Crosscurrents Hide a Rapidly Cooling Labor Market

To understand why, it helps to identify three distinct forces currently at work: first, Covid-19 and its aftermath; second, the normal business cycle; third, the supply of labor.  

Let’s take each of these in turn. 

First, since the economy reopened after the pandemic lockdowns of early 2020, employers have struggled to fill vacant positions. 

In fact some sectors are so understaffed, their hiring has been virtually impervious to business conditions. Total employment in leisure and hospitality, education and health and government expanded at a 4.6% annual rate in the three months through March—little changed from a year earlier. This tells us little about the underlying state of labor demand.

Second, let’s look at sectors less afflicted by Covid, and more sensitive to the business cycle. Employment in retail trade, construction, manufacturing and finance was growing more than 4% annualized a year ago, but in the three months through March 2023 that had slipped to 0.7%. 

Other indicators point to labor demand falling back: the number of job vacancies has plummeted by 17%, or 2 million, in the past year. Last week the Labor Department revised weekly data on new claims for unemployment insurance and, instead of staying low, they now appear to have been trending higher since January. Private surveys, such as by the National Federal of Independent Business, show less hiring. 

This shouldn’t come as a surprise. The Fed began raising interest rates a year ago specifically to slow the economy and cool off a labor market it considered too tight. It has actually taken longer than expected, in part because higher interest rates hadn’t really done much to tighten overall financial conditions, such as the level of stock prices or the availability of credit.

That changed in mid-March when two regional banks failed and deposits flooded out of small and midsize banks. In its Global Financial Stability Report released Tuesday, the International Monetary Fund said banks’ stock prices are strongly correlated to their willingness to lend and their recent fall pointed to bank lending in the coming year falling by 1% and economic growth lower by 0.44 percentage point.

The IMF still expects the U.S. economy to grow 1.6% this year but worries the recent banking stress will spread if central banks keep interest rates high, or raise them further, to combat inflation. “A hard landing—particularly for advanced economies—has become a much larger risk,” it said.

Will the Fed head off that risk by using the latest evidence of weakening labor demand to conclude its job is done, and lower interest rates? Probably not, which brings us to the third factor in the labor market: supply. It is still constricted, which is helping to sustain wage and inflation pressure.

To be sure, it is less constricted than before. The labor-force participation rate—the share of working-age people employed or looking for work—fell from 63.3% in February, 2020, to 61.5% at the end of that year, but has since recovered to 62.6% in March. Moreover, because the population is aging, participation would have fallen even without the pandemic, and indeed it is roughly where the Congressional Budget Office, in early 2020, projected it would be now. For people aged 25-54, participation is 83.1%, higher than in February, 2020.

This doesn’t mean, though, that the labor supply is fine. First, even if the loss of some retiring baby boomers was expected, that still leaves a hole in the labor force that employers have to fill. Second, the U.S. population is 1.4 million people smaller and the labor force 900,000 smaller than would have been expected in 2019 because of deaths from Covid and reduced immigration, according to a study by Wendy Edelberg, director of the Hamilton Project, a liberal think tank, and three co-authors. (Immigration has rebounded somewhat in the past year.) 

Third, the people who are employed worked 0.6 fewer hours a week in the last quarter of 2022 than in the months just before the pandemic, according to a Brookings Institution study co-written by University of Maryland economist Katharine Abraham. This is equivalent to 2.3 million fewer workers. Some of that might be because of the effects of Covid on their health, and some might reflect people simply wanting to spend less time working, the study said. 

Add it all up, and there simply isn’t as much labor for employers to draw on. So even if their need for labor has cooled, they must still pay up. Wage growth has slowed in recent months, but not to levels consistent with 2% inflation. The modest 0.3% rise in hourly pay in March was more like 0.4% when adjusted for the shifting composition of jobs, according to independent analyst Riccardo Trezzi, formerly an economist with the Fed and the European Central Bank.

The bottom line is that while labor demand may be weakening, it will likely have to weaken further, perhaps into recessionary territory, for the Fed to consider easing.

