Until recently, the idea that economy could simultaneously have low levels of unemployment and low inflation seemed to be a fantasy. Conventional wisdom, after all, holds that when unemployment is low, businesses need to pay higher wages to attract workers, which pushes up the cost of goods and services, and, ultimately, inflation.
Today, we think that the economy has reached full employment and that a virtuous cycle that bolsters productivity and dampens inflation is now possible.
But that logic has been turned on its head. The American economy over the past nine months has been one of the best in 50 years, with rising real incomes, disinflation and low unemployment.
Today, we think that the economy has reached full employment—the maximum level of employment consistent without causing an increase in inflation—and that a virtuous cycle that bolsters productivity and dampens inflation is now possible.
Something has changed. It now seems possible to have full employment between 3.5% and 4% and inflation around 2.5% to 3%.
Part of the reason has been the Federal Reserve, which has successfully pursued a tough monetary policy over the past two years as it seeks to fulfill its dual mandate of maximum sustainable employment and price stability,
The numbers tell the story: The unemployment rate has averaged 3.6% and remained below 4% for more than two years, while inflation is within striking distance of the Fed’s inflation target of 2%. All the while, the economy has grown above the long-term rate of 1.8% since the middle of 2022.
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The jobs report for March, to be released on Friday, will continue these trends. We expect the unemployment rate to fall to 3.8%—which would be the 28th consecutive month of unemployment below 4%— with an increase in total employment of 215,000 jobs. We also expect average hourly earnings to increase by 0.3% on the month and by 4.1% on a year-ago basis.
But can these trends last? Can the economy continue to outperform its long-term rate of 1.8% per year while inflation stays under control and the labor market remains strong?
We think that it is possible.
But continuing such conditions would require the Fed to let go of its obsession with 1970’s cost push inflation, make policy for an economy that has changed in recent years, and for India and China to export a bit of deflation to offset the obvious insufficient aggregate supply conditions. The result would be what we call a 3-2 condition, when unemployment rate stays in the 3% range, below 4%, and inflation is in the 2% range.
In a 3-2 condition, improved productivity, healthy immigration and an appropriate policy mix from the Federal Reserve can help the economy can grow above 1.8% while unemployment ranges between 3.5% and 4% and inflation resides at or near 2.5% to 3%.
Admittedly, it seems somewhat improbable.
Yet there weren’t too many people who thought that a soft-landing scenario for the economy, where inflation would come down amid low unemployment and the economy would expand, was possible. In fact some economists thought that taming inflation would require an unemployment rate above 7%.
The generally recognized minimal level of unemployment that would not cause inflation to move higher, the so-called non-accelerating inflation rate of unemployment, or NAIRU, is 4.4%, according to the Congressional Budget Office’s February estimate.
Because of the perceived trade-off between unemployment and inflation, NAIRU implied that the Fed would not stop fighting inflation until the unemployment rate increased, to 4.4% or more.
And with unemployment averaging 3.6% over the past two years and inflation still elevated above the Fed’s 2% target, that implies the Fed may keep its policy rate at 5.5%.
Some would argue that allowing both low unemployment and low inflation would be unprecedented. But there have been precedents:
- Pre-pandemic: In 2018 and 2019, the annual personal consumption expenditures index—the Fed’s preferred measure of inflation—was 2% and 1.5%, respectively, while the unemployment rate was 3.9% and 3.7%.
- Dot-com boom: In 2000, such a scenario happened at the end of the first tech revolution.
- Postwar surge: Earlier, in the 1950s, it took place during the postwar industrialization of the U.S. economy when the consumer price index was the main inflation measure and the PCE index did not exist.
Admittedly, those three periods comprise a brief period— roughly five years in total out of the 76 years’ of unemployment rate data from the Bureau of Labor Statistics. But in our estimate, as long as the economy continues to grow at 2% (RSM’s forecast is 2.1%) or slightly higher this year—which means outperforming most forecasts but not reaching levels as high as 3% in the fourth quarter last year—we should be able to maintain the 3-2 scenario for at least most of this year.
The Fed seems to agree that it’s happening again. In its March 2024 Summary of Economic Projections, the median estimate of NAIRU was 4.1%, with six members of the Federal Open Market Committee, or a third of the committee, projecting a sub-4% long-term unemployment rate while inflation is expected to reach 2% in the long term.
