The Federal Reserve embarked on an aggressive tightening cycle in 2022, raising interest rates from nearly 0% to a range between 5.25% and 5.5% in less than 2 ½ years. Despite this, as of July 2024, the unemployment rate remains low at 4.1%. Job growth in the US has also remained robust, averaging 232,000 per month over the past 6 months, significantly higher than the average monthly gains of 190,000 from 2015 to 2019, which was a period of stable economic growth. However, as economic activity in the US continues to slow down, we are observing a linear deceleration in the labor market. The unemployment rate has increased for 3 consecutive months, a trend last seen in 2016. Unemployment is rising despite strong job gains because the unemployment rate is calculated using the household survey from the Bureau of Labor Statistics rather than the establishment survey. According to the household survey, job growth has been much weaker, averaging -95,000 per month over the past 6 months. Additionally, job openings have been declining. Over the past 12 months, job openings decreased by an average of 136,000 per month, dropping from a record high of 12,182,000 in March of 2022 to 8,140,000 as of May 2024, though still considerably higher than the 2019 or pre-pandemic average of 7,154,000.
The risk associated with a prolonged labor market slowdown induced by tight monetary policy is that it could rapidly transition from a linear deceleration to a steeper, nonlinear decline. Identifying proximity to an inflection point in the labor market requires looking beyond current job openings and the unemployment rate; it necessitates statistical analysis to uncover existing nonlinear relationships in the labor market. One prominent example is the relationship between job openings and the unemployment level. Job openings are a crucial indicator measuring open, unfilled positions, while the unemployment level gauges the total number of actively seeking unemployed individuals. In theory, there exists a nonlinear relationship between job openings and the unemployment rate. When unemployment is high, an increase in job openings can significantly reduce unemployment because there are many unemployed individuals available to fill the jobs. However, as unemployment decreases and fewer people are actively seeking jobs, the same increase in job openings will have a smaller impact on reducing the unemployment rate. Conversely, in a high job openings environment, employment levels are typically already high. Therefore, a reduction in job openings might simply reduce the number of unfilled vacancies rather than result in layoffs. As a result, the impact on the unemployment rate is minimized because employed individuals are not directly affected. When job openings are low, a further reduction in job openings will cause displaced workers to struggle to find a new job, causing a greater rise in the unemployment rate. Additionally, in times when job openings are low, further reductions in job openings are often accompanied by broader cost-cutting measures, including layoffs.
The theory of a nonlinear relationship between job openings and the unemployment level finds support when examining data from various periods, such as from 2010 to 2019.
The chart above illustrates the nonlinear relationship between job openings and the unemployment level. The line of best fit was generated using a polynomial model with three degrees. The statistical result of the model is presented below, where the dependent variable is the unemployment level, and the explanatory variable is Job Openings.
The R-squared indicates that our model can explain approximately 98% of the variation in the unemployment level, with all three polynomial terms being highly significant. To further explore how the same decrease in job openings affects the unemployment level differently at various points along the curve, we will utilize the model above to predict the unemployment level based on different levels of job openings.
For instance, when job openings decrease from 7,000,000 to 6,000,000, our model predicts an increase in the unemployment level of 1,095,234. However, a decrease from 4,000,000 to 3,000,000 job openings is predicted to result in a larger rise in unemployment, specifically 2,753,540. This illustrates that a 1,000,000 decrease in job openings leads to a much greater increase in unemployment when job openings are at 4,000,000 compared to when they are at 7,000,000. To further clarify this nonlinear relationship, we can examine the slope of the line of best fit generated by our polynomial model with three degrees across different levels of job openings.
As depicted in the chart above, as job openings decline, the slope of the line of best fit becomes steeper. This suggests that a consistent decrease in job openings will lead to a more pronounced rise in the unemployment level as job openings continue to fall at the same rate.
Using data from the years 2000 to 2010 indicates a similar nonlinear relationship.
As illustrated in the chart above, the line of best fit depicting the relationship between job openings and the unemployment level, created using a polynomial regression model with three degrees, steepens as job openings decline.
Implications for the Federal Reserve
Labor market conditions in the US are coming into better balance. The Fed has emphasized that ongoing progress in achieving balance in the labor market is crucial to gaining confidence that inflation is on a sustainable path towards the Fed's two percent target. During the pandemic, job openings reached an all-time high and have since declined as labor market conditions come into better balance. This trend is also reflected in the ratio of job openings to the unemployment level, which has significantly decreased, as shown in the chart below.
Despite the decrease in job openings, there has not been a substantial increase in the unemployment rate due to the high initial level of job openings.
However, the risk now increases with continued declines in job openings potentially leading to a more pronounced rise in unemployment, as indicated in this analysis. In other words, as job openings continue to decrease, the potential for a nonlinear increase in the unemployment rate grows. The Federal Reserve is closely monitoring this situation. Chairman Powell has cautioned that sustained decreases in job openings could amplify the rise in unemployment, while noting that labor market conditions continue to come into better balance.
Additionally, after inflation progress stalled in Q1 of 2024, recent data on inflation and the ongoing rebalancing of labor market conditions support the narrative that the Fed may feel confident enough to begin lowering interest rates at the September Federal Open Market Committee meeting.
In conclusion, this article highlights the presence of nonlinear dynamics in the labor market that must be carefully considered to assess proximity to an inflection point and understand how continued moderation in labor demand will impact the unemployment rate.
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