Federal Reserve Chairman Jerome Powell gave up optimism that policymakers could secure a soft landing for the US economy and avoid a recession in his Jackson Hole speech on August 26. The new goal: Avoid a major crash.
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Powell signaled that the Fed would keep policies tighter and the economy grounded for longer to avoid the current inflationary spurt turning into a chronic 1970s-style catastrophe.
“Restoring price stability will take time and will require vigorous use of our tools to better balance supply and demand.”
With that, Powell took the breath away from the Dow Jones, which abruptly collapsed by 1,000 points and continued to snow.
But what Powell glossed over is why today’s economy is so out of whack that it needs to make an emergency landing. Finally, inflation is falling from its peak and GDP has only declined for consecutive quarters, which is rare outside of a recession. Even so, the Fed’s steady hand has done little to correct historic labor and housing shortages, and these imbalances continue to fuel outsized wage and rent increases.
The result: there may be little relief from elevated inflation until unemployment falls on a sustained basis. Most likely, it will take a recession to create enough leeway to avoid a further rise in inflation once the Fed takes its foot off the brakes. And if we head for a hard landing, it certainly means more turbulence for the Dow Jones and the stock market as a whole.
Fed miscalculation of labor force
The US economy seems to have almost no room left. The labor supply appears to have been exhausted, with the unemployment rate hitting a half-century low and two job openings for every unemployed person. The housing shortage is causing a cost crisis for families. It will also likely exacerbate labor shortages by making it harder for people to move.
But July’s sizzling jobs report of 528,000 new jobs signaled that labor shortages were getting worse. While Friday’s jobs report is expected to show more dovish attitudes, broader trends are warning investors it’s time to pull together.
Labor force participation, which reflects all employed or jobseekers, fell for the third month in four in July. It is now below the level reported in February.
As Fed Chairman Powell explained on July 27, one of the major miscalculations by policymakers was that more workers affected by the pandemic would return to work.
The Fed’s view was that “these problems on the (labor) supply side would be resolved relatively quickly,” Powell said. “Everyone would get vaccinated, schools would open, children would go to school and labor force participation would increase again.”
But that didn’t happen — even after unemployment benefits expired last September with an additional $300 a week.
Chronic labor shortage
The working-age population has grown by 4.4 million since February 2020, just before Covid struck. Still, the ranks of the employed are still down by about 360,000, Labor Department data show. Despite this, there are fewer unemployed than at any time since 2000, when the labor force was about 15% smaller.
Aging demographics explain much of the labor shortage: the population aged 65 and over has grown by 2.8 million in the last two and a half years, accounting for about 60% of the total growth in the working-age population. Older Americans are working less often than before Covid. The decline in the labor force participation rate among the over-65s has shrunk the available workforce by more than 600,000, according to an IBD analysis.
Overall, Jefferies chief economist Aneta Markowska believes the decline in labor force participation has shrunk the labor force by 1.8 million workers compared to pre-Covid levels.
By early next year, “once the job slack is fully exhausted and there is no more hiring,” Markowska expects the US economy to start succumbing to Fed tightening.
recession needed?
A soft landing is “almost impossible the way I think about it,” Peter Hooper, global head of economic research at Deutsche Bank, told IBD.
“To bring inflation back down, you need to see a significant slowdown in labor cost inflation.”
The problem: Hooper and his colleagues estimate that the natural, or non-inflationary, unemployment rate is “now just over 5%.”
That’s well above the 4% unemployment rate that the Fed has long assumed to be inflation-neutral. It’s even higher than the current rate of 3.5%. Getting there will require a much larger rise in unemployment than the half-point rise that’s thought to be the minimum threshold for a recession.
So the job market is not just tight; it’s not working as smoothly as it did before the pandemic, Hooper argues. This view is fairly widely shared.
“I think, by and large, many economists believe that the … natural unemployment rate will have risen significantly above the level we think it was before,” Powell said July 27.
Before Covid, the unemployment rate had fallen to 3.5%, with wage growth just over 3% and no discernible inflationary impact. At the same rate, wages are now increasing at more than 5% per year.
