The labor shortage could lead to a recession next year

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Opinion by Gad Levanon for CNN Business Perspectives

Over the past 12 months, US consumer prices rose by 7.5%, the highest rate in nearly 40 years. Worse, inflation is showing no signs of slowing.

The Federal Reserve typically fights inflation by raising interest rates, which slows the economy by reducing the demand for goods and services. Ideally, the rate increases are sufficient to slow inflation without leading to a recession. But the problem is that the Fed cannot precisely control the rate of economic growth. So with the central bank expected to raise rates next month, barring a major impact on the US economy from the war in Europe, the question remains: Can the Fed contain inflation without triggering a recession?

While we probably won’t see a downturn this year, a recession next year is becoming increasingly likely, for a number of reasons.

First, there is typically a lag between an interest rate hike and its economic effect. Some estimates suggest that it takes one to two years for the impact of monetary policy to peak. While the Fed is likely to start raising rates in March, most of its hikes are likely to occur in the second half of this year. That means that the negative economic impact will be much stronger in 2023 than in 2022.

Second, the in-person services sector, hard-hit by the pandemic, is likely to continue its rapid growth through 2022. Spending on things like restaurants, hotels, entertainment, public transportation, hairdressers, gyms and many other consumption categories may not fully recover in 2022, but the receding fear of the pandemic will spur strong growth.

That may sound like good news, but most of the positive impact of the recovery of in-person services will trail off by early 2023. Spending on these services will have normalized by then, just as the higher interest rates pack their strongest wallop.

What’s more, a strong recovery in in-person services this year will also fuel the demand for workers, which we at the Burning Glass Institute expect to grow by about 4 million during 2022. We expect that to lower the unemployment rate from 4% now to below 3% in early 2023. This low unemployment will sustain wage pressures, which will continue to feed inflation. In the second half of 2022, the Federal Reserve may find that, despite its early interest rate hikes, inflation is not coming down much. The Fed’s hard-earned credibility on containing inflation will erode. With pressure to contain inflation mounting, it may raise interest rates faster than it currently predicts, and further depress economic growth in 2023.

Far from receding with the pandemic, the labor shortage will become the new normal. Pandemic-related factors such as the drop in immigration, early retirements and lower labor force participation among working-age people combined with long-running underlying trends have radically reduced the US labor supply. In 2020, for example, the working-age population of the US started shrinking, driven by longer-term factors like the baby boomer generation aging and retiring. In addition, women’s labor force participation rate stopped growing, while that of men and young adults have declined dramatically even before the pandemic.

The fact is that labor shortages are not going anywhere. Would the Fed’s interest rate hikes be enough to set off a 2023 recession? That’s not yet clear, but it is a real possibility. What is certain is that the dwindling labor supply is becoming a serious constraint on US economic growth.

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