The latest consumer price index (CPI) report released Wednesday, May 11, has confirmed that the U.S. Federal Reserve has a long way yet to go in its fight against inflation. Core inflation — all items except food and energy — rose 6.2% year over year in April, keeping it at a level not seen in nearly 40 years.
Much of this is, no doubt, created by supply shocks, which fall outside the central bank’s area of control, as Fed Chair Jerome Powell pointed out in his press conference earlier this month. The Fed can, however, affect demand in the historically tight labor market. Its plan to continue implementing 50 basis point (bps) rate hikes should introduce some slack — but the question is, how far will it have to go to achieve its goal on inflation?
We are starting to see a moderate wage-price spiral developing in the United States, and as I've looked at the landscape, I don’t see a clear path to bring inflation back to the Fed’s 2% target without putting the economy into a recession.
Here are four charts about labor dynamics that explain why I believe this is the case:
1. Workers expect bigger salaries to make up for higher prices
Inflation expectations largely track food and fuel prices

Sources: University of Michigan, Bureau of Labor Statistics. Data as of April 30, 2022. Shaded areas represent recessions.
2. Employers are raising wages given tight market
Compensation soars as unemployment returns to pre-pandemic lows

Sources: Bureau of Labor Statistics, Congressional Budget Office. ECI = employment cost index. Data as of April 30, 2022. Shaded areas represent recessions.
3. Productivity growth is not offsetting compensation costs
Less for more: Productivity declines as wages rise

Source: Bureau of Labor Statistics. CPI = consumer price index. Data as of April 30, 2022. Shaded areas represent recessions.
4. Relieving this pressure could require growth to slow well below potential
Okun’s law indicates growth must slow to bring inflation down

Source: Capital Group calculations, Bureau of Labor Statistics, Congressional Budget Office, Bureau of Economic Analysis. Data as of April 30, 2022. GDP = gross domestic product. Potential GDP is the theoretical level of where a country’s GDP should be if all its resources are fully employed, Y-axis on the right-hand side of the chart is inverted to illustrate the correlation between GDP and unemployment. Shaded areas represent recessions.
The bottom line
Inflation appears to be increasingly entrenched and persistent. Interest rates, both short- and long-term, could go up more than the market expects. The only way to really break the wage-price spiral, in my view, is to create a lot of slack in the labor market, which is done by pushing the unemployment rate up, which in turn could lead us into a recession.
There are, of course, alternative scenarios that could come to pass, including: 1) inflation falls of its own volition, 2) the Fed capitulates and lets inflation run unchecked, or 3) the Fed achieves a “soft landing” (a moderate economic slowdown). However, none of these appear to me to be high-probability outcomes, and a soft landing may not free up much slack anyway.
Given the Fed’s focus on taming inflation, which is being exacerbated by recent developments that include rolling COVID-19 shutdowns of cities in China and a prolonged Russia-Ukraine conflict, there is now a higher probability that we may be in a recession by the end of 2022 or early 2023.