Diminished U.S. workforce could lead Fed to keep interest rates high

Still eager to hire, America’s employers are posting more job openings than they did before the pandemic struck 2½ years ago. Problem is, there aren’t enough applicants. The nation’s labor force is smaller than when the pandemic struck.

The reasons vary—an unexpected wave of retirements, a drop in legal immigration, the loss of workers to COVID-19 deaths and illnesses. The result, though, is that employers are having to compete for a smaller pool of workers and to offer steadily higher pay to attract them. It’s a trend that could fuel wage growth and high inflation well into 2023.

In a recent speech, Federal Reserve Chair Jerome Powell pointed to the shortfall of workers and the resulting rise in average pay as the primary remaining driver of the price spikes that continue to grip the economy.

Though inflation pressures have eased slightly from four-decade highs—average gasoline prices are now below where they were a year ago—costs are still rising fast in much of the economy’s vast service sector. As a result, the Fed is expected Wednesday to raise its benchmark short-term rate for a seventh time this year, though by a smaller amount than it has recently.

The central bank has boosted its key rate by a substantial three-quarters of a point four straight times, to a range of 3.75% to 4%, the highest level in 15 years. Powell has signaled that the Fed will likely raise its benchmark rate by a half-point this week, and many economists expect quarter-point rate hikes after that.

Cumulatively, those rate increases may be helping slow inflation. But they have also sharply increased borrowing costs for consumers and businesses — on mortgages, auto loans and credit cards, among other loans. Many economists have warned that the resulting decline in borrowing and spending will likely cause a recession in 2023.

Yet with price increases still uncomfortably high, Powell and other Fed officials have underscored that they expect to keep rates at their peak for an extended period, possibly through next year. On Wednesday, members of the Fed’s rate-setting committee will update their projections for interest rates and other economic barometers for 2023 and beyond.

The higher wages that many employers are having to offer don’t always lead to higher inflation. If companies invest in more efficient machines or technology, workers can become more productive: They can increase their output per hour. Under that scenario, businesses could raise pay without having to raise prices.

But productivity has been especially weak in the past year. And Powell has noted that higher pay will likely feed too-high inflation in the service sector—everything from restaurants and hotels to retail stores, medical care and entertainment. The employers in these industries are labor-intensive, and they tend to pass their higher labor costs on to their customers through higher prices.

Higher wages also typically spur Americans to keep spending, a trend that can perpetuate a cycle that keeps prices high.

“This labor shortage that we have,” the Fed chair said, “it doesn’t look like it’s going away anytime soon. It’s been very disappointing and a little bit surprising.”

The leading cause of the worker shortfall, according to research by the Fed, is a surge in retirements. In his recent speech, Powell noted that there are now about 3.5 million fewer people who either have a job or are looking for one compared with pre-pandemic trends. Of the 3.5 million, about 2 million consist of “excess” retirements—an increase in retirements far more than would have been expected based on pre-existing trends. Roughly 400,000 other working-age people have died of COVID-19. And legal immigration has fallen by about 1 million.

For Diane Soini, it was the experience of working from home and then having to endure a dismal return to the workplace that led her to retire after working 11 years as a computer programmer with the University of California, Santa Barbara. Before the pandemic, Soini had enjoyed going into work. She felt respected by colleagues. She had asked for, and received, her own office.

“And the pandemic came along and took it all away,” said Soini, 57, who lives in Santa Barbara.

She disliked communicating over Zoom and felt disconnected from her co-workers. Once she returned to the office, she often found it mainly empty. Motion-sensitive lights would turn off, and she’d have to walk around to turn them back on. Women’s bathrooms in her building, Soini said, were often locked.

“I just thought, this is horrible, I hate this,” she said.

Soini retired in July. Soon after, she hiked 800 miles of the Continental Divide trail along the Montana and Idaho borders. Next spring, she plans to hike the Arizona National Scenic Trail from the border with Mexico to Utah.

Soini and her partner are financially secure, she said. She puts the likelihood of her ever returning to work at maybe one-third. She quit a volunteer job she had taken once it began to seem like work.

Besides fueling inflation, a smaller workforce is causing other consequences. Some businesses, particularly retailers and restaurants, have had to cut back their hours of operation, losing revenue and frustrating customers.

Jeffrey Moriarty, who manages a family-owned 42-year-old jewelry company called Moriarty’s Gem Art in Crown Point, Indiana, said his company had to close its jewelry repair business late last year, a service it had provided for 30 years, because it couldn’t replace its longtime employee. Though the repair service accounted for only about 15% of Moriarty’s revenue, it allowed the business to distinguish itself from rivals in the area.

“It’s hard enough finding workers, but a bench jeweler is a dying breed,” said Moriarty, referring to an artisan who does stone setting and engraving. “You just can’t bring someone in with no experience.”

How the Fed will manage a robust labor market, with its effect on inflation, could prove perilous. Powell and other Fed officials have said they hope their rate hikes will slow consumer spending and job growth. Businesses would then remove many of their job openings, easing the demand for labor. With less competition for workers, wages could begin to grow more slowly.

Powell has even named a wage target: He regards annual pay growth at a rate of about 3.5% as compatible with 2% inflation. Right now, average pay is growing about 5%-6% a year.

Three months ago, the Fed’s policymakers estimated that the unemployment rate would rise to 4.4% next year, from 3.7% now. On Wednesday, the policymakers may forecast a higher unemployment rate by the end of 2023. If so, that would suggest that they foresee more layoffs and likely a recession.

“What will it take to get wage growth to slow to the extent that inflationary pressures go away?” asked Matt Klein, an economics commentator who writes The Overshoot newsletter. “We don’t really know the answer.”