Time for a rethink

Things are not working out the way the Federal Reserve and the Bank of Canada expected. Their rapid policy tightening is aimed at bringing inflation back to the 2 percent target in both countries.  Inflation is coming down all right: in both the US and Canada it is well below the peak seen in mid-2022, with further declines in prospect in the months ahead.  Yet employment on both countries continues to increase smartly, with little sign of any increase in wage growth.  The 60-year-old Phillips curve proposition that unemployment and inflation are inversely related seems not to apply in today's circumstances. Who knew? (Spoiler alert: quite a lot of people did, just not the decision makers at the central banks).

Canada's December employment data, released this morning, are downright startling.  The economy added 104,000 jobs in the month, far surpassing consensus expectations. The unemployment rate ticked down to 5.0 percent, just 0.1 percent above its all-time record low. The details behind the headline figures are uniformly strong: 85,000 of the new jobs were full-time in nature, and all of the newly-created jobs were in the private sector. The services sector accounted for the bulk of the gains, but there was also increased employment in the goods-producing sectors, apart from manufacturing.  Year-on-year wage gains actually eased to 5.1 percent in December from the 5.6 percent pace posted in the previous month. 

The December employment data for the US are not as remarkable as those for Canada, but still show a labour market that is in robust health despite all the Fed's efforts. The economy added 223,000 jobs in December, slightly above market expectations. This pushed the unemployment rate down to 3.5 percent. There were small downward revisions to the data for October and November, but despite these, 2022 was one of the strongest years on record for US employment. Year-on-year wage gains eased to 4.6 percent in the month from 5.1 percent in November. 

It seems depressingly likely that both the Bank of Canada and the Fed will see today's data as cause for further rate hikes later this month. They should instead be asking themselves whether their whole approach is wrong. The whole Phillips curve approach to inflation fighting relies on the idea that wage rises are a key driver of inflation, meaning that increasing unemployment s the way to get inflation under control. This may once have been true -- back in the 1970s and 1980s maybe -- but it is clearly not the case today.  The global inflation spike resulted from supply chain disruptions, created by the COVID pandemic and then exacerbated by the Russian invasion of Ukraine. Wages have not been part of the problem at any stage, as the December data very clearly show. 

CPI Inflation is going to fall in the coming months whether or not the central banks take any further action -- it's pretty much baked in to the data by the so-called "base effect".  Raising rates further is almost pointless and could at some stage be damaging to the real economy.  Messrs Powell and Macklem -- it's time for a rethink!