In rare situations, Nobel Prize-winning economist Peter Diamond sees a “significant power shift from employers to workers” taking place

Peter Diamond, winner of the 2010 Nobel Prize in Economics, has shied away from the press for most of his long and illustrious career and says he worries about being misunderstood. Given the chance to interview him, MarketWatch jumped on it.

His supporters think Diamond is the smartest economist.

His selection by President Barack Obama for the Federal Reserve Board of Governors in 2010 was blocked by Senate Republicans in retaliation after Democrats voted to confirm University of Chicago economist Randall Kroszner to a second full term on the Fed’s board in the year blocked in 2009 .

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

Here are five takeaways from our hour-long conversation:

“I think we’re seeing a clear power shift from employers to workers”

Diamond agreed that the US job market is tight. This is relevant for inflation as it translates into higher wages rising 5.2% in the latest quarterly reading. Higher wages for workers are fueling a spending boom. Many economists believe the only way the Fed can bring inflation down is to weaken workers’ bargaining power by raising the unemployment rate.

But this shift in power, a key driver of inflation, will not be cured by raising interest rates. Because it’s about supply, not demand.

Because of the pandemic, workers are starting to reclaim some of the power they ceded starting in the 1980s, Diamond said.

People in jobs like care and education quit because of the working conditions. Many workers are looking for jobs that allow them to 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’s going to give us a more productive workforce,” Diamond said. “But I’m concerned that if we get a bad recession… it’s going to disrupt the whole process. And I don’t know how this disruption will play out.”

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

So inflation will only come down slowly because one of its main drivers isn’t as sensitive to slowing aggregate demand, he concluded.

“The message is that you go slowly”

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

“The pandemic recession was different. The recovery is different. We’re not flying blind, though [there] is uncertainty,” he said.

As a result, “the message seems to me to be that you’re going slow,” Diamond said.

Diamond said he agrees with the central bank’s desire to hike 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 Economics.

Flickr/US Embassy in Sweden

Most Fed watchers believe the central bank will hike interest rates by three-quarters of a percentage point next week to a range of 3% to 3.25%. That would be the third straight move of this magnitude, marking the most aggressive rate hike since 19801981

Many Fed officials have talked about bringing this rate to or even above 4% by the end of the year.

“I have no argument against 4% – it seems like a reasonable number,” Diamond commented.

“If inflation comes down very slowly, they might have to go further. [But] If inflation slows down and you don’t trigger a bad recession, then go ahead.”

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

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

The rule of thumb known as the Sahm Rule states that the onset of a recession is signaled when the three-month moving average national unemployment rate rises half a percentage point from its low in the last 12 months.

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

Optimists, including Fed Chairman Jerome Powell and Central Bank Governor Christopher Waller, believe the Fed may be able to cool down the labor market simply by reducing excessive labor demand, which is reflected in the large number of job vacancies.

According to the US Department of Labor, there are currently almost two open positions for every job-seeking worker.

The relationship between unemployment and vacancies is determined by what is known as the Beveridge curve.

Pessimists like Larry Summers point to the possibility that a 6% unemployment rate may be needed to sufficiently cool inflation. Such a sharp rise in unemployment implies a deep recession.

When asked to referee and decide the competition, Diamond hesitated.

“Every one of them says: If the Beveridge curve does that, we can have a soft landing. If the Beveridge curve does that, we can have a hard recession,” Diamond said. “I have nothing to say about that other than repeating my message: This is uncertainty. You don’t know what kind of recession you’re going to get.”

Little attention was paid in the debate to how a sharp rise in interest rates might affect hiring of workers who are not unemployed. The so-called acknowledgment rate was unusually high.

Summers has predicted a big rise in unemployment but hasn’t specified who will lose their job, Diamond said.

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

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

Diamond thinks that’s a mistake. He suggests a range that should be “at least that wide at 2% to 3% and possibly wider at both ends.”

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

What the Fed wants to avoid is a widespread sentiment among householders that inflation will rise and not be reined in – an expectation that could then spiral back through wages.

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

“So,” Diamond replied, “I think the Fed should realize that 2% isn’t magic.”

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

A recession may not cure inflation, and it could make matters worse.

Diamond said one concern for him is that a recession may not be a cure for inflation, as many – including the central bank – seem to think. And that could backfire.

“If the Fed does something to hammer inflation, and I mean people notice that unemployment is coming from what the Fed is doing, and then inflation doesn’t come down or it doesn’t come down as much as the public expected, then it will the anticipation piece more explosive.” he said.

Failure to cut inflation drastically would undermine public confidence in the Fed’s ability to carry out this task. When you set the bar high, you invite people to be disappointed.

“Triggering a recession and not allowing inflation to live up to expectations is an invitation to higher expectations. This is going to get out of hand,” Diamond said.

Bottom Line: Diamond’s dovish views are at odds with Wall Street’s dovish bias.

Diamond’s comments go against the trend. The Fed and the bond market TMUBMUSD10Y,
have turned down the outlook for inflation on the back of hot August CPI data that have sent shockwaves through to DJIA stocks.

with the benchmark S&P 500 down 5% this week and many notable stocks falling double-digit percentages.

Most of the voices currently vocally criticizing the Fed’s policies are more hawkish, arguing that the Fed’s interest rate may need to rise above 5% to really cool inflation.

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