To The Moon

• Thursday’s Consumer Price Index (CPI) report was a promising, albeit sluggish sign that inflation is starting to come under control.
• It seems the last remaining metric that needs realignment is unemployment, which has remained stubbornly low despite the Federal Reserve’s best efforts.
• While arguing unemployment is good for the economy is typically a difficult case to make, it’s just the position many economists currently hold.

With Thursday’s Consumer Price Index (CPI) coming in line with estimates for the first time in a while, things seem to be heading in the right direction. However, there remains one variable that has always been a bit stubborn and that appears to be the case again this time: Unemployment. As rumors circulate that the Federal Reserve will ease off the gas at its next rate hike decision, unemployment remains a question mark going forward. Is unemployment good for inflation?

Well, in a sense, yes. Unemployment is intrinsically linked to the aggregate demand of the U.S. economy. This makes sense. When everyone has well-paying jobs typically they go out and spend that hard-earned money. It’s the reason why when pandemic-induced unemployment initially skyrocketed, the immediate Federal response was to hand out stimulus checks. Unemployment is a key metric in measuring economic growth because high unemployment typically accompanies lower demand, which hurts businesses’ respective bottom lines. Unfortunately, however, right now, higher unemployment may just be the recipe the economy needs.

Why Aren’t Prices Falling?

The Fed’s battle with inflation is essentially an issue of overzealous demand. Despite 2022’s bear market, 2021 was one of the country’s strongest years for economic growth ever. The government stipends, rock-bottom interest rates, and moratoriums on things like rent and student loans meant Americans had all the reason in the world to go out and spend money. And they did.

While the U.S. experienced strong, almost unprecedented growth in 2021, it did so while welcoming rampant inflation. Indeed, at its peak in June 2022, inflation was more than 9%, the highest level in 41 years.

While Thursday’s inflation report was met with rejoicing from the masses, prices are still nearly 7% up from the same time last year. Even according to the relatively bullish Mark Zandi, Chief Economist at Moody’s Analytics, as promising as things look, prices need to fall:

“Inflation is quickly moderating. Obviously, it’s still painfully high, but it’s quickly moving in the right direction…I see nothing but good news in the report except for the top-line number: 6.5% is way too high.”

In regard to stubborn inflation, unemployment is likely the missing piece to the puzzle.

Unemployment Needs to Rise for Prices to Fall

For inflation to truly make strides towards the Fed’s 2% target, unemployment needs to rise. It’s strange that something considered so recessionary, unemployment, could be an economic cure of sorts, but that’s what’s happening.

As unemployment rises, it’s the subsequent fall in demand that will eat away at prices. Indeed as more Americans are laid off, there will be a general pullback in spending. This in turn will result in businesses lowering prices in order to stay competitive. There’s a reason economists and analysts everywhere are jumping up and down over a potential recession this year. The Fed’s rate hike efforts have all been for essentially the same reason: lower aggregate demand enough to drive prices lower. A recession will, by all historical counts, lower demand substantially.

If you think this sounds eerily familiar, it’s because it is. In October, former Treasury Secretary Larry Summers commented on the painstaking unemployment needed to effectively lower prices:

“I would be very surprised if we were to simultaneously — as the Fed believes or the Fed forecasts — bring inflation down to something approaching the 2 per cent range and, at the same time, see unemployment rise no higher than 4.4 per cent. It continues to be my view that we are unlikely to achieve inflation stability without a recession of a magnitude that would take unemployment towards the 6 per cent range.”

Clearly, unemployment and inflation are bitterly linked. What do the latest CPI and jobs reports tell us about the path forward, and what the country can expect as the economy hurdles toward a Fed-induced recession?

Unemployment Good for Inflation, Bad for Economy

Somehow, the Fed’s long-prophesied “soft landing” may well be on course. Inflation is down from its peak and seemingly falling, consumer spending intentions as measured by Deloitte’s State of the Consumer Tracker are down year-over-year, and unemployment…fell 0.2% from last month.

Unemployment is a lagging indicator, meaning it will be one of the last macroeconomic signals to accurately reflect the state of the economy. This can already be seen, in more ways than one. If you’ve had your eyes on layoff reports, you’d have noticed an abrupt rise in job cuts, especially for growth and tech companies. More than 150,000 tech employees were laid off in 2022, with an additional 23,000 layoffs already in the new year. The leveraged nature of high-growth companies means they’re quicker on the jump when earnings fall.

Despite this, December unemployment came in at just 3.5%, a historic low, and a decrease from the month prior.

Wishing for higher unemployment feels strange. It’s almost contradictory that the long-term health of the economy depends on millions of Americans losing their jobs in the near term. Yet that’s exactly the conundrum the country faces today.

Summers puts it best:

“To be crystal clear, I yield to no one in my hatred for unemployment, for its consequences for inequality, for its consequences for subsequent economic capacity…The question is not some trade-off of inflation against unemployment. The question is what policy path would minimise the total amount of unemployment distress over time.”