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In rare sit-down, Nobel Prize–winning economist Peter Diamond sees ‘significant power shift from employers to workers’ underway

Peter Diamond, winner of the 2010 Nobel Prize in economics, has avoided the press for most of his long and illustrious career, explaining that he is concerned about being misunderstood. When he got the chance to interview him, MarketWatch jumped in.

His supporters think Diamond is probably the brightest of all economists.

His selection by President Barack Obama to serve on the Federal Reserve’s board of governors in 2010 was blocked by Senate Republicans in retaliation as Democrats rejected the confirmation of University of Chicago economist Randall Kroszner for a second. full term on the Fed board in 2009 .

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Since Diamond is an expert on the labor market, we sought a conversation about the Fed, the economy, the labor market and inflation.

Here are five insights from our hour-long talk:

‘I think we’re seeing a significant power shift from employers to employees’

Diamond agreed that the US job market is tight. This is relevant for inflation as it leads to higher wages, which are up 5.2% according to the latest quarterly measurement. The higher wages of employees are driving a boom in spending. Many economists believe the only way the Fed can curb inflation is to weaken workers’ bargaining power by raising unemployment.

But this shift in power, a key driver of inflation, will not be remedied by interest rate hikes. That’s because it’s about supply, not demand.

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Due to the pandemic, workers are beginning to take back some of the power they relinquished in the 1980s, Diamond said.

People in professions such as nursing and education stop because of working conditions. Many employees are looking for a job where they can work from home.

It’s a slow process as companies have to reorganize to make decisions about what to do and how to invest to implement the new plans.

“I think it will give us a more productive workforce,” Diamond said. “But I’m concerned that if we have a severe recession… it will disrupt the whole process. And I don’t know how that disruption will turn out.”

“The job market is different, and it’s going to take a while to sort out, and that’s something to keep in mind,” he said.

So inflation will slow down because one of the main drivers is not as sensitive to slower aggregate demand, he concluded.

‘The message is that you go slow’

In the interview, Diamond said the models of the US economy that the Fed uses to see trends “are not as relevant as people think”. But the same goes for critics of the Fed, such as Larry Summers, former US Treasury Secretary and director of the National Economic Council, he added.

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“The pandemic recession was different. The recovery is different. We don’t fly blind, but [there] is uncertainty,” he said.

As a result, “it seems to me the message is that you go slow,” Diamond said.

Diamond said he agreed with the central bank’s desire to raise interest rates, but “75 basis point moves in one fell swoop are too big.”

Peter Diamond in 2010, when he was awarded the Nobel Memorial Prize in Economic Sciences.

Flickr/US Embassy in Sweden

Most Fed watchers think the central bank will raise its key rate by three-quarters of a percentage point next week to a range of 3% to 3.25%. That will be the third in a row of that magnitude, which would represent the most aggressive rate of increase since 19801981.

Many Fed officials have talked about getting that percentage at or even above 4% by the end of the year.

“I’m not arguing with 4% — it seems like a fair number,” Diamond noted.

“If inflation is falling very slowly, they may need to move on. [But] if inflation is slowing down, and you don’t cause a bad recession, then you keep going.”

Impossible to say whether the US is headed for a severe recession or something milder

Economists are debating how much unemployment needs to rise to bring inflation all the way down to the Fed’s annual target of 2%.

The rule of thumb, known as the Sahm rule, is that the beginning of a recession is signaled when the three-month moving average of the national unemployment rate rises half a percentage point from its lowest point in the past 12 months.

When the pandemic hit in March 2020, unemployment rose to 4.4% from 3.5% in February. It then rose to 14.5% in April, before declining steadily to 3.7% in August.

Optimists, including Fed Chair Jerome Powell and central bank governor Christopher Waller, think the Fed may be able to cool the job market by simply reducing excess demand for workers, as evidenced by the large number of job openings being advertised.

Right now, there are nearly two job openings for every employee seeking a job, according to data from the U.S. Department of Labor.

The relationship between unemployment and job vacancies runs through something called the Beveridge curve.

Pessimists, including Larry Summers, point to the possibility that a 6% unemployment rate might be needed to cool inflation sufficiently. Such a large increase in unemployment implies a deep recession.

Asked to referee and decide the match, Diamond objected.

“Each one of them says, if the Beveridge curve does this, we can make a soft landing. If the Beveridge curve does that, we could have a hard recession,” Diamond said. “I have nothing else to say about that, except to repeat my message: this is uncertainty. You don’t know what kind of recession you’re going to get.”

Little attention has been paid in the debate to the potential impact of a sharp rise in interest rates on hiring workers who are not unemployed. The so-called quit percentage was unusually high.

Summers has forecast a major rise in unemployment but has not specified who will lose their job, Diamond said.

The Fed should abandon the 2% inflation target in favor of a range of 2 to 3%.

Right now, the Fed has a 2% inflation target as one of its operating mandates, and Fed officials are showing no signs of changing their compass.

Diamond thinks this is a mistake. He suggests a range “at least as wide at 2% to 3% and possibly wider at both ends.”

A range, he said, makes more sense than a 2% target. “What’s catastrophic for the US economy is exploding inflation,” Diamond said. “I see no reason to think that a roughly stable 4% [inflation rate] is noticeably different from a roughly stable 3% or 2%,” he said.

What the Fed wants to avoid is the widespread feeling among households that inflation will rise and will no longer be contained – an expectation that could then flow back through wages into an upward spiral of inflation.

Can the Fed avoid that without pushing for a return to 2% inflation?

“So,” Diamond replied, “I think the Fed should recognize that there’s nothing magical about 2%.”

“My take on what they might say is, ‘We’re going in the right direction. There’s no point in rushing because we have these uncertainties and because of the risk of unemployment,’ he said.

A recession may not cure inflation and could make things worse.

Diamond said he is concerned that a recession may not be a cure for inflation, as many – including the central bank – seem to assume. And this can backfire.

“If the Fed does something to drive inflation, and I mean people notice unemployment as a result of the Fed’s actions, and then inflation doesn’t fall or not fall as much as the public expected, then expectations become more explosive, ” he said.

Failing to severely curb inflation would undermine public confidence that the Fed can do the job. If you set the bar high, you invite people to be disappointed.

“Inducing a recession and not bringing inflation back to the satisfaction of expectations is an invitation to higher expectations. This is going to get out of hand,” Diamond said.

The bottom line: Diamond’s moderate stances run counter to Wall Street’s aggressive shift.

Diamond’s comments go against the trend. The Fed and the Bond Market TMUBMUSD10Y,
3.453%
have become more aggressive on the inflation outlook in the wake of the hot consumer price data in August, which led to tremors in DJIA stocks,
-0.45%

spx,
-0.72%,
with the benchmark S&P 500 losing 5% this week and many notable stocks dropping double digits.

Most of the voices currently heavily criticizing the Fed’s policies tend to come from the aggressive side, arguing that the Fed’s key rate may need to rise above 5% to really cool inflation.

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