High wire act for the holidays

No one really complains if things are going right. But when they are not, everybody does their best impersonation of a Monday morning quarterback. Here are the facts:

3.7% unemployment rate in November 2022

6 million people unemploymed in November 2022 1.5 million weekly jobless claims in November 2022 165 million size of labor participation rate

10.7 million unfilled jobs as of November 2022 1.75 jobs for every 1 job seeker as of November 2022

7.4% Producer Price Index in November 2022

7.1% inflation rate in October 2022

Economist are academic theorist trained to predict the future state and trajectory of economies by looking at studies and patterns of the past. They see the world as a constant stream of cause and effect, the equilibrium of supply and demand, the inverse relationship between inflation and unemployment, and a dual mandate of full employment and price stability.

The Phillips Curve is often used as a framework for policy to explain the relationship between unemployment and inflation. As unemployment goes up, inflation goes down as consumers spend less forcing prices go lower. The current rate of unemployment is considered 'tight' at 3.7% compared to the optimal 4% - 5%. To raise unemployment, the Federal Reserve board uses tools to loosen the economy by manipulating the federal funds rate and/or initiating asset purchases of fixed income securities as they see fit. It's a delicate balancing act of two data points that are inherently negatively correlated. Many pundits have criticized Jay Powell, the current FED chair, for not acting early in raising the interest rate but then raising it substantially in a short time. In most cases, they are valid. The FED is built and structured to base short-term actions on backward looking data, only to react on trends. On the other hand, financial markets are known to be anticipatory six months out.

So why is employment stubbornly high in an environment of high inflation? Aside from the global pandemic and the war in Ukraine, we think these factors are starting to influence a long-held theory about the relationship between unemployment and inflation.

1) Rise of technology. Automated processes increase productivity with less headcount. Employees freed of manual and repetitive movement are deployed to higher added value jobs in managerial or technical positions crowding out lower level employees who require less training.

2) Definition of work - Gig economy and social media influencers contribute to gross domestic product but are not included in the count of the unemployed since they do not fit the 'traditional definition".

3) Generational changes - Boomers are leaving the workforce and Generation Z are holding out on traditional jobs. This exodus keeps the labor force at a constant size. Coincidentally, a recent study suggests that roughly fifty percent of the younger people aged 18-24 live with their parents. Inherently, they have more disposable income to spend on luxury items, going out, travel, etc.

4) Fall in immigration in the last 5 years due to federal policy and pandemic are contributing to a shrinking labor force. In addition, birth rates have slowed as more women opt to delay childbirth.

While the FED marches to two more expected rate hikes, one this month and again in February 2023, there are inchoate signs the labor market is weakening. Companies have announced layoffs or have slowed hiring. But other companies are holding on to staff for fear of having to compete to bring back employees when the economy turns. Delta Airlines has lowered qualifications to lure workers back by dropping the requirement for a college degree. Could a skills gap exacerbate low unemployment?

There is a silver lining to this delicate balance. Supply chain problems have shifted strategies to de-globalization as companies move from international factories to suburban Americas. This benefits blue collar jobs. However, this poses the resurgences of union formations who could demand higher wages and depress corporate margins which could result in higher prices for consumers.

Roughly 10 years after William Phillips concocted the theory of an inverse relationship between money wage change and unemployment in 1958, renowned economists Milton Friedman and Edmund Phelps debunked the longterm efficacy of the Phillips Curve saying that it only works in the short run as evident in the recession of 1973-1975 when unemployment and inflation were simultaneously elevated. So here is the FED raising interest rates to curb inflation and raise unemployment. Will this work only in the short term? Or is the Phillips Curve a proven structured framework even in an era so different from 1958?

It's almost like walking through a crowded room full of people dancing while balancing a tray of champagne glasses. It's not a question of IF anything will break. It's how much or how little will break.