Will Slaying Inflation Require Recession?

Labor Market Dynamics and Inflation Outlook

• Structural Debate on Unemployment

  • Olivier Blanchard (Peterson Institute) asserts that a sharp decline in job vacancies without a significant rise in unemployment is historically unprecedented and logically unlikely.
    • Blanchard argues that firms facing lower sales will inevitably reduce hiring and initiate layoffs, noting that no previous economic turnaround has avoided this pattern.
    • He estimates the pre-COVID natural unemployment rate was 3.5%, but post-pandemic structural changes likely raised it to 4.5%.
  • Jan Hatzius (Goldman Sachs) contends that the current labor market imbalance can resolve without a severe spike in unemployment due to unique post-pandemic conditions.
    • He attributes high vacancy rates to a 2021 environment with the fastest GDP growth relative to potential in four decades and persistent supply constraints.
    • Hatzius believes these temporary forces are reversing, allowing the labor market to rebalance primarily through a reduction in openings rather than layoffs.

• Specific Data Points and Trends

  • Vacancy Decline: The job openings rate fell by 0.4 percentage points following the July data, marking the largest quarterly decline on record outside of a recession.
  • Quits and Growth: The quits rate has declined, and employment growth has decelerated smoothly, though total unemployment has remained low in the short term.
  • Growth Rates: Current U.S. GDP growth is approximately 1%; Hatzius notes that if this dips to -2%, significant layoffs would follow, but he does not foresee a necessary slide into negative territory.
  • Unemployment Forecasts:
    • Blanchard forecasts unemployment could reach 6% to 7% to fully tame inflation, with a median forecast near 6%.
    • Hatzius forecasts unemployment will rise modestly to 4.2% by the end of 2024.
  • Recession Probability: Hatzius places the probability of a recession at approximately 30% over the next 12 months and nearly 50% over the next 24 months.

• Inflation Drivers and Mechanisms

  • Blanchard's Three-Factor Inflation Theory:
    • Structural Mismatch: A higher natural rate of unemployment (approx. 4.5-5.5%) implies the economy remains overheated at current levels (3.7% unemployment).
    • Commodity and Energy Prices: High input costs trigger a wage-price spiral where firms raise prices and workers demand higher wages, requiring higher unemployment to break the cycle unless commodity prices fall sharply.
    • Inflation Expectations: If the public loses faith in the 2% target, unemployment must rise further to restore credibility.
  • Hatzius's Inflation View:
    • Goods inflation is abating due to resolving supply constraints and dollar appreciation.
    • Service and rent inflation are decelerating, though slower to materialize in CPI data due to statistical construction lags.
    • He argues inflation can be tamed to 2.5% without hitting the 2% target, provided growth remains slow but positive.

• Recession Scenarios and Fed Policy

  • Blanchard's Recession Outlook:
    • To raise unemployment by 1.3 percentage points (from 3.7% to 5%), output growth must fall below normal by approximately 3%, which Blanchard equates to a recession if occurring within a year.
    • A severe recession appears unavoidable if unemployment must reach 6% to 7%, as the Fed would lack the time to cool the economy gradually without losing credibility.
    • He suggests avoiding a recession is only possible if the Fed accepts a 3% inflation target or allows a 3-4 year timeline for disinflation, neither of which he believes the Fed will do.
  • Hatzius's "Soft Landing" Path:
    • Increased confidence in a soft landing stems from three factors: confirmed sub-trend growth, early labor market adjustments, and improving inflation indicators.
    • He remains less certain on the service sector but cites evidence of unclogged supply chains and decelerating wage growth from surveys (e.g., National Federation of Independent Business).

• Forward-Looking Statements and Timelines

  • Blanchard predicts a rise in unemployment within six months if the Fed continues its current tightening trajectory, despite recent data showing vacancies falling without immediate job losses.
  • Blanchard warns that if vacancies and stable unemployment persist for another three months, it would be evidence against his standard economic models.
  • Hatzius indicates that the transition to slower growth is "much more of a fact than a forecast" and expects the full impact of commodity price declines and dollar appreciation to feed into consumer prices over time.
  • The podcast notes that inflation expectations and the Fed's willingness to endure a longer horizon for disinflation will be the critical variables determining whether a recession occurs.