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Economic Insights: The softening labor market may be a good thing

Fewer job openings and rising unemployment aren’t usually reasons to celebrate, however, these latest labor statistics are welcome news for capital markets and inflation hawks.

With unemployment coming in at 3.8% in August (up from 3.5%) and job openings falling to 8.8 million (down from a high of 12.0 million in March 2022) while also seeing job openings fall from 2.0 to 1.0 for every unemployed individual to 1.4 to 1.0 today, these are the most reliable signs yet that the labor market is softening and the Fed’s efforts to curb inflation are on track.

Why does it matter if inflation is already falling without a labor contraction?

The explanation revolves around the distinction between headline and underlying inflation. Headline inflation, which represents the publicly reported increase in prices, experienced a notable shift from being below 2% (the Fed’s target rate) in early 2021 to reaching 9.1% by June 2022.

This drastic increase can be attributed to factors such as disrupted supply chains, heightened consumer spending due to stimulus measures and lockdowns, as well as escalating oil prices due to geopolitical unrest. However, inflation has dropped significantly this year to below 4%, mainly due to a normalization from the Ukraine war, a slowdown in housing costs, and flatter health insurance increases.

The critical question here is: What is the state of underlying inflation, which essentially reflects the rate once all these unique influences have dissipated? This hinges largely on the equilibrium between total supply and demand, with the labor market serving as the most reliable indicator. To simplify, even if inflation recedes to 2%, it may not remain at that level if the labor market is exceptionally tight and causes wages to rise at an accelerated rate.

The narrative of a cooling economy doesn't find strong support in the job growth data since payrolls increased in August by 187,000, which is still higher than historic averages. However, it's important to acknowledge that this data needs to be considered in the light of persistent pandemic influences that we’ve never really encountered before and we are still seeing total nonfarm payroll jobs slowing on the margin from 3.3% growth at the beginning of 2023 to 2.0% in August 2023.

And though inflation ticked up to 3.7% in August, from 3.2% in July, it still appears to be under control and the Fed decided to leave interest rates at current levels during its most recent meeting.

Bottom Line: A looser labor market is necessary for inflation to go down and stay down. It does clash with economic output numbers, though, since gross domestic product demonstrated a robust annualized growth rate of 2.1% in the second quarter, and estimates are calling for above 3% in the third quarter.

But consumer spending is also showing signs of change as consumers are trading down for some necessities like dog food, cleaning supplies, and restaurants, as “needs” vs. “wants” lists are more carefully scrutinized. We also question how material of an impact student loan payments starting up again will have on the consumer.

All of this leads to broader questions on what the real rate of inflation should be going forward (is the Fed’s 2% guidance accurate?). The forecast for inflation impacts the Fed’s target for longer run interest rates. When this forecast was first introduced in 2012, the Fed’s longer run interest rate forecast was 4.25%. That fell all the way to 2.5% in 2019, which is where we remain today. Recently, the Fed appears to be slowly working towards moving this forecast higher again with their most recent guidance staying at 2.5%, but with a range of 2.5%-3.3%. 

It's important to remember that all of this is a prediction. If inflation experiences a smooth decline over the next year, if economic growth suddenly decelerates, if the unemployment rate continues to move higher, then inflation will likely continue to fall, as will the actual interest rates.

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— Marcus Scott, CFA, CFP®, Chief Investment Officer (CIO) for Country Club Trust Company

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