An unexpected job surge confounds the Fed's economic models

Does the Federal Reserve have it wrong?

For months, the Fed has been warily watching the U.S. economy's robust job gains out of concern that employers, desperate to hire, would keep boosting pay and, in turn, keep inflation high. But January's blowout job growth coincided with an actual slowdown in wage growth. And it followed an easing of numerous inflation measures in recent months.

The past year's consistently robust hiring gains have defied the fastest increase in the Fed's benchmark interest rate in four decades — an aggressive effort by the central bank to cool hiring, economic growth and the spiking prices that have bedeviled American households for nearly two years.

‘Economic fiction’

Yet economists were astonished when the government reported last week that employers added an explosive 517,000 jobs last month and that the unemployment rate sank to a new 53-year low of 3.4 percent.

"Today's jobs report is almost too good to be true," Julia Pollak, chief economist at ZipRecruiter said Jan. 3. "Like $20 bills on the sidewalk and free lunches, falling inflation paired with falling unemployment is the stuff of economics fiction."

In economic models used by the Fed and most mainstream economists, a job market with strong hiring and a low unemployment rate typically fuels higher inflation. Under this scenario, companies feel compelled to keep boosting wages to attract and keep workers. They often then pass those higher labor costs on to their customers by raising prices. Their higher-paid workers also have more money to spend. Both trends can feed inflation pressures.

Yet even as hiring has been solid in the past six months, year-over-year inflation has slowed from a peak of 9.1 percent in June to 6.5 percent in December. Much of that decline reflects cheaper gas. But even excluding volatile food and energy costs, the Fed's preferred inflation gauge has risen at about a 3 percent annual rate over the past three months — not so far above its 2 percent target.

Those trends have raised questions about a core aspect of the Fed's higher rate policy. Chair Jerome Powell has said that conquering inflation would require "some pain." And the Fed's policymakers have forecast that the unemployment rate would rise to 4.6 percent by the end of this year. In the past, an increase that large in the jobless rate has occurred only during recessions.

Yet the report suggests the possibility that the long-standing connection between a vigorous job market and high inflation has broken down. And that breakdown holds out a tantalizing possibility: That inflation could continue to decline even while employers keep adding jobs.

"Their model is that this inflation is driven specifically by wage inflation," said Preston Mui, senior economist at Employ America, an advocacy group. "In order to get that down, they think we have to bring some pain in the labor market in terms of higher unemployment. And what the past three months have shown us is that that model is just wrong."