High inflation today, a “job-full recession” tomorrow

Historically, such high bouts of inflation have been quickly followed by recessions and widespread job losses. This “stagflation” is what occurred in the 1970s and early 1980s—an unpleasant mix of double-digit inflation, declining economic activity, and high unemployment. What are the risks that history repeats?

We now have two of the three ingredients for stagflation—high inflation and low or no economic growth—but missing the third, high unemployment. The U.S. labor market is on a tear that shows few signs of abating.

Consider the following, which indicates that we’re in little danger of repeating the ‘70s:

• The U.S. economy added more than a half million jobs in July and another 315,000 in August.
• The unemployment rate is at a low 3.7%.
• Job openings are still plentiful despite the growth slowdown.
• Some of the supply-side issues that fed inflation over the past year are improving.
• Energy prices (and therefore headline inflation) are trending down.

But other signs are mixed and indicate that core inflation may stay elevated longer. Although companies can easily reprice most goods and services to reflect the new reality, that’s not the case for housing and services more broadly, where prices have accelerated in recent months. Monthly mortgage and rent payments are the largest single expense for most households (a 30% weight in the CPI) and are unlikely to shift directions quickly.

A danger of high inflation is that it becomes a self-fulfilling prophecy, making inflation stubbornly “sticky.” When people expect prices to rise even further, they will understandably ask for higher pay. (And during labor shortages, they often get it.) To make up for any difference in their profit margins, employers in turn charge higher prices for the goods and services they provide, which in turn leads to demand for higher pay, feeding the wage-price spiral.

That said, although measures of inflation expectations for the next 12 months have risen, most consumers, business leaders, and the financial markets don’t expect such inflation rates to persist much longer after that—a sharp contrast from the mindset of the 1970s, when most were resigned to double-digit inflation.

Another difference from the ‘70s: The Fed is aware that its recent aggressive rate hikes are still not restrictive enough. Although the Fed was late in raising rates last year, it is now biased for action and intent on driving inflation down even if a recession occurs. When a central bank does that, it usually gets what it wants. 

Our baseline expectation for 2023 is for a recession in the U.S. and other leading economies, primarily because central banks will need to continue to raise rates to help quell inflation. In the United States, that would likely entail inflation falling but remaining above 3% and short-term interest rates landing around 4%­—no soft landing, but no stagflation either.

Recessions are not pleasant. Financial markets have not fully priced in this scenario. We will likely see market volatility in the months ahead. But this recession will likely be different from those of the past. The 2020 COVID-19-induced recession was profoundly deep but short-lived. The 2007–2009 global financial crisis produced deep job losses and a very weak recovery. The 2001 recession was mild yet was characterized by a “jobless recovery” with anemic job gains for years after the recession.

In 2023, the most likely outcome is lower CPI inflation and declining real GDP for a time. More layoffs will likely occur, and unemployment will rise from its very low 3.7% rate, but perhaps not by much. My base case has it remaining well below 5%—a so-called job-full recession compared with recessions of the past.

Why? Because much of the labor demand reflects a deep need for certain skills across a range of industries, and the labor supply remains insufficient for the jobs at hand, even with lower growth. Even if firms cut their job openings by 20% and increase layoffs by 20%, the U.S. labor market would still be relatively tight. And some firms may be reluctant to let go of workers because they fear they may not be able to hire them back, as was the case for some businesses during COVID.

As I said, every recession is different. The labor market will likely weaken, but not as much as some may fear.