The U.S. labor market holds the key to the inflation outlook and the timing of the withdrawal of monetary policy accommodation. After all, it is pressure on resources that ultimately leads to persistent inflation. If workers are in chronic short supply, wage inflation climbs and that usually feeds through into prices. In contrast, supply disruptions typically get resolved with time. Businesses respond by reallocating resources. Once this occurs, price pressures abate. In those cases, inflation turns out to be transitory.
The labor market situation is particularly murky at the moment. As the pandemic abates and the economy rebounds, there is no good historical example to use as a benchmark. Moreover, labor market indicators are all over the place, with some indicating lots of slack and others suggesting unprecedented tightness.
On the side of slack, the civilian unemployment rate stands at 5.9%, well above the trough of 3.5% reached in February 2020, right before the start of the pandemic. Similarly, the level of employment—measured by the Labor Department’s household survey—is still about seven million jobs short of what it was just prior to the pandemic. The shortfall is larger than what’s implied by the unemployment rate gap because the labor force participation rate fell sharply during the pandemic.
The seven million figure is the measure Fed Chair Jerome Powell likes to cite to demonstrate that there is a still a long way to go before the central bank meets its goal of “substantial further progress” toward maximum sustainable employment. That is an important benchmark because it is the standard that Fed officials have said they need to meet before they begin to taper asset purchases.
On the side of stringency, job openings remain at record highs, with businesses reporting 9.2 million available positions in May, two million more than in February 2020. Anecdotal evidence supports the inability of companies to find sufficient workers. The Fed’s latest Beige Book report notes: “The lack of job candidates prevented some firms from increasing output, and less commonly, led some businesses to reduce their hours of operation.” This implies that the economic recovery is being held back by worker shortages.
So which is it? Is the labor market loose or tight?
The answer is both. There are three important factors making it difficult for employers to find workers, but these factors are mostly transitory. As they abate, the labor market is likely to loosen.
First, labor supply has fallen as some potential workers withdrew from the workforce. For example, retirements soared as Covid-19 put older people at particular risk. The Federal Reserve Bank of Dallas estimates that 2.6 million people have retired since the start of the pandemic, about 1.5 million more than would have been expected.
Second, unusually high unemployment compensation benefits are causing some potential employees to sit on the sidelines. The Biden administration’s fiscal stimulus package included a supplemental $300 per week unemployment compensation benefit on top of what state plans pay. This meant that some lower wage workers could actually earn more by staying unemployed and collecting unemployment benefits.
Third, some parents have decided to stay home to take care of children that have not been able to attend school in person. Earlier, schools were mostly virtual but now it’s summer and they are out of session.