Beveridge curve implies a balanced labor market as hiring cools

The labor market has finally come into balance. After two years of worker shortages and a strained hiring environment, traditional measures like the monthly employment report, job openings and layoffs have returned to their pre-pandemic levels.

This data, Federal Reserve Chairman Jerome Powell told the U.S. Senate in early July, has sent “a pretty clear signal that labor market conditions have cooled considerably compared to where they were two years ago."

But a labor market in better balance will not remain that way for long should the federal funds policy rate remain too restrictive and cause real rates to rise further.

That is a recipe for higher unemployment, slower spending and falling fixed business investment, and it runs the risk of causing an early termination of the business cycle.

For now, though, the labor market has achieved an equilibrium. Look no further than the Beveridge curve, which captures the relationship between unemployment and job vacancies.

After a wild swing during the pandemic, the curve has reverted to its long-term relationship from before the pandemic.

Note that the elevated job vacancy rate has been one of the Fed’s top targets, as it indicates the strength of the labor market. Now, with the curve back to its steady state, it is much harder to bring down labor demand without pushing the unemployment rate higher.

The jobs report

That improved balance was on vivid display in the June U.S. employment report.

Total employment increased by 206,000, down from 218,000 in May, and the unemployment rate rose to 4.1%. At the same time, wage growth eased to 0.3% on the month and 3.9% on the year.

The top-line gains were in line with our estimates of a sustainable and noninflationary range for job gains in the short run, which is 150,000 to 200,000 on average each month because of the recent increase in the domestic labor supply linked to immigration.

In the longer run, that range should move down to between 100,000 and 150,000 as the impact of immigration begins to fade.

More evidence

To determine the tightness of the labor market, we look at five key metrics—the quit rate, job opening rate, unemployment rate, prime-age employment rate and the vacancy-to-unemployed ratio.

To compare the current state of the market with historical benchmarks, we normalize all metrics by calculating their z-score based on the period of 2001 to 2019 and set all values for February 2020 to zero.

All five metrics are now at or only slightly off their pre-pandemic levels in 2019. For context, in 2019, the year-over-year personal consumption expenditures index—the Fed’s key gauge for inflation—was around 1.5% while the Fed’s policy rate peaked at the same time at only 2.5%.

As of June, core PCE inflation, which excludes the more volatile food and energy components, is at 2.6% while the federal funds policy rate is in a range of 5.25% to 5.5%—which means today’s spread between interest rates and inflation rates is almost double what it was in 2019.

Policy implications

June’s employment report was the last jobs report before the Fed reconvenes in July to make its policy decision. The Federal Open Market Committee will most likely be considering the idea of a labor market back in balance as inflation now stands within shouting distance of its 2% target.

That means the Fed should reduce a too-restrictive federal funds policy rate sooner rather than later to avoid unforced policy errors that could unnecessarily result in higher unemployment rates, slower growth and a premature end to the current business cycle.

In keeping its policy rate between 5.25% and 5.5% for almost a year now, the Fed has been relying on a robust labor market and the residuals of trillions of dollars in fiscal support to sustain economic growth. 

While the decision to hike rates to such elevated levels was appropriate at the time, we do not see any reason for the Fed not to relax its too-restrictive rate later this year as disinflation continues to take hold.

Most of the key metrics on labor market slack have fallen back to their 2019 levels, except for wage growth. But if we factor in the sharp increase in productivity over the past couple of quarters, wage growth is also much closer to its sustainable level. 

When we say monetary policies operate with a long and variable lag, that view applies both ways. Our view that the labor market is nearing an inflection point suggests the Fed risks being behind the curve again by waiting too long to act on rates.

But even with the recent encouraging numbers, the Fed is stuck with its data-dependent mantra and forward guidance that do not leave much room for a surprise rate cut in July, barring an unexpected economic shock.

That is why we are calling for the Fed to cut rates starting this September, followed by one or two more cuts in the fourth quarter before the damage to the labor market becomes irreversible.

The takeaway

The resilience of the U.S. economy over the past 12 months has been the result of a strong labor market, residual support from fiscal policy and improved financial conditions linked to optimism over the economic impact of artificial intelligence.

Those factors have successfully offset the impact of elevated borrowing costs that are at a multidecade high.

These are factors beyond the Fed’s control and will eventually fade if monetary policy remains too tight for too long. We think it will soon be time for the Fed to cut rates to avoid unnecessary damage to jobs and economic growth.