Write to Greg Ip at greg.ip@wsj.com

To understand why, it helps to identify three distinct forces currently at work: first, Covid-19 and its aftermath; second, the normal business cycle; third, the supply of labor.  

Let’s take each of these in turn. 

First, since the economy reopened after the pandemic lockdowns of early 2020, employers have struggled to fill vacant positions. 

In fact some sectors are so understaffed, their hiring has been virtually impervious to business conditions. Total employment in leisure and hospitality, education and health and government expanded at a 4.6% annual rate in the three months through March—little changed from a year earlier. This tells us little about the underlying state of labor demand.

Second, let’s look at sectors less afflicted by Covid, and more sensitive to the business cycle. Employment in retail trade, construction, manufacturing and finance was growing more than 4% annualized a year ago, but in the three months through March 2023 that had slipped to 0.7%. 

Other indicators point to labor demand falling back: the number of job vacancies has plummeted by 17%, or 2 million, in the past year. Last week the Labor Department revised weekly data on new claims for unemployment insurance and, instead of staying low, they now appear to have been trending higher since January. Private surveys, such as by the National Federal of Independent Business, show less hiring. 

This shouldn’t come as a surprise. The Fed began raising interest rates a year ago specifically to slow the economy and cool off a labor market it considered too tight. It has actually taken longer than expected, in part because higher interest rates hadn’t really done much to tighten overall financial conditions, such as the level of stock prices or the availability of credit.

That changed in mid-March when two regional banks failed and deposits flooded out of small and midsize banks. In its Global Financial Stability Report released Tuesday, the International Monetary Fund said banks’ stock prices are strongly correlated to their willingness to lend and their recent fall pointed to bank lending in the coming year falling by 1% and economic growth lower by 0.44 percentage point.

The IMF still expects the U.S. economy to grow 1.6% this year but worries the recent banking stress will spread if central banks keep interest rates high, or raise them further, to combat inflation. “A hard landing—particularly for advanced economies—has become a much larger risk,” it said.

Will the Fed head off that risk by using the latest evidence of weakening labor demand to conclude its job is done, and lower interest rates? Probably not, which brings us to the third factor in the labor market: supply. It is still constricted, which is helping to sustain wage and inflation pressure.

To be sure, it is less constricted than before. The labor-force participation rate—the share of working-age people employed or looking for work—fell from 63.3% in February, 2020, to 61.5% at the end of that year, but has since recovered to 62.6% in March. Moreover, because the population is aging, participation would have fallen even without the pandemic, and indeed it is roughly where the Congressional Budget Office, in early 2020, projected it would be now. For people aged 25-54, participation is 83.1%, higher than in February, 2020.

This doesn’t mean, though, that the labor supply is fine. First, even if the loss of some retiring baby boomers was expected, that still leaves a hole in the labor force that employers have to fill. Second, the U.S. population is 1.4 million people smaller and the labor force 900,000 smaller than would have been expected in 2019 because of deaths from Covid and reduced immigration, according to a study by Wendy Edelberg, director of the Hamilton Project, a liberal think tank, and three co-authors. (Immigration has rebounded somewhat in the past year.) 

Third, the people who are employed worked 0.6 fewer hours a week in the last quarter of 2022 than in the months just before the pandemic, according to a Brookings Institution study co-written by University of Maryland economist Katharine Abraham. This is equivalent to 2.3 million fewer workers. Some of that might be because of the effects of Covid on their health, and some might reflect people simply wanting to spend less time working, the study said. 

Add it all up, and there simply isn’t as much labor for employers to draw on. So even if their need for labor has cooled, they must still pay up. Wage growth has slowed in recent months, but not to levels consistent with 2% inflation. The modest 0.3% rise in hourly pay in March was more like 0.4% when adjusted for the shifting composition of jobs, according to independent analyst Riccardo Trezzi, formerly an economist with the Fed and the European Central Bank.

The bottom line is that while labor demand may be weakening, it will likely have to weaken further, perhaps into recessionary territory, for the Fed to consider easing.

Write to Greg Ip at greg.ip@wsj.com