Why a recession is now likely
James Rogan
Rarely do prominent left-of-center economists, such as Jason Furman, Paul Krugman, or Larry Summers, as well as members of the Federal Open Market Committee, or the FOMC, the interest-rate-setting body of the Federal Reserve, agree on a policy matter as important as the appropriate level of interest rates.
But the shocking hourly wage data from the November employment report brought a uniform response from the economists: Wage inflation is too high.
Responding to the average hourly wage data of the November employment report, an increase of 0.6% when the market was anticipating an increase of 0.3%, professor Jason Furman, former economics adviser to President Barack Obama, tweeted: “The biggest news in this release is large upward revisions in wage growth for September and October and a big number for November. This is the second time this year we’ve seen AHE revisions like this dashing the hopes that maybe nominal wages growth was cooling.”
Krugman echoed the sentiment: “When the data don’t tell you what you want to hear, you have to listen. I was a lot more optimistic about near-term inflation at 8:29 this morning than I am now.” And Larry Summers tweeted: “I suspect they’re going to need more increases in interest rates than the market is now judging.”
These opinions are consistent with the views of Federal Reserve Chairman Jerome Powell, James Bullard, president of the St. Louis Federal Reserve Bank, and John Williams, president of the New York Federal Reserve Bank, all voting members of the FOMC. They believe that interest rates must go higher in order to reduce wage inflation. After all, wage inflation is everything. Regardless of positive news on goods inflation and shelter inflation, if wage inflation consistently runs more than 2 percentage points above a trend productivity growth of 1.5%, then a wage price spiral will take hold. In time, wage inflation will lead to a resumption in goods inflation and shelter inflation.
Wage inflation causes margin erosion. The market will discipline managers who tolerate margin erosion. Businesses will raise prices to protect margins. Profits are necessary for investment, which drives productivity in turn. When profits are compressed, investment slows, which leads to lower productivity growth. When wage inflation runs hot, businesses raise prices. Labor chases prices. A negative feedback loop is created.
Researchers at the San Francisco Federal Reserve Bank explain that “the longer inflation and inflation expectations remain elevated, the higher and longer-lasting the pressures on wage growth are likely to be.”
The FOMC will move aggressively to quell wage inflation. Aggressive rate action raises the risk of recession. And there are several signs that a recession is approaching.
First, the personal savings rate is low. According to the Bureau of Economic Analysis, the U.S. personal saving rate dropped in October to 2.3%. That is the second-lowest on record. The record low was set in the housing bubble of 2005. Consumers will retrench to rebuild savings. Second, consumers are tapping savings to finance current consumption. That behavior is not sustainable. Finally, over the past 50 years, every time the Chicago purchasing managers index has dropped below 40, a recession has followed. Last week, the Chicago purchasing managers index fell to 37.
To quell wage inflation, the FOMC will continue to raise rates aggressively. Consumers are financially stretched. Factory activity is slowing. Higher interest rates are bringing us closer to the tipping point. Larry Summers is right: A hard landing is coming.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on finance and the economy, politics, sociology, and criminal justice.