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Good morning. Ethan here; Rob’s on sabbatical. Federal Reserve officials spent yesterday insisting, “Guys, we actually are going to raise interest rates until inflation falls.” Treasuries sold off, a lot. The 10-year was up 14 basis points and the five-year nearly 20bp.
In other news, after her inaugural newsletter yesterday, readers suggested Katie should write happy things about ESG just to annoy Rob while he’s gone. Rob hired me, so my official stance is that I denounce Katie and her antics. If you feel otherwise, email us: firstname.lastname@example.org and email@example.com.
Still arguing about a soft landing
Back in June, we wrote about Fed governor Christopher Waller’s theory of a soft landing. The gist of his argument: the labour market is so tight that restrictive monetary policy can bring down historically high job vacancies while only raising unemployment a bit. That’s the rough story, anyway. We felt sceptical but, then again, the only PhD Unhedged employs is in philosophy.
It took another month for a few heavyweight economists to have their say. In July, Larry Summers, Olivier Blanchard and Alex Domash hit back at Waller and the Fed with a withering paper. That prompted a reply from Waller on Friday and a reply-to-the-reply from Summers et al this week titled, “The Fed is wrong: Lower inflation is unlikely without raising unemployment.”
The essence of the Blanchard-Domash-Summers argument is that vacancy rates — job openings divided by the labour force — have never fallen from a peak without a meaningful rise in unemployment. The orange lines below show every two-year period after a peak in vacancy rates since 1953. The pattern looks uniform. Vacancies down, unemployment up, often by quite a lot:
A simplified version of the chart shows the decline more plainly:
Moreover, the vacancy rate looks like it peaked in March:
So if history is any guide, Summers et al argue, the next couple of years should come with a nasty jump in unemployment.
Waller’s counterpoint is that history might not be a good guide this time. The labour market has perhaps never been tighter, workers never more in demand. So you have to rely on theory instead. Waller and co-author Andrew Figura model a world where normalisation in the vacancy rate, falling from today’s 7 per cent to a pre-Covid 4.6 per cent, only coincides with a 1 per cent rise in unemployment. They write:
We recognise that it would be unprecedented for vacancies to decline by a large amount without the economy falling into recession. As a result, we are, in effect, saying that something unprecedented can occur because the labour market is in an unprecedented situation.
This chart from Waller’s June speech helps illustrate his thinking. It shows the vacancy rate on the vertical axis and unemployment on the horizontal. The dots clustered near January 2019 are pre-pandemic observations, while the spread-out trail after March 2022 are all data after the pandemic began. Post-pandemic, vacancies are higher at each level of unemployment, compared to before the start of the pandemic. Waller argues the vacancy rate can snap back to the old reality without unemployment rising much (green arrow):
Why might this work? Back to Waller and Figura:
Because the [ratio of vacancies to unemployment] is so high currently, it is possible to reduce vacancies with a much smaller effect on hiring than is typical. In addition, because such a decline in vacancies would still leave labour demand strong (a 4.6 per cent vacancy rate is historically still quite high), it seems plausible that lay-offs, which historically are only elevated (above their longer-run trend) when labour demand is weak, would not rise significantly.
Some find this argument plausible. In an otherwise hawkish interview yesterday, San Francisco Fed president Mary Daly pointed to tech hiring freezes as an example of vacancies falling without unemployment rising. Even for critics it’s hard to deny outright, as Summers, Domash and Blanchard write: “Given that the current vacancy rate is outside of historical experience, anything is obviously possible.”
But the biggest reason to doubt Waller is that monetary policy works like a sledgehammer, not a scalpel. It smothers demand indiscriminately, across industries that are hiring like mad and industries that are already slashing headcount. As the FT’s chief economics commentator Martin Wolf put it:
What are the chances that [tighter monetary policy] will only reduce demand in the firms with substantial vacancies, without also reducing demand in struggling firms that are considering laying people off? Zero.
There is also no chance that merely by reducing demand the matching of job seekers with vacancies will magically become instantaneous. Those who lose their jobs will need time to find new ones in this weaker economy.
I cannot see any reason whatsoever why a reduction in aggregate demand should affect only vacancies and not employment. That would be nothing short of a miracle.
The soft landing story Waller tells, in other words, has never happened and looks unlikely at best.
One good read
This Taipei Times editorial on Nancy Pelosi.