The wild ride for the global economy and markets this year is in no small part the consequence of the growing recognition of the scale of the US inflation challenge and the extreme measures the Federal Reserve will be forced to take to bring prices under control. When the Fed began raising rates in March, markets were pricing in a terminal rate of just 2.8%. As of mid-November, that expectation has risen to 5%—matching the forecast Bloomberg Economics set out in July.
Could they be forced to do even more? Absolutely. If the Fed is underestimating the natural rate of unemployment, or if the pandemic has resulted in a significant deterioration in productivity, a terminal rate of 6% could come into view.
There are also risks in the other direction, even if they’re less likely. It would take a lot more than the shocks to date, but a prolonged period of market mayhem—of the sort seen after the UK’s mini-budget fiscal fumble in September—might be enough to persuade the Fed to halt at a lower rate.
What Higher U* Would Mean
At its September meeting, the Federal Open Market Committee’s dot plot showed a higher trajectory of rate hikes, despite a deterioration in the growth outlook. A simple explanation for this anomaly is that the committee’s estimate of u*—alternatively called NAIRU, or the unemployment rate associated with price stability—has risen from the traditional 4%.
The Bloomberg Economics rule—a modification of the classic Taylor rule that captures the relationship between unemployment, inflation, and Fed policy—can be used to work out an estimate of where the FOMC now puts u*. The u* values that best fit the September dot plot are 4.4% in 2022, 4.3% in 2023 and 2024, and 4.0% in 2025. That suggests the FOMC sees u* as temporarily elevated and expects it to gradually fall back to the pre-pandemic norm in 2025.
What if u* is even higher? A recent estimate by Fed staff put it in the 5%-to-6% range. Given the wrenching dislocations in labor markets that have resulted from the pandemic—with both companies and workers rethinking their priorities—that’s entirely plausible. Fed Chair Jerome Powell himself has said the natural rate of unemployment has “moved up materially.”
Holding the committee’s inflation forecast constant, a u* estimate of 5% would mean a terminal rate of 6%.
What Lower Productivity Growth Would Bring
Broader macroeconomic factors, such as a slowdown in productivity growth, could also push up u*. If workers demand faster wage growth than what companies can earn from their output—either to compensate for higher inflation or simply because they have the bargaining power—the result is higher unemployment. That’s what happened in the 1970s, when productivity gains fell below wage growth.
Mainstream economists appear to believe the pandemic won’t result in a repeat performance. That assumption ignores some hard-learned lessons from the 1970s that linked high inflation to lower productivity:
- High inflation means a sharp shift in relative prices. Businesses that have optimized their production processes on the assumption of stable input costs may find their old approaches obsolete or inefficient.
- On their balance sheets, companies charge themselves for property, machinery, and other capital stock based on the equivalent rental price. High inflation raises the rental price, discouraging investment.
- Uncertainty about inflation and central bank rates—as well as factors like geopolitics—adds an additional hurdle for companies making costly long-term investments. A project that looks profitable today might not be tomorrow if borrowing costs continue to rise.
All of those factors that weighed on productivity growth in the 1970s are also present today, suggesting a high risk that potential growth may be downshifting from its already low pace before the Covid-19 pandemic.