One of the biggest challenges for officials and investors is assessing how the COVID-19 pandemic is affecting the US economy. Three years after the outbreak, the impact is most evident in high US inflation and record low unemployment. This is a paradox considering the economy could be close to recession, and many are wondering how the Federal Reserve will react.
To understand what is happening, one has to consider how the pandemic has evolved, how politicians have responded to it, and how companies and workers have changed their behavior.
When the pandemic hit in early 2020, the economy collapsed as shops and schools closed. From February to May, a total of almost 23 million jobs were lost, while the unemployment rate rose to almost 15 percent. This number underestimated the number of unemployed as millions of workers left the labor force to take early retirement, avoid exposure or to care for family members.
At the time, there was significant uncertainty as to whether a recovery would be “V-shaped” or gradual. That debate was settled when businesses reopened and legislation was passed granting massive transfer payments to individuals and corporations. By the end of 2020, more than half of the job losses had been recouped and most of the unemployed had jobs by the end of 2021.
Last year saw two big surprises that weighed on the economic outlook. One was the surge in inflation, which Fed officials initially blamed on supply disruptions related to the pandemic. But when inflation rose well above the Fed’s 2% target, it was forced to raise interest rates aggressively, leading investors to worry about recession or stagflation.
The second surprise was that the labor market remained tight even as the pace of economic growth slowed to 1 percent from 5.7 percent in 2021. That pattern continued into January amid a Blockbuster jobs report showing nonfarm payrolls rose by 517,000, while the household survey released nearly 900,000 more. They caused the unemployment rate to drop to 3.4 percent, the lowest level since 1969.
Some commentators have dismissed the January data as a statistical fluke due to seasonal adjustments and benchmark revisions. Nevertheless, the trend over the past year is unmistakable: the number of non-agricultural private employees rose by 4.5 million – a monthly average of 375,000. The pace of hiring has slowed over the year but remained well above previously strong levels.
What is striking in the data is that despite the Fed’s tightening, job growth was broad-based. Since the recovery began in mid-2020, there has also been rotation in the sectors that have led to job gains. Initially, the strongest job gains were in areas benefiting from the disruptions caused by COVID-19. They included technology and professional services, design, manufacturing, and transportation and warehousing. In comparison, last year sectors recovering from the pandemic, including leisure and hospitality, healthcare, and professional and business services, led the way.
The biggest job turnover in the last three years has been in the leisure and hospitality sectors, which has reversed most of the losses of 8 million workers. This has led some observers to believe that there is limited room for further big gains. However, there are still numerous “Help Wanted” signs for workers in restaurants, hotels and cruise lines.
This is also true for the labor market as a whole: the most recent Job Opening and Labor Turnover Survey (JOLTS) showed that the number of vacancies rose to 11 million in December from 10.4 million in November. With 6 million unemployed, there are now more than 1.8 vacancies for every job seeker.
On the supply side of the equation, there has been a steady increase in labor force participation over the past 18 months. In January, the rate rose to 62.4 percent, while the ratio of employment to the over-60 population rose – the highest since COVID. The exit rate has also fallen since mid-2022.
So what motivates people who have retired to re-enter the market?
One explanation is that this group is now feeling the pinch of higher inflation depressing their real income and increasing uncertainty about the economic outlook. In 2020-2021, many people received generous federal transfer payments and were able to save a significant portion of the proceeds. US households will have amassed an additional $2.7 trillion in savings by the end of 2021, according to Moody’s Analytics.
Over the past year, however, the household saving rate has fallen as transfer payments are phased out and people resume normal activities as fears of the pandemic ease. Goldman Sachs estimates that Americans have now used up about 35 percent of their additional savings and that they will have used up about two-thirds of the windfall by the end of this year.
With jobs still plentiful, wage pressure could be expected to rise. Still, there are signs that they are moderating. For example, the year-on-year increase in average hourly wages has slowed from 6 percent in mid-2022 to around 4.5 percent most recently, and it has been accompanied by a slowdown in unit labor costs. This reflects in part a shift in hiring to low-skilled workers, which should help keep wage increases in check.
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So how will the Fed respond to high inflation, a tight labor market and weak growth?
Following the January jobs report, investors reassessed the prospects for Fed tightening. They now agree that the Fed will hike rates to 5.0-5.25 percent by May and likely pause in the second half of this year. This is reasonable given that the Fed’s mandate is to aim for both price stability and full employment. With unemployment now at a five-decade low and inflation at a four-decade high, investors should not expect the Fed to cut rates until there is a significant rise in unemployment and a fall in inflation is coming.
Nicholas Sargen, Ph.D., is an economic advisor with Fort Washington Investment Advisors and a member of the University of Virginia’s Darden School of Business. He is the author of three books including Global Shocks: An Investment Guide for Turbulent Markets.
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