For this reason, we think that the current federal funds rate of between 5.25% and 5.5% is restrictive. Not reducing the policy rate in the near term could result in higher unemployment and slower growth than necessary, given that PCE inflation is 2.5% and is trending toward 2%.
Why we think it is possible
The economy has been outperforming forecasts over the past two years when many predicted a recession. Now, with job gains expected to remain strong in March, the economy will most likely grow at 2% or higher in the first quarter, higher than the current median forecast of 1.8%.
The adoption of industrial policies and the push to bring supply chains closer to home will be a main driver of low unemployment over the next three to five years as spending filters through the economy.
For example, the triple-digit percentage growth in manufacturing construction spending on new factories like semiconductors will take a couple of years to come online and show up in job gains. Because of the extended time horizon for this latest round of infrastructure spending, the pressure on inflation should be minimal.
We see the recent gains in productivity as the byproduct of private sector investment in maintaining America’s global competitiveness.
At the same time, the potential upsides of artificial intelligence on driving growth and lowering inflation through improved productivity are tremendous. It is likely that AI won’t hurt job growth, similar to the last time we had this kind of productivity boom during the late 1990s, when the internet and personal computers recharged the economy.
Moreover, our proprietary RSM US Middle Market Business Index survey for the first quarter showed that, for the 14th consecutive quarter, senior executives at middle market businesses said they intended to bolster spending on productivity-enhancing equipment, software and intellectual property.
This recent surge in productivity is an echo of the below 4% unemployment rate and 1.9% inflation in 2000, the peak of the dot-com era. A measure of policy dexterity here could be the difference between subpar growth and a period of outperformance.
We see the recent gains in productivity as the byproduct of private sector investment in maintaining America’s global competitiveness. The public investment in infrastructure and advanced manufacturing signal what we think will be sustainable economic growth.
We think that the Fed can manage risks to the outlook carefully even as it reduces a restrictive monetary policy back to a terminal rate between 2.5% and 3% over the next two to three years.
Necessary conditions
Achieving the 3-2 scenario would require a clear and precise policy path from the Fed, as well as a sustained increase in productivity.
Because of the surge in immigration in the past two years, the economy’s sustainable—or non-inflationary—pace of job gains is estimated to be around 200,000 instead of the 100,000 mentioned frequently by the Fed, according to a recent study by the Hamilton Project. That means we are much closer to maintaining full employment than previously thought.
On inflation, we expect that there will be fluctuations as it continues to moderate toward the Fed’s 2% target. But the Fed has signaled that it would tolerate a slightly higher rate if it is necessary to shift its focus toward maintaining growth.
Such flexibility means, in principle, that the Fed should be able to lower interest rates sooner than many expect and with more cuts than what the market is pricing in over the next two to three years.
It will be a necessary condition to keep the economy running above its potential, as well as keeping the unemployment rate below 4%.
All else being equal, if the Fed’s policy holds that the risk of doing too little outweighs the risk of doing too much, the Fed will not likely move away from its risk management mode. That unfortunately means it will most likely miss out on the opportunity to sustain the 3-2 scenario.
Our modified Taylor Rule implies that the federal funds rate should be reduced to a range between 4.75% and 5% in the near term, which underscores our call for the Fed to reduce its policy rate in June. Given our forecast of a modest 2.1% pace of growth this year and unemployment at 4.1%, it is aligned with our call of three rate cuts this year.
But it is also important to acknowledge the risks from the other side of the equation. If interest rates were to remain too restrictive, rising real rates would tip the economy toward higher unemployment and to slower growth, below 1.8%, than would otherwise be the case.
The takeaway
Given the risks around the economic outlook there is no such thing as a perfect monetary policy. We are on board with the risk-management mantra that the Fed has adopted.
Nevertheless, it is also important not to ignore the opportunity costs of each monetary decision. It will certainly be an interesting research topic once we are done with this period of aggressive monetary policy tightening.
It is our contention that the economy is on the cusp of generational technology advances through artificial intelligence and quantum computing.
It is critical that the Fed, despite pervasive incomplete information, not miss the opportunity to support full employment, achieve price stability and bolster the American economy.
