Peter Diamond, the 2010 Nobel Prize winner in economics, has kept away from journalism for most of his long and illustrious career, stating that he worries about being misunderstood. Given the opportunity to interview him, MarketWatch jumped at it.
His supporters believe Diamond may be the smartest economist.
His selection by President Barack Obama to serve on the Federal Reserve Board of Governors in 2010 was blocked by Senate Republicans in a retaliatory move as Democrats blocked Randall Kreuzner’s confirmation of the University of Chicago economist for a second full term on the Federal Reserve in 2009.
Since Diamond is an expert on the labor market, we sought to have a conversation about the Federal Reserve, the economy, the labor market, and inflation.
Here are five insights from our hour-long conversation:
“I think we’re seeing a huge shift in power from employers to workers”
Diamond agreed that the US labor market is tight. This is closely related to inflation as it leads to higher wages, rising at a pace of 5.2% in the last quarterly reading. Higher wages for workers are fueling the spending boom. Many economists believe that the only way the Fed can lower inflation is to weaken workers’ bargaining power by raising the unemployment rate.
But this shift in power, the main driver of inflation, will not be addressed by raising interest rates. This is because it is about supply, not demand.
Because of the pandemic, Diamond said, workers are beginning to regain some of the power they gave up in the 1980s.
People in professions such as nursing and education leave work because of working conditions. Many workers are looking for jobs that allow them to work from home.
It’s a slow process because companies have to reorganize to make decisions about what to do and how to invest to implement the new plans.
“I think that will give us a more productive workforce,” Diamond said. “But I worry that if we get a bad recession… it will disrupt the whole process. And I don’t know how this disruption will end.”
“The job market is different, and it will take some time to get resolved, and that is something to keep in mind,” he said.
He concluded that inflation will only decline slowly because one of its main drivers is not very sensitive to slowing aggregate demand.
“The message is that you’re going slow.”
In the interview, Diamond said that the models of the US economy that the Federal Reserve uses to see trends “are not as relevant as people think.” He added that the same applies to critics of the Fed such as Larry Summers, the former US Treasury secretary and director of the National Economic Council.
Epidemiological stagnation was different. Recovery is different. We don’t fly blind, but [there] It is uncertainty,” he said.
As a result, “it seems to me the message is that you’re going slow,” Diamond said.
Diamond said he agreed with the central bank’s desire to raise interest rates, but “moves by 75 basis points in a very big blow.”
Most Fed watchers believe the central bank will raise its policy rate by three-quarters of a percentage point next week to a range of 3% to 3.25%. This would be the third consecutive move of this magnitude, which would represent the most aggressive rate hike since 1980 – 1981.
Several Federal Reserve officials have talked about raising that rate to, or even higher, 4% by the end of the year.
“I have no argument with 4% – it seems like a reasonable number,” Diamond commented.
If inflation drops too slowly, they may have to move on. [But] If inflation is going down slowly, and you’re not the cause of a bad recession, then you’re going to continue.”
It is impossible to say whether the US is heading into a severe recession or something milder
Economists debate how much unemployment must rise to reduce inflation all the way to the Fed’s annual 2% target.
The general rule, known as Sahm’s rule, is that the onset of a recession is signaled when the three-month moving average of the national unemployment rate rises by half a percentage point relative to its lowest level in the past 12 months.
When the pandemic hit in March 2020, the unemployment rate jumped to 4.4% from 3.5% in February. It then rose to 14.5% in April before falling steadily to 3.7% in August.
Optimists, including Federal Reserve Chair Jerome Powell and Central Bank Governor Christopher Waller, believe the Fed may be able to cool the labor market simply by reducing the excess demand for workers that shows up in the large number of job vacancies being announced.
Right now, there are roughly two job openings for every worker looking for a job, according to U.S. Department of Labor data.
The relationship between unemployment and employment is through what is called the Beveridge curve.
Pessimists including Larry Summers suggest a 6% unemployment rate may be needed to sufficiently cool inflation. Such a large increase in unemployment means a deep recession.
When he was asked to play the referee and decide to compete, Diamond objected.
“Every one of them says, ‘If the Beveridge curve does that, we can go down gently. If the Beveridge curve does that, we can have a hard slump.’” I don’t have anything different to say about it, except to reiterate my message : This is uncertainty. You don’t know what kind of slack you’re going to get.”
Little attention in the debate has focused on how the sharp rise in interest rates affects the employment of unemployed workers. The smoking cessation rate was unusually high.
Diamond said Summers expected a significant jump in the unemployment rate but did not specify who would lose their jobs.
The Fed should abandon its 2% inflation target in favor of a broad range of 2% to 3%.
Right now, the Fed as one of its operating mandates has a 2% inflation target, and Fed officials are showing no sign of wanting to change their compass.
Diamond thinks this is wrong. He suggests a range “at least as large as 2% to 3% and possibly wider on both ends.”
The range makes more sense than the 2% target, he said. “What is a disaster for the American economy is explosive inflation,” Diamond said. “I see no reason to believe that 4% is roughly flat [inflation rate] It differs markedly from the roughly flat 3% or 2% rate.”
What the Fed wants to avoid is the feeling among households that the rate of inflation will rise and not be reined in again – an expectation that, through wages, may fuel an upward spiral of inflation.
Can the Fed avoid this without pressing for a return to 2% inflation?
Diamond replied, “So, I think the Fed should realize that there is nothing magical about 2%.”
“My take on what they can say is, ‘We’re moving in the right direction. It makes no sense to hurry because we have these doubts and because of the risks of unemployment.
Recession may not cure inflation, and it may make it worse.
Diamond said his concern is that stagnation may not be a cure-all for inflation, as many – including the central bank – seem to assume. This may be counterproductive.
“If the Fed does something to curb inflation, and I mean people notice unemployment coming from Fed actions, and then inflation doesn’t go down or as much as the public expected, then the forecast piece becomes more explosive,” he said.
Failure to cut inflation sharply would undermine public confidence in the Fed’s ability to do the job. When you set a high ceiling, you invite people to be disappointed.
“Splitting a stagnation and not bringing inflation to a level that satisfies expectations is an invitation to higher expectations. This is going to get out of control,” Diamond said.
Bottom line: Diamond’s cautious views contrast with the hawkish shift on Wall Street.
Diamond’s statements contradict this trend. Federal Reserve Bank and Bond Market TMUBMUSD10Y,
They became more hawkish about inflation expectations in the wake of hot consumer price data in August, which sent tremors in DJIA shares,
Most of the voices criticizing Fed policy loudly at the moment tend to be from the hawkish camp and argue that the Fed’s policy rate may have to rise above 5% to really cool inflation.