Why January's low unemployment rate shouldn't have sunk stocks and stoked recession fears

Only in today’s topsy-turvy economy is a blockbuster jobs report a major bummer.

January’s booming 517,000 employment gains and 3.4% unemployment rate, a 54-year low, were instantly distilled Friday as bad news for the stock market and a development that increases the already high risk of recession this year. The Dow Jones Industrial Average closed down 149 points.

Why?

Robust job growth could mean that inflation remains elevated longer, economists say, leading the Federal Reserve to raise interest rates more sharply and possibly tip the nation into a mild recession. .

Some economists say it doesn’t have to be this way.

“We should celebrate the fact that we have robust job growth,” says Bernard Baumohl, chief global economist of the Economic Outlook Group. “It shouldn’t be frightening to us and it certainly shouldn't frighten the Federal Reserve.”

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What does high job growth mean?

First, January’s robust hiring may have been a blip after job growth slowed to a monthly average of under 300,000 in the second half of last year from more than 400,000. Some economists at least partly attributed last month’s big gain to challenges the Labor Department faced in adjusting the figures to remove the effects of seasonal patterns after weak holiday hiring and COVID-19-related worker absences a year ago.

While hiring did pick up last month, much of it was by restaurants, hotels and stores that have grappled with longstanding labor shortages and so scooped up workers in anticipation of the busy spring season, says Becky Frankiewicz, president of ManpowerGroup, a leading staffing firm.

Because such hiring happened early, job growth could slow more than expected in the spring, she says.

Frankiewicz generally expects hiring to quickly return to last year's slowing trend.

Why does low unemployment often lead to inflation?

Historically, strong job growth and a low unemployment rate have meant rising wages as employers compete for a limited supply of workers. That, in turn, bumps up prices as companies pass their higher labor costs to consumers.

But that relationship between unemployment and wage growth “has been shattered” in recent decades, Baumohl says.

In the decade after the Great Recession, unemployment declined steeply while wages increased modestly. That’s largely because Americans came to expect weak inflation for various reasons and didn’t demand big raises.

From 2020 through 2022, as the nation recovered from the COVID-19 pandemic and firms jostled for fewer workers, pay increases did accelerate along with job growth and the unemployment rate returned to a five-decade low.

But Mark Zandi, chief economist of Moody's Analytics, doesn’t believe wage growth was propelled by worker shortages but rather by high inflation expectations. Record gasoline prices, supply chain troubles and Russia’s war in Ukraine drove up consumer prices, prompting workers to demand bigger raises, he argues.

Now, however, pump prices have fallen sharply – notwithstanding a recent rise – and supply snarls have improved, lowering consumer inflation expectations for the next 12 months, according to recent surveys.

As the supply problems have eased, annual inflation itself fell to 6.5% in December from 9.1% earlier in 2022, still well above the Fed’s 2% target.

What is the wage growth rate?

Wage growth also has drifted lower. In January, employers added half a million jobs even as annual pay increases slowed to 4.4% from 4.8% the previous month and 5.9% in March, Baumohl notes.

That’s higher than pre-pandemic wage growth of about 3%. But pay increases have moderated despite intensifying worker shortages, Baumohl says. In December, there were a record 1.9 job openings for each unemployed worker.

How does productivity improve wages?

Economists say strong wage growth doesn’t need to drive up prices if worker productivity – or output per labor hour – improves. In the fourth quarter, productivity increased at a 3% annual rate after a 1.3% rise the previous quarter and a decline the first half of the year, the Labor Department said last week.

In other words, if workers produce more, that drives down the cost to make each good and an employer can afford to increase pay without passing that added cost to consumers.

“What matters fundamentally is productivity,” says Brian Bethune, an economist at Boston College.

In the second half of 2022, the average labor cost to make a product rose 1.7% at an annual rate while all other business costs increased 5.8%, Bethune noted. So, he says, it was supply chain snags, high energy costs and other business expenses that fueled inflation, not labor costs.

But Jonathan Millar, senior U.S. economist at Barclays and a former Fed official, is skeptical.

Is it possible to have low inflation and low unemployment?

Millar says that while the tie between unemployment and wage growth has weakened, it still exists. For example, he says, studies have shown it now takes a percentage point increase in the unemployment rate to lower wage growth by a quarter point. That means it could take a recession to boost unemployment enough to curtail big pay increases and reduce inflation further.

Fed Chair Jerome Powell has said price increases in service industries like health care and education account for 55% of inflation, and they're linked mostly to labor costs.

Millar, meanwhile, doesn’t expect a productivity boom that will offset hefty pay increases.

Although productivity rebounded in the second half of 2022, Millar says, it was bouncing back from a weak first half. After productivity soared during the pandemic as a smaller contingent of workers picked up the slack created by their idled co-workers, it’s probably just returning to its pre-pandemic pace.

“It’s concerning that (Fed officials) aren’t getting any traction in slowing the labor market,” Millar says, adding it could mean inflation that takes longer to subdue and higher Fed rates.

On the other hand, he concedes, "it may be they don't have to." It's possible, he says, inflation will drift down to the Fed's target even if job growth remains strong and unemployment stays near a half-century low.

This article originally appeared on USA TODAY: Why January's low unemployment rate shouldn't have spooked the market