- If the Federal Reserve's benign view on inflation prevails, employment will be key.
- The longer it takes to get people back to work, the more employers will have to pay.
- The Fed wants higher inflation but not so high that it will have to tighten policy early.
- Consumer prices rose 5% in May, but the Fed believes inflationary pressures will ease in the months ahead.
If the Federal Reserve's view on inflation prevails, a few key things have to go right, particularly when it comes to getting people back to work.
Solving the jobs puzzle has been the most vexing task for policymakers in the coronavirus pandemic era, with nearly 10 million potential workers still considered unemployed even though the number of open positions available hit a record of 9.3 million in April, according to the latest data from the U.S. Labor Department.
There's a fairly simple inflation dynamic at play: The longer it takes to get people back to work, the more employers will have to pay. Those higher salaries in turn will trigger higher prices and could lead to the kinds of longer-term inflationary above-normal pressures that the Fed is trying to avoid.
"Unfortunately, we see good reasons to think that labor participation might not return quickly to its
pre-Covid level," Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a note. "Whatever is happening here, the Fed needs large numbers of these people to return to the labor force in the fall."
The pace of inflation is of critical importance for economic trajectory. Inflation that runs too high could force the Fed to tighten monetary policy quicker than it wants, causing cascading impacts to an economy dependent on debt and thus critically tied to low interest rates.
Consumer prices increased at a 5% pace year over year in May, the fastest since the financial crisis. Economists, though, generally agreed that much of what is driving the rapid inflation surge is due to temporary factors that will ease up as the recovery continues and the economy returns to normal following the unprecedented pandemic shock.
That's far from certain, though.
The Atlanta Fed's gauge of "sticky" inflation, or price of goods that tend not to fluctuate greatly over time, rose 2.7% year over year in May for the strongest growth since April 2009. A separate measure of "flexible" CPI, or prices that do tend to move frequently, increased a stunning 12.4%, the fastest since December 1980.
In their most recent forecast, Fed officials put core inflation at 2.2% for all of 2021; Shepherdson said the current numbers suggest something closer to 3.5%.
"That's a huge miss, and it potentially poses a serious threat to the Fed's benign view of medium-term inflation because of its potential impact of the labor market," Shepherdson said.
What's keeping workers home
Surveys show a variety of factors keeping workers from taking jobs: Ongoing pandemic concerns, child-care issues, particularly for women, and enhanced unemployment benefits that are being withdrawn in about half the states and will expire entirely in September.
From the employer perspective, worries over skill mismatches have persisted for several years and have worsened during the pandemic. For instance, a survey from online learning company Coursera showed that the U.S. has fallen to 29th in the world in digital skills needed for high-demand entry-level jobs.
The dilemma is a pervasive one in American business nowadays.
David Wilkinson, president of NCR Retail, the cash register maker that now provides a variety of products and services to the industry, said he sees "a bit of a labor crisis" unfolding.
"As labor gets harder to come by, as labor gets more expensive, the other side of the inflationary worry is that as prices go up, the cost of living goes up and you have to pay people more as they demand more," Wilkinson said. "All of my customers are struggling to staff at levels that they need staff to really get to the other side of this surge."
While he thinks inflation eventually will come down from its current level, he expects it will be higher than the sub-2% that prevailed during most of the post-financial crisis era.
The implementation of technology accelerated during the Covid era. While that will continue, Wilkinson said he also expects to see retailers paying higher wages to fill the demand for staff.
"We're seeing an increased focus on the worker in retail, and part of that is both the experience, the technology they need to do the job, and part of that is the willingness to pay," he said. "This brought that back to the forefront."
Managing its way through the various dynamics could prove difficult for the Fed.
Previous attempts to normalize policy over the years have largely failed, with the central bank having to revert back to the zero-interest money-printing world that arose during the financial crisis.
"The Fed is trapped," wrote Joseph LaVorgna, chief economist for the Americas at Natixis and former chief economist for the National Economic Council.
While LaVorgna sees inflation as staying relatively under control, he thinks the Fed could face problems from deflationary pressures. The central bank doesn't like inflation that's too low, as it creates a low-expectation cycle that constricts monetary policy during downturns.
"The political pressure to do nothing will be intense" as government debt increases, LaVorgna said. "If the Fed cannot (or will not) remove excessive policy accommodation when the economy is booming, how can policymakers do it when growth invariably slows?"
Markets betting on the Fed
Indeed, markets aren't expecting much movement at all in policy.
Treasury yields actually have dropped since Thursday's hotter-than-expected consumer price index report, and market pricing now points to no rate hikes until about September 2022 and a fed funds rate of just 1% through May 2026.
A report Friday from the University of Michigan also showed consumers are lowering their inflation expectations, with the year-ahead outlook at 4%, down from 4.6% in the last survey, and at 2.8% over five years, down from 3% though still well above the Fed's 2% target.
"For all the fears that the Fed will be prompted to tighten policy early to curb inflation, we suspect officials will be just as worried about a slowdown in the recovery in real activity," wrote Michael Pearce, senior U.S. economist at Capital Economics.
Fed officials likely will talk next week about which way the risks are tilted in the current scenario. They've been lukewarm about the recovery, continuing to emphasize the role, albeit diminishing, of the pandemic and encouraging a full-throated policy response.
However, if inflation readings persist to the upside, the pressure at least to tap the brakes on the monthly asset purchases will build.
"There's been this debate about whether inflation is different this time," said Quincy Krosby, chief market strategist at Prudential Financial. "If inflation rises in a more material and less transitory way, consumers are going to need higher wages."
The Fed is betting that a return to the labor market, particularly by women, will help hold down wage pressures and keep inflation in check. The current labor force participation rate for women is 56.2%, up from the pandemic lows but otherwise the worst since May 1987.
Regardless of the inflation pressures, the Fed last year changed its mission statement to keep policy accommodative until the economy sees inclusive labor gains, meaning across gender, income and race.
"They are going to make sure that the glide path to [policy] liftoff is long," Krosby said. "The question is, if inflation picks up in a more meaningful way and is stickier, what does the Fed do? That's the concern the market has."
Become a smarter investor with CNBC Pro.
Get stock picks, analyst calls, exclusive interviews and access to CNBC TV.
Sign up to start a free trial today.