TPLC - We Don't Need Job Losses To Rein In Inflation

Summary

• A modestly weaker jobs report is reviving risk asset prices.
• Investors sense that this reduces the chance of a larger increase in short-term rates at the next Fed meeting.
• Yet, jobs are not the enemy in our battle against inflation.
• We need a strong labor market and some patience to avoid recession and give birth to a new bull market.

The idea that today's jobs report is pivotal in the Fed's decision about whether to raise short-term interest rates by 50 or 75 basis points later this month is pretty nonsensical in the grand scheme of things. It's even more absurd that investors are buying or selling long-term assets, such as stocks, based on this one report. Investors have been gearing up to sell stocks on news of a better-than-expected jobs number because of its propensity to be inflationary and encourage the Fed to execute a larger increase in interest rates, further pressuring stock prices. A weaker number would have the opposite effect. Yet I don't see job growth or wage increases as being the primary cause of inflation in this economic cycle. Furthermore, the economy has not had time to respond to the deflationary monetary medicine the Fed has already delivered. Before I explain why, let's break down today's number.

The economy created 315,000 jobs last month, which is slightly more than expected, but numbers from the prior two months were lowered by 107,000, so the net was only 208,000. That's below expectations. The unemployment rate rose from 3.5% to 3.7%, which was largely due to an outsized 0.3% increase in the labor force participation rate to 62.4%. This is what the Fed wants to see, as more people entering the labor force reduces the tightness of the labor market. It also reduces the upward pressure on wages. On that note, hourly earnings growth slowed from 0.5% in July to 0.3% in August, and the year-over-year growth rate also eased to 5.2%. The knee-jerk reaction to this news was a surge in risk asset prices in the futures market, because it modestly reduced the probability of a larger rate increase by the Fed at its Sept. 20-21 meeting. This news should give an oversold stock market a decent bounce going into the Labor Day weekend, but I think investors and the Fed should recognize that job growth is not the enemy. We don't need to lose jobs to rein in inflation.

Job growth and rising wages are the foundation of a vibrant economy. Yet the consensus of investors seems to be convinced that in order to maintain that vibrancy, we need to see Americans lose their jobs and have their wages capped. This idea was reinforced by Chairman Powell in his Jackson Hole speech last week when he suggested that we need to target a "growth recession" rather than a soft landing. The difference is that a growth recession results in a protracted period of sub-trend growth with rising unemployment, while a soft landing does not. The concern investors have with this strategy is that a growth recession can run perilously close to a real one, and the Fed's track record on steering the economy with precision is like that of a drunk driver speeding down a winding mountain road late at night.

The Fed fears making the mistake of its former self by allowing inflation to entrench, as it did in the mid-1970s, which required strangling the economy through higher interest rates with a recession in the early 1980s. The problem with this line of thinking is that inflation is not entrenched today, as can be seen in consumers' inflation expectations over the coming 3-5 years. According to the New York Fed's latest survey , median inflation expectations at the three-year horizon declined from 3.6% to 3.2%, while the five-year horizon fell from 2.8% to 2.3%. The three-year horizon is down from 4.2% one year ago and very close to pre-pandemic levels. This is not the 1970s, but the Fed is insinuating that with its rhetoric of late. This has investors understandably unnerved.

The Fed seems to see the tight labor market and wage growth as the primary cause of the inflation we see today, but I think that blame is misplaced. Inflation is the most lagging of all economic indicators and its level today has more to do with past events in my view. We are still suffering from the adverse impacts of the pandemic and the war in Ukraine, both of which disrupted the global supply chain and led to shortages of key materials. These supply constraints are just now starting to ease. We also had unprecedented fiscal stimulus that put money directly into the pockets of consumers, but this was not an unlimited line of credit. We're starting to see early signs that consumers are reining in their unbridled spending of the past 12-18 months. This is why inflation most likely peaked over the summer.

As supply constraints continue to ease, and the fuel tank of savings filled to the brim with fiscal stimulus runs lower, we should see the rate of inflation decline on its own. It takes time, which is why it's a lagging indicator. Additionally, monetary policy also works with a lag that economists estimate can be as long as 12-18 months. Therefore, the four rate hikes we have seen this year from the Fed have yet to work their way through the economy. Still, Fed governors talk about a larger rate hike this month as though it will have an immediate impact on the rate of inflation. That's ridiculous.

Unlike the 1970s, our inflation problem has been an 18-month phenomenon, and the peak looks to be behind us. Furthermore, today's inflation was largely caused by one-time shocks to the global economy, the impacts of which are gradually diminishing. Instead of viewing the increase in wages and strength of the labor market as lifting the rate of inflation, investors and the Fed should appreciate that both are helping consumers survive what should be a relatively short period of extraordinary price increases.

My message to the Fed is let the rate increases to date combined with the ongoing quantitative tightening, which is another form of rate increase, do their work! We're just now seeing their impact on the housing market, and both have resulted in a significant loss of financial wealth since the beginning of the year. At the same time, the rate of inflation is gradually declining on its own as supply constraints ease and fiscal stimulus wanes. This combination should result in a rate of inflation that falls closer to the Fed's target one year from now. We don't need to sideline workers during this process, as the strength of the labor market is what should allow this economic expansion to continue.

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