second half. Under that scenario, the unemployment rate will approach 6% by yearend, and the growth of wages and salaries will slow further, even as pricey energy and food continue to rob consumers of buying power. Through June 21, new claims for unemployment insurance had risen above 380,000 per week for the third week in a row. Historically, that level has been accompanied by a rising unemployment rate.
For now, the tax rebate checks are helping to stave off a recesssion. They boosted second-quarter consumer spending, but the lift will reverse as the amount of the payouts dwindles in the third quarter and as overall inflation surges. Unlike the 2001 rebates, these offer only a temporary jump in aftertax income, which will fall back in the coming months as sharply as it spiked up. Plus, the transitory nature of the payouts is unlikely to impel businesses to beef up their payrolls.
In an economy this weak, if higher overall inflation is driven only by energy and food, it's more apt to help control core inflation than push it higher. If the weakness persists, growing slack in the labor markets will preclude the need for rate hikes this year.