America's good fortune on unemployment may be short-lived

The New York Times highlights that the surge in inflation may be subsiding, but new economic challenges are emerging as the labour shortage wanes. 

Gauti Eggertsson, an Icelandic economist at Brown University, is known for his insightful observations on economic phenomena. He introduced the concept of the "paradox of toil," which highlights how increased individual work desires can lead to reduced overall employment. Eggertsson recently coined a new term, the "Beveridge threshold," at the annual economic conference in Jackson Hole, Wyoming.

This concept is significant because, if accurate, it helps explain why inflation has decreased sharply without a corresponding rise in unemployment, and why further reductions in inflation may not be straightforward. In a discussion last week, Eggertsson expressed pride in his latest term and hopes it gains traction.

He, along with Pierpaolo Benigno from the University of Bern, presented a paper at Jackson Hole that introduced the Beveridge threshold. Their framework suggests that the risk of increased unemployment now outweighs the risk of inflation rising, which aligns with expectations from Fed Chair Jerome Powell regarding upcoming Federal Open Market Committee decisions. 

The Beveridge threshold is named after William Henry Beveridge, a British economist known for his advocacy of comprehensive social insurance. Despite his extensive work on labor market dynamics, Beveridge himself did not create the curve named after him, which depicts the inverse relationship between unemployment rates and job vacancies. The term "Beveridge threshold" adds to the legacy of concepts associated with Beveridge, albeit ones he did not directly coin. These three paragraphs delve into some technical concepts, but here’s a simplified explanation.

The Beveridge curve can be expressed numerically, showing the ratio of job vacancies to job seekers. The Beveridge threshold, as defined by Benigno and Eggertsson, is the point where there is exactly one job opening for each unemployed person. Although this doesn’t guarantee easy employment—since job requirements and geographic mismatches might still pose barriers—when the number of vacancies exceeds this threshold, the labor market becomes excessively tight, leading to a “labor shortage” condition. 

Benigno and Eggertsson analyzed 111 years of US economic data, including six major inflation spikes, and found that in a tight labor market, where job vacancies outnumber job seekers, the vacancy rate increases significantly even with only a slight drop in unemployment. Additionally, a small uptick in economic activity can cause a sharp rise in inflation, making the Phillips curve steeper. Conversely, in a loose labor market, where there are more job seekers than openings, it takes a substantial drop in economic activity to reduce inflation even slightly. For those not versed in economics, this helps explain the recent job market and inflation trends.

During and after the Covid recession, the job market was severely disrupted. As the economy recovered, spending patterns shifted dramatically, and many job seekers lacked the skills needed for available positions. The ratio of vacancies to unemployed surged to its highest since World War II. Despite predictions from some economists that high unemployment would be necessary to lower inflation, Powell and others, including Benigno and Eggertsson, hoped for a soft landing, which largely occurred. Inflation eased as vacancies dropped rather than unemployment rising. 

The debate continues over whether the inflation surge during President Biden’s term was driven more by supply issues, such as Covid-related disruptions, or by demand factors, including pandemic relief funds and increased spending. The authors attribute two-thirds of the inflation to demand factors and suggest that significant demand must push the economy past the Beveridge threshold for supply shocks to have a notable impact. Eggertsson shared an anecdote about his family being turned away from a restaurant due to staff shortages, despite plenty of open tables, illustrating the real-world implications of labor market tightness.

He noted that some economists may prefer to blame supply shocks for inflation to avoid attributing it to demand-driven factors, which could be politically sensitive. While the worst of the inflation surge may be behind us, new risks are emerging as the labour shortage recedes. Benigno and Eggertsson have identified an unemployment rate tied to their Beveridge threshold, marking the point where the labour market is no longer tight. They estimate this threshold at about 4.4 per cent, slightly above the actual 4.3 per cent unemployment rate reported in July. 

This “Beveridge threshold unemployment rate” might become a valuable tool for policymakers moving forward. If it does gain traction, you heard it here first. Regarding current monetary policy, if the economy slows further and we have moved past the Beveridge threshold, the unemployment rate might rise significantly beyond its current level.

Alternatively, though less likely, there is a chance their calculations could be incorrect and the labor market could still be tight, potentially increasing the risk of inflation spikes. Over the past three years, attention has largely been focused on combating high inflation, which has been a pressing concern. However, if Benigno and Eggertsson’s predictions hold true, the potential rise in unemployment could be a more pressing issue now. 

Recent data from the Bank of America Institute, which analyzed anonymized credit card transactions, shows consumers are opting for cheaper clothing in response to high inflation. Since July 2022, spending on discount retail items per household has grown faster than overall retail spending. The market share for budget-friendly apparel has risen nearly four percentage points among Gen Z and Millennials over the past year, with a more pronounced increase among lower- and middle-income consumers.