Is a ‘softish’ landing ahead for the US economy? I believe it is.

If I had one gift I could wish for this holiday season, it would be a “softish” landing for the US economy in 2023. Here’s why I think I might actually get that gift in the new year.

Many people, including those who serve on the Federal Open Market Committee (FOMC), think about inflation in terms of the Phillips Curve. Simply put, the Phillips Curve posits that?inflation and unemployment move inversely to each other. So when unemployment falls, inflation should rise, and when unemployment rises, inflation should fall.

In the past several months, Federal Reserve officials have talked about how much unemployment needs to rise in order to tame inflation. The Fed's latest economic projections, released after the September FOMC meeting, show expectations for unemployment rising to between 4.4% and 5% — up from October's 3.7% — as inflation declines.(1) Assuming no change in the labor force, that would mean approximately 1.2 million to 2.2 million job losses. Former US Treasury Secretary Larry Summers is even more aggressive in his prescription for how much unemployment needs to rise in order to combat inflation: “We need five years of unemployment above 5% to contain inflation — in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.”

The Phillips Curve is flawed

While the Phillips Curve relationship is a simple and easy rule of thumb to follow, it is flawed. For example, in the 1970s, the US experienced a “stagflationary” environment in which both unemployment and inflation were high for an extended period of time.

We’ve even seen that, at times, the Fed doesn’t seem to have believed in the Phillips Curve either. At Jackson Hole in August 2020, Fed Chair Jay Powell announced a new average inflation target policy that allows for inflation to rise “moderately” over its 2% target for “a period of time.” What was surprising is that this new policy carried with it an asymmetric employment goal: As long as inflation is in check, the Fed will become more accommodative if unemployment is running higher than target, but will not tighten if unemployment is lower than target. In his speech, Powell explained “… the historically strong labor market did not trigger a significant rise in inflation” – hence its new policy. I took that to mean that the Fed clearly did not believe there was a strong correlation between unemployment and inflation, which was of course borne of recent experience.

What the Phillips Curve ignores

The Phillips Curve ignores a critical factor impacting wage growth and therefore inflation: job mobility. If a person earning $13 per hour at a fast food restaurant – let’s call it Los Pollos Hermanos – learns that Big Kahuna Burger is hiring at $15 per hour, they can either switch employers or simply ask their current employer for a raise in order to remain. In fact, there is research that supports the view that it is job mobility, rather than unemployment, that has a strong correlation with wage growth and therefore inflation. Research has shown that job openings and mobility can impact wage growth in two ways. First, there are the employees who quit their jobs for higher-paying positions. And then there are the employees who benefit without actually switching jobs: “the more opportunities workers have to quit, the more aggressive are their employers with their wage responses, to try and retain them.”(2)

The good news is that job openings are abundant. The most recent JOLTS Survey for October shows job openings at 10,334,000, well above the approximately 7 million or so job openings that was normal in the year before the pandemic began.(3) That means that if employers seeking to cut costs choose to reduce job openings rather than jobs, then wage growth is likely to ease. And why would employers cut more job openings than jobs? One key reason is that many employers have a lower-than-normal number of employees as a result of the tight labor market, so they can’t afford to shed many employees. As reported in the most recent Federal Reserve Beige Book, “…some contacts expressed a reluctance to shed workers in light of hiring difficulties, even though their labor needs were diminishing.”(4) I suspect that will be a common theme among employers in coming months.

And so while there will be more layoffs and an increase in the unemployment rate, I expect US employers will show a distinct preference for cutting job openings rather than jobs to the extent possible. That increases the odds the US will avoid any broad, lengthy recession and will instead experience a shorter, more modest downturn early in the coming year.

That in turn can set the US economy up for a recovery to begin to unfold later in 2023 — if the Fed cooperates. Keep in mind we will need the Fed to hit the “pause” button on rate hikes, which I expect will happen sometime in the first half of the coming year (inflation data will of course need to show continued moderation). Markets are likely to anticipate an imminent Fed pause and eventual economic recovery, which means stocks and other risk assets may be likely to begin a period of outperformance.?

All this means that 2023 is likely to be a better year than 2022 for investors — and a less bad year than expected for the US economy. Happy Holidays — and may yours and my holiday wishes come true.

?

1 Source: Summary of Economic Projections, September 2022

2 Source: “Wage Posting and Business Cycles,” Giuseppe Moscarini and Fabien Postel-Vinay, Papers and Proceedings of the One Hundred Twenty-Eighth Annual Meetings of the American Economic Association, May 2016

3 Source: US Bureau of Labor Statistics, as of Nov. 30, 2022

4 Source: Federal Reserve Beige Book, November 2022?

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Past performance is not a guarantee of future results.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

The Job Openings and Labor Turnover Survey (JOLTS) from the US Bureau of Labor Statistics produces data on job openings, hires, and separations.

The Summary of Commentary on Current Economic Conditions by Federal Reserve District (commonly known as the Beige Book) is published eight times per year. Each Federal Reserve Bank gathers anecdotal information on current economic conditions in its district, and the Beige Book summarizes this information by district and sector.

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

Stagflation is an economic condition marked by a combination of slow economic growth and rising prices.

The opinions referenced above are those of the author as of Dec. 1, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.