Why labor is hard to find
So what has changed? The short answer is that it has become more difficult to match available labor with jobs on offer. For every unemployed worker, there was an all-time high of 1.2 job vacancies in February 2020. But that number is off the charts — up 67% — on two job postings.
Hooper attributes the poorer agreement in part to the mass retirement of “older, more experienced workers.”
Reduced immigration, both from policies put in place under President Donald Trump and from Covid restrictions, has also impacted labor supply and assimilation, he says.
The difficulty of obtaining affordable housing in many geographic areas has further limited flexibility in the labor market, Hooper says.
The National Association of Realtors Affordability Index fell to a 33-year low in June. The double rise in mortgage rates and house prices sent monthly mortgage payments soaring 54% year over year.
apartment inventory
The affordability slump is likely to eventually put pressure on home prices, but so far homeowners have responded by choosing to stay put.
The number of existing homes for sale generally topped 2 million from the mid-1990s to the mid-2010s, topping 3 million during the housing bubble and ensuing crisis. The number of single-family homes and condos for sale has been slashed to a range of 1.5-2million pre-Covid. But the housing stock has fallen in the wake of the pandemic to just 1.3 million homes for sale in July.
Existing home sales fell 20% year over year in July to 4.8 million a year, the lowest since 2015. Still, the average home price was still up 10.8% from July 2021.
New single-family home sales, meanwhile, have tumbled 30% year-on-year to an annualized rate of 511,000 units, the lowest since 2016.
The supply of homes on the market has skyrocketed relative to current sales, but longer-term bottlenecks remain.
Millennial Tailwind
The housing shortage also has a demographic element: the biggest birth years for Millennials — over 4 million a year — were 1989 to 1993. This group has started to live to be 33, the median age of first-time buyers, while 31 is the median age of renters in unsubsidized housing, according to RealPage.
The tailwinds in demand from Millennials followed a decade-long slump in housing construction that ended in 2019. But the pandemic and the associated supply problems quickly turned this dynamic on its head.
Realtor.com notes that the number of US households increased by 13.8 million from 2012 to 2021. However, builders have only built 8 million single-family homes, a gap of 5.8 million.
Rent rise fuels core inflation
This explains the strong increase in demand for apartments. According to RealPage, the national vacancy rate has fallen from over 6% before the pandemic to 3.9% in July. Apartment rents for newly signed leases rose 17.2% compared to the previous tenant’s rate, while those renewing leases paid 11% more.
Rent increases and high occupancy rates have started to moderate from their recent highs. That should continue into 2023 if a bumper crop of new developments should arrive.
Still, Markowska expects “at least 12 more months of very high rental inflation” as wage growth supports demand.
CPI inflation began to ease in July, slipping from 9.1% to 8.5% on falling gas prices. But non-energy services inflation hit a 30-year high of 5.5%. These categories – which include housing costs, medical care, transportation and education – make up 57% of the household budget.
As long as labor shortages and wage pressures persist, there is little chance of core inflation falling to the Fed’s 2% target.
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Emergency landing for the US economy
With the job market “clearly out of balance,” as Powell put it on Aug. 26, the Fed must plan an emergency landing, even if it means a recession.
The message from his Jackson Hole speech is that the US economy will likely have to remain grounded for a while longer.
The Fed, he said, is focused on avoiding a repeat of its failure in the 1970s. Back then, whenever the US economy faltered, policymakers would let their guard down, only to see inflation flare up again. In the end, 20% interest and 10% unemployment would be necessary to dampen the risk of inflation.
“Our aim is to avoid this result by acting decisively now.”
That’s why the Fed’s new stance derailed the Dow Jones rally. Before Powell reversed his script, investors viewed good economic news as bad news for stocks because it tended to push up Treasury yields. But they hailed bad news as good, preferring the Fed to switch to rate cuts.
But suddenly “bad news is also bad news,” wrote Ipek Ozkardeskaya, an analyst at Swissquote Bank, as the hoped-for slowdown now appears to be more severe and worse for earnings.
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