Is a Soft Landing Possible?

A whopping gain of 517,000 jobs in January surprised most economists who have been expecting a recession this year. At the same time, the Employment Cost Index, the Fed’s favorite measure of wage pressures, dropped a bit in the fourth quarter, from 5.3 percent to 5.1 percent. The latest report on average hourly earnings suggests that inflation might well be decelerating at the start of the year, down from an average rate of 0.4 at the end of last year to a slightly lower 0.3 in January. If January is repeated for the rest of the year, then wage inflation would be down to a 3.6 percent rate.

One of the predictable patterns of stagflation is that price inflation declines to wage inflation, and then they both stay stubbornly high. This leads the Fed to tighten conditions until unemployment rises sharply, driving wages, then prices, down. Core CPI also came in at 0.3 percent in December, which confirms the historical pattern of convergence, but wage inflation, if sustained, is lower than historical precedent would suggest it should be.

The latest data show a strong job market but decelerating inflation. While these two sets of facts might lead one to despair that macroeconomics is of no use to understanding our present circumstances, there are reasons to expect that the surge in economic activity suggested by the jobs report is a head fake. For one thing, we have observed a January job growth in recent years, suggesting that there may be seasonal factors driving the strong numbers. If we don’t need to hire lots of people to handle Christmas retailing, then we don’t need to fire lots of people in January. Moreover, other measures of how the economy is doing are much more modest. The Institute for Supply Management’s survey suggests that manufacturing is steeply contracting, something confirmed by December’s industrial-production report, which was down 0.7 percent in December month on month, while retail sales dropped sharply in November and December and are likely down again this quarter.

Nonetheless, the service sector is holding up, and the Atlanta Fed is now forecasting that first-quarter growth is likely to be mildly positive. If it is, and inflation continues to decline, then the mythical soft landing may be possible. The question then arises: If it is, what the heck is going on in the macroeconomy?

It is possible to weave a story that accounts for a soft-landing scenario. This is what it looks like.

We had a pandemic, and many people got used to working from home, or not working at all. Meanwhile, government subsidies for people who didn’t work at all increased so much that the incentive to participate in the labor force disappeared for a large swath of working-class Americans. Right now, about 1 percent of the U.S. population appear to have learned to stay home and stop working.

Normally, when inflation jumps, workers demand higher wages so that their standard of living does not collapse. When those higher wages come, low-income individuals grow more aggressive in seeking work because they need the extra cash to make ends meet. Covid-related government subsidies, however, have softened that instinct. Employers who lost many workers during the pandemic are unable to lure them back and are still sitting on 11 million job openings whether they lift wages or not. So, as demand drops in response to the Fed hikes, the number of job openings declines but remains large and positive because of the effects of pandemic-era policies. Firms just try to make do with the workers who have stayed.

For the workers who have stayed, there really isn’t much reason for firms to raise wages, even if these workers’ standard of living is falling. They have proven to be a reliably inelastic supply of labor. For the workers who have stayed out, no plausible wage increase will draw them back in.

If this story is true, then consumption will start to fall as real wages decline, but firms will hoard the workers they have, muting the severity of that drop. As a result, it will be easier to bring inflation back under control with milder monetary policy.

In my first guide to stagflation, I argued that the Fed would have to wallop the economy to slow down wage growth. But, if our workforce has truly bifurcated into inelastic workers who either work no matter what or stay home no matter what, then firms will be able to pay lower wages (in real terms) as demand declines without fearing that their workers will quit.

It may be that firms are beginning to figure that out, and, if they are, a softer landing than any of us expected might be